By Constantinos Antoniades, Liquidnet's Head of Fixed Income
The combination of market volatility and liquidity reduction in the last three months has been a stark reminder of the urgent need for a more robust ecosystem in the corporate bond market. A storm is brewing now that this asset class has doubled in size, while dealer warehousing capabilities and risk appetite have simultaneously shrunk. These two factors – combined with additional macroeconomic conditions (including the commodities cycle), repricing in emerging market risks, unorthodox monetary policies, and concerns about a Chinese slowdown – have created perilous conditions. The corporate bond market may well find itself in the midst of a perfect storm.
The single biggest issue facing institutions in the corporate bond market today is the ability to access liquidity. Until a few years ago, liquidity was considered to be a static measure – the sum of capital commitment available to the marketplace by traditional dealers. Today, such a measure of liquidity is outdated as buy-side institutions are increasingly the providers of direct natural liquidity. A good portion of this new liquidity is available via alternative trading systems which put the buy side in the driver’s seat. Traditional voice or electronic RFQ dealer-to-client protocols will still be dominant; however, they now form the base rather than the totality of available liquidity. The ability of buy-side firms to access this additional liquidity via buy-side to buy-side crossing networks is becoming a differentiating factor, especially in harder-to-trade securities or larger size trades.
Looking at TRACE data for US corporate bonds over a four month period, the 500 most active investment grade bonds account for around 40% of institutional trading volume. The top 200 most actively traded high yield bonds account for 36%. What this means is that approximately 6% of the CUSIPs in the market account for 38% of the trading volume in the combined segments. This is a sub-optimal and likely harmful level of concentration. Dealer capital commitment in securities outside the most liquid group is the biggest casualty of the post-crisis landscape. Faced with shrinking balance sheets, regulatory requirements, reduced risk appetite, and a “juniorisation” of trading desks, it’s no surprise that dealers are concentrating their time and firepower on the easiest to trade securities. The good news is this problem is where electronic crossing networks can add considerable value – bringing together natural buyers and sellers in securities where the traditional intermediaries cannot trade or have chosen to not trade [with their own capital]. Of course, electronic crossing networks cannot create buyers or sellers out of thin air, but where there is a natural buyer and a natural seller they can provide the matching opportunity that may not be readily available in the voice market or via RFQ protocols.
So, what are the best trading protocols to power crossing networks? The truth is, there is not a single answer or even a “best protocol”. Different protocols are suited for different sizes and types of securities, and even market conditions. For example, the RFQ protocol works best with smaller size trades in more liquid securities, as by definition an RFQ action requires immediacy of execution. On the other hand, larger trades outside the most actively traded bonds require information protection and most times a natural buy-side opposite, as dealers would not typically warehouse that position, particularly at a significant size. This is where the network effect and passive liquidity-matching in a dark pool can really shine. Matching a natural buyer with a natural seller while removing the threat of information leakage will likely produce the best outcome. Dark pools in corporate bonds can become a significant part of market infrastructure provided they can bring to the table critical mass, connectivity, and the equally important operational transparency.
Operational transparency is crucial to the healthy development of crossing networks and by definition a healthier corporate bond market. Operational transparency includes clarity on how a venue operates, who gets to interact with what kind of liquidity, and whether any conflicts of interest are present. Not to be confused with price/size information transparency, operational transparency is critical in giving the buy side the confidence it needs to fully engage with alternative crossing networks. At Liquidnet, we believe the corporate bond market has the opportunity to avoid some of the issues that plagued the equities market, many driven by the lack of this transparency. It should be the responsibility of all corporate bond venues to explain clearly to their customers and prospects how they work and who has visibility into or usage of customer order information.
Finally, another common misconception in market structure discussions revolves around the ‘dealers versus electronic platforms’ topic and the false assumption that there can only be one ‘winner.’ At Liquidnet, we respectfully disagree. In the foreseeable future, dealers will remain the main source of liquidity and intermediation to the buy side. At the same time, both the buy side and the dealers can benefit from an ecosystem that facilitates additional liquidity exchange opportunities that are not available or cannot be sourced efficiently in the dealer-to-client relationship model. A new playing field in the corporate bond market requires a new approach to trading and sourcing liquidity by the buy side.
There isn’t a silver bullet for the liquidity issues in the corporate bond market and it is unlikely that a single solution will solve the problem. However, crossing networks that focus on building critical mass while protecting client information and providing operational transparency can go a long way toward helping build a more robust and more liquid corporate bond market. This is why Liquidnet focused on building a trading platform that combines all of the above. While dealer liquidity and relationships will always remain very important to the buy side, they are unlikely to solely provide the maximum liquidity and alpha generation opportunities that can be achieved. It is our hope that with a more robust market structure the corporate bond market will be better positioned to weather the storm and provide the best outcome to all participants and end-investors.