To predict in what ways these factors will shape the corporate bond market of the future, we might learn some lessons from how equities markets have evolved over the past decade.
The biggest impact on equities markets was the electronification of trading first seen in the early 1980s when national exchanges, such as the London Stock Exchange, moved from an open outcry model to screen-based trading. This change brought with it the benefits of better liquidity and execution efficiency, which in turn led to greater trading volumes.
The positive influence that technology had on these markets was followed in 2007 by the opening up of trading to greater competition. The objective of MiFID I in Europe and Reg NMS in the US was not only to foster competition among trading venues but also to break the monopolies of national exchanges by introducing alternative trading venues, which in turn lowered the cost of trading in US and European equities.
But there was a price to pay for such benefits in the form of market fragmentation due to the proliferation of trading venues. Over the past few years we have seen a natural consolidation of these venues but also – ahead of MiFID II implementation – we have seen the launch of new models.
Successful venues that remain strong today are those that offer value to the buy side in terms of delivering access to quality liquidity, execution performance, the ability to execute in block size and the quality of participants within the venue itself amongst other factors.
Though very different from equities in terms of the sheer number of securities available and the lack of a reference price, the challenges which the corporate bond markets are currently facing mirror many of those which were experienced in the equities markets more than ten years ago.
The issues around liquidity in the corporate bond market largely stem from the fact that the banks – which were major market facilitators – are retreating from trading in this space. Regulations such as Basel III have started to impose new capital and liquidity requirements, while the Dodd Frank Act and the Volcker Rule have essentially banned banks from operating proprietary trading desks. These changes, combined with lower risk appetite and higher cost of capital, have made corporate bond inventories less attractive and more expensive for banks to hold. These factors reduce the capital commitment and liquidity available to the banks’ buy-side clients.
At the same time, the trading needs of buy-side firms have increased dramatically as their portfolios have become larger and more complex. Buy-side firms have always been the largest holders of corporate bond inventories. However, with the banks retreating, potential liquidity, which once resided with them, now sits solely with buy-side firms, thus providing greater impetus for buy-side firms to trade with each other. To facilitate this requires new ways of trading corporate bonds and the time for change is now.
We are already seeing a shift in trading reflecting the new liquidity structure in the corporate bond markets. The infrastructure that supports it must now adapt to make trading more efficient. The need for a new solution is increasingly urgent, as the size of the corporate bond market has exploded driven by the prolonged low interest rate environment which has made debt funding cheaper.
To understand the optimal market structure, it is important to understand the needs of the buy-side and the different types of trades which, in turn, suit different approaches to sourcing liquidity.
Smaller trades in highly liquid securities could be well served by request-for-quote (RFQ) trading protocols, for which banks and other intermediaries can easily provide the necessary liquidity and capital commitment.
There are also trades that are best suited by execution in the voice-based over-the-counter (OTC) market. These could relate to orders that match against dealer inventory or orders that a dealer may be able to facilitate with capital commitment.
Then there are trades that can only be facilitated by matching buy-side to buy-side liquidity. They represent a large part of the buy-side’s needs and are currently the biggest 'pain point' in the corporate bond market. These trades are typically larger and require anonymity and protocols designed to minimise information leakage and price impact. A neutral and anonymous all-to-all institutional trading network providing both a lit orderbook and a dark block trading facility is best suited to execute such trades.
Liquidnet is offering a new way for the buy-side to trade in fixed income by bringing together its network of asset managers, who own the majority of the world’s corporate bonds, to share their liquidity and accelerate efficiencies within the market.
This ability to exchange institutional liquidity in a neutral environment in large size and in an anonymous way will be key to ensuring a smooth and necessary transition from a dealer-focused liquidity structure to an environment in which buy-side firms will increasingly trade with each other.
A healthy corporate bond market structure benefits all market participants. At the same time, the only way to ensure a healthy corporate bond market is by making sure the buy-side has all the tools it needs to efficiently source liquidity from all sources, including each other.
©TheDESK 2015