By Rob Laible, Liquidnet's Global Head of Equity Strategy
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.
Growing demands to cut costs, streamline processes, and generally do more with less are a reflection of today’s consolidation in the institutional trading industry. As the market continues to fragment, liquidity is becoming harder and harder to find. At the same time, we’ve seen an onslaught of new and evolving sources of mega-data that needs to be incorporated into the portfolio and trading processes. All this is set within the context of increased regulatory scrutiny and transformational changes that underlie MiFID II, as well as the need to build a consistent process around achieving and proving best execution.
That’s a lot of different balls to be kept up in the air at the same time – and the responsibility for all of this metaphorical juggling sits squarely in the hands of the buy side.
Quick change: Markets, electronification, regulation
Traditional broker-dealers are being pressured to re-prioritize business models while the buy side is under equal pressure to take more responsibility for achieving and justifying best execution Both of these trends can be traced back to regulation, which doesn’t show any signs of slowing down. At Liquidnet, we have identified three key factors driving this transition:
- Market structure: Broker-dealers are finding it increasingly expensive to perform their traditional role as market-makers due to Basel III, which places significant capital restrictions on banks. Less capital commitment from the sell side leads to a withdrawal from certain business areas, ultimately resulting in lower liquidity across the market. The buy side, by holding an increased number of fixed income securities, is now in a position to help improve market liquidity. Yet what the industry really needs are more efficient ways for the buy side to locate liquidity and utilize assets.
- Electronification: Technology can help the buy side seek superior trading performance and greater levels of control and transparency. According to a report by Greenwich Associates, approximately 80% of buy-side order flow for equities is handled by trading algorithms and smart-order routers, which aim to help traders navigate through today’s fragmented marketplace. Yet the same report reveals that only 7% of traders are happy with the standard algos provided by their brokers. The writing on the wall is clear – buy-side traders are demanding new levels of performance, control and transparency, and they are asking their technology partners for specific, customized tools that can streamline processes, consistently deliver better results, and be easily integrated into their day-to-day workflows.
- Regulation: Trends relating to market structure changes, and the pursuit of liquidity through innovation, have been underpinned by post-2008 regulatory upheaval. And that’s just the beginning. Best execution rules, scrutiny of the broker voting process and Transaction Cost Analysis (TCA) mean today’s buy-side trader needs to have a better understanding of what the sell side is providing and how much it costs. Furthermore, upcoming MiFID II rules mean that buy-side firms will need to annually assess and validate the integrity of trading systems used, fundamentally giving them more control over the execution process and its outcomes.
The buy-side trader’s stage fright?
At Liquidnet, we talk to buy-side traders all across the globe, and they know that their jobs have become more than just executing a PM’s investment strategy with minimal performance erosion. They understand that the trading desk itself must be an alpha generator and a competitive performance advantage for their firms. Easier said than done. Infrastructure changes, technology evaluation and selection, regulatory compliance, liquidity access, and a host of other issues simply erode a trader’s ability to maximize performance and achieve best execution.
From our conversations with the buy side, we hear about two specific trader needs. First, buy-side traders need to spend less time chasing liquidity and more time managing it. They need tools to help them efficiently and safely source liquidity from across the globe, and then help evaluate which liquidity sources are the best ones for their specific execution strategy. Second, they need to be able to quickly sort through the vast amounts of market information they receive, filter out the noise, and focus only on what’s relevant, urgent, and most actionable.
This combination is essential, because information without liquidity is lost opportunity. And liquidity without information is lost alpha.
The winners will be those firms that are able to overcome these two challenges, thereby freeing the trading desk to focus its attention on capturing and generating alpha, enhancing fund performance, and attaining best execution. And the technology providers that can deliver these types of liquidity-sourcing and trader intelligence tools will become long-term valued partners of the buy side.
The evolution of innovation
The brilliant thing about innovative technology is that it continually improves and adapts to the changing needs of the buy-side trader. Today’s technology can help traders find liquidity, measure potential trade impact, monitor market conditions, and decide on how to best execute a trade strategy. With the development and deployment of these tools, the entire industry will benefit from a globally consistent and data-enhanced trading process for better informed pre-trade and “in-trade” decisions.
For example, in the quest to enhance decision-making abilities for buy-side traders and deliver more control over best execution, platforms have been developed that are able to sort through massive amounts of market data and deliver real-time, relevant information at both a portfolio level and an order-by-order level. This technology provides market intelligence directly to the trader, customized for each order based on both overall market conditions and specific performance objectives. In addition, being able to generate a fully documented audit trail of decisions helps easily satisfy best execution obligations.
Technology, when delivered in these meaningful, insightful and actionable ways, can truly make a difference in terms of capturing and maintaining alpha. We’re seeing some inspiring solutions out there right now but, no doubt, there’s even more exciting innovation around the corner.