When it comes to the current market conditions in the corporate bond market, some see a liquidity problem, while others see a ticking time bomb.
A commonly quoted statistic is a Federal Reserve estimate that dealer inventories are down 75 to 78 percent from their 2007 highs, and it is widely assumed that capital constraints imposed by the Basel accords in Europe and by the Dodd-Frank Act in the U.S. will continue to keep those inventories low.
Everyone knows there is this massive overhang of inventory in the hands of the buyside community at exactly the same time that the dealer community the world over has had a very dramatic reduction in the capital available to facilitate that trading, said John Kelly, chief operating officer of Liquidnet, which entered the bond market in March with the acquisition of Vega-Chi.
With rates being kept artificially low by Federal Reserve monetary policy, there has been relatively little activity in the bond markets to upset a fragile balance.
We have had this extended period of low interest rates and stable interest rates, so everyone is getting by, Kelly said. When those rates start to turn up and the buyside is biased more to the selling of fixed income than the holding of fixed income, then this problem that everyone is staring at will be real.
Some point to a sharp sell-off of bonds in June of last year when then-Federal Reserve Chairman Ben Bernanke discussed an end to tapering as a small preview of what the market could look like.
Its going to be an ugly exit, said Michael Chuang, chief executive of iTBconnect, a bond platform that connects bond market participants to multiple ECNs. It will be very ugly.
Enter Electronic Bond Trading
For the corporate bond market, where trading has historically been bilateral and relationship-driven, some see these market conditions as ushering in electronic trading in levels that proponents of electronic bond trading have long anticipated.
When bond prices fall, there will be an enormous catalyst to adopt the platforms because volatility will return, secondary trading will return, and people will need to get out of bonds and dealers cant buy them, said iTBconnects Chuang. There will be no place else to go. There are $10 trillion in U.S. corporate bonds. That is way too big of a market for there to be no liquidity. That is going to be a major catalyst for electronic trading.
Wider adoption of electronic trading might not even be enough to handle trading volumes in the event of a sharp sell-off, Chuang says.
Its like having a fire extinguisher in a house thats burning down. At least you have a fire extinguisher, he says.
The predictions from analysts on the effect of these market forces on electronic trading vary widely. Tabb Group analyst Radi Khasawneh predicts a substantial increase in electronic trading, estimating that by 2016 electronic trading will increase to 37 percent of the overall corporate bond market from 24 percent today.
Noting that buyside-only markets with participants trading only their own interests have failed to take off, Khasawneh explained that having sellside involvement in a model will be key. That said, many dealer-to- client platforms are beginning to expand trading protocols, with a variety of innovative trading models that may have the potential to solve different market issues.
The one issue that needs to be grappled [with] is how do you incentivize dealers to continue making markets in those environments, Khasawneh said.
Meanwhile, John Mangano, Aite Group fixed income analyst and a former sellside trader with Fidelity Capital Markets, expects buyside firms to be wary of electronic platforms in volatile times. Especially in volatile markets, the buyside is going to want the color that it gets from the dealer community, he said.
According to Mangano, buyside firms aim for as close to a complete picture as they can get, and there wont be one platform able to provide that until there is a platform that shows the majority of the liquidity in the market.
Its almost like the buyside wants a super-aggregator, where it all comes together in one place and they can see all the different bids and offers on given securities from MarketAxess and from Bloomberg and what-have-you, he said. I see that a long way off.
Finding New Models
Nevertheless, the electronic platforms have been lining up to serve a market that many see as poised for some kind of shift. Most of the platforms offer new trading models aimed at branching out from the request-for-quote model that is considered less efficient than equity markets, but is the primary model that has been able to chalk up a proven track record so far in electronic trading of corporate bonds.
According to Liquidnet, tackling the macro issues facing the corporate bond market was a prime driver in its decision to branch out from its comfortable position as operator of an equity dark pool and enter the bond market with the acquisition of Vega-Chi. It is one of the most important problems to be solved in capital markets around the world, Kelly said.
While most of Vega-Chi users are buyside so far, Vega-Chis is an all-to-all market, meaning buyside and sellside clients have the same abilities to submit bids or access liquidity anonymously. Through the acquisition by Liquidnet, Vega-Chi has been introduced to more than a dozen dealers who are members of Liquidnets H2O market. Liquidnet is also introducing Vega-Chi to the fixed income counterparts of its 740 asset management clients, said Vega-Chi founder and CEO Constantinos Antoniades.
Vega-Chi, which trades only high-yield in the U.S. so far, operates two anonymous markets. Its lit market is patterned on a central limit order book, where at the time a bid is posted, its price, size and direction are visible to the marketplace and available to all participants as live actionable liquidity. Its dark market is a block order market with a minimum size of $5 million that shows only the bond being traded but not the order size, direction or price. The platform will expand from high-yield into investment grade in the first quarter of next year.
What we try to deliver is a set of protocols which concentrates liquidity in one particular bond without making details of the liquidity available unless there is a match, Antoniades said.
Market Leaders
Meanwhile, market-leading corporate bond trading platforms MarketAxess and Bloomberg have been making adjustments as well, though are understandably more loyal to the RFQ model that has brought them success.
Having partnered with BlackRocks Aladdin, MarketAxess has expanded its model into an all-to-all market based on the RFQ process that it calls Open Trading.
Our Open Trading effort is not something thats separate from the way our clients are doing business with the Street on a daily basis; rather, it extends from that, said Rich Schiffman, head of Open Trading product management. Schiffman previously led the Aladdin Open Trading effort at BlackRock.
For example, an investor who sends out RFQs for a bond or a list of bonds to a select group of dealers can now publish the trade details of the RFQ to the rest of the 1,000 buyside and sellside participants in the MarketAxess platform. While the investment firm would reveal its name in the initial RFQ because it has a relationship with the dealers selected, the public inquiry would be posted anonymously. Any participant in the platform, regardless of buyside or sellside, can respond anonymously to public inquiries. An average of 5,000 to 7,000 line items per day are now posted as public inquiries on what is called the market list page, which translates into three-quarters of RFQs being posted to the full customer base in this manner.
In addition, MarketAxess now runs an order book called Open Markets that is designed to function more like a central limit order book. Through Open Markets, investors can publish client axes or indications of interest that may include the bond, quantity, and either a price or a market indication, such as at mid-market. Unlike RFQs, which are often time-sensitive, client axes are often used to post available liquidity that can wait until the desired conditions are met. In a departure from the equity market CLOB format, responses to client axes are not publicly visible, but rather are private bilateral negotiations.
We havent even begun to scratch the surface with regards to innovation in the RFQ model, in particular the way that it relates to Open Trading, Schiffman said. Its really the way that everyone in the market is familiar with working, and what we are trying to do with it is expand upon it in a way that makes it more flexible in sourcing liquidity. Looking forward, the company is planning to roll out generics, which are RFQs that are not tied to one CUSIP but allow users to request quotes with broader parameters of the types of securities that might be acceptable.
Meanwhile, Bloomberg has not yet ventured into an open-market model, but is watching the space and will reevaluate once the model earns a longer track record in credit markets.
Its a space we are watching very closely and may participate in at some point but not at this time, said George Harrington, Bloombergs head of fixed income currency and commodity trading. We expect continued offerings in this space as people really try to find a solution that accounts for a smaller sellside balance sheet and a larger buyside playing a more significant role in the liquidity picture.
