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Bonds E-trading: The More Things Change, the More They Attempt to Stay the Same

Mr Ponzo is one the speakers at our upcoming 4th Annual European Electronic Bond Trading Forum on 12th & 13th September 2016.

Bonds E-trading: The More Things Change, the More They Attempt to Stay the Same


Written by Frederic Ponzo  26/07/2016

In 2016, the bonds trading markets in general remain challenged by the forces of structural change instigated by the onset of the financial crisis. Nowhere are these structural challenges more apparent than in the corporate credit corner of the fixed income universe.

New regulations that are global in their reach were designed to stem the tide of systemic risk instigated by the opaque asset-backed securities corner of the fixed income markets in the years leading up to the crisis. To date, these regulations proved successful in not only quashing structured products manufacturing, but also in muzzling the leverage risk associated with sellside corporate bonds market-making business models.

As a result of this new normal, the depth of corporate credit liquidity for buyside and sellside counterparties alike – large and small – is at record low levels. The shallowness of the marketplace means that the width of bid/ask spreads in OTC, RFQ trading environments are widening for the vast majority of ISINs, and it also means that the velocity at which dealers can work risk off of their balance sheets and back into the marketplace has considerably slowed.

Meanwhile, supply and demand for corporate debt are both up. Record low interest rates driven by quantitative easing have not only incentivised non-financial corporates to issue more debt than their investors and the markets can realistically digest, they have also left the buyside hungry for access to yield, with USD 73bn seen flowing into fixed income exchange-traded funds (ETFs) by July 2016.
Herein, though, the nature of the challenge facing the corporate credit marketplace in 2016 and into the future becomes apparent.

The Buyside Must Change into the Sellside

Based on recent GreySpark Partners observations, there remains  a degree of unwillingness within the buyside to accept the ability of new exchanges or exchange-like trading venues to assist in resolving the liquidity dilemma plaguing the corporate credit marketplace. Granted, the buyside industry is now facing its own existential moment following the financial crisis and the implementation of new regulatory regimes – specifically in terms of the push away from active funds management business models and toward passive ones that favour investment vehicles like fixed income ETFs.

This buyside-specific challenge though does not undercut the reality that, given the design of regulations such as the Basel III Accords, the buyside – be it hedge funds, pensions investors or industrial-scale wealth managers – hold all the cards going forward. Where once buyside fixed income trading desks were quoted bank-set prices for corporate bonds and single-name credit-default swaps (CDS) in bank-run marketplaces, new exchanges are emerging with business remits designed to specifically allow investors to trade directly with one another in conjunction with their dealers.

These so-called all-to-all (A2A) trading models do not create new liquidity in an already shallow marketplace out of thin air. But what A2A-thinking is now threatening to succeed in doing is to quite simply empower the buyside to take advantage of the reality of its place in the post-financial crisis corporate credit marketplace as the holders of balance sheets capable of warehousing more risk than banks can now handle.

The Trends in Fixed Income Trading

Starting in 2013, GreySpark has published an annual report analysing trends in the structure of trading in the fixed income markets globally. Given the plethora of new electronic corporate bonds exchanges or exchange-like trading platforms that have emerged in that, admittedly, short span of time, the firm’s analysis of the fixed income trading trends has focused heavily on the corporate credit arena, culminating in the Trends in Fixed Income Trading 2016 report published in June.

Over the course of that three-year arc of analysis, GreySpark has reached a number of constantly evolving conclusions about the ways in which the corporate bonds market will present itself to sellside broker-dealers and buyside investors alike out to 2020 from which a number of objective ‘truths’ can be derived.

The first and most obvious of those truths: global and regional regulators are not going to roll back the clock on the last eight years of post-financial crisis regulations one iota in an effort to protect the interests of long-standing corporate credit market structures. If anything, the Basel Committee on Banking Supervision’s Fundamental Review of the Trading Book (FRTB) proposals represent the final nail in the coffin for risk-taking in the investment banking industry. More specifically, FRTB – via the separation of the banking book from the trading book and via the prohibition of proprietary VaR methodologies – firmly places the responsibility for any and all long-term financial markets risk-taking initiatives into the hands of the so-called shadow banking sector.

In 2016, at least, these shadow banking entities – specifically, asset managers, institutional investors and hedge funds – remain inherently unsuited in their shape and form to fill the market-making role that Tier I and Tier II broker-dealers have played in the corporate credit market place since the inception of the fixed income asset class.

Moreover, there is indeed a need – as the International Capital Market Association stated in its July 2016 study – to assemble the fixed income market’s constituents in an attempt to reach a consensus about how to address the realities of mandates encased within the second iteration of the EU’s Markets in Financial Instruments Directive (MiFID II) or within the US Dodd-Frank Wall Street Reform and Consumer Protection Act and its Volcker Rule. However, it can be argued that those conversations are already taking place.

GreySpark has observed that they are taking place within the offices of the banks, buyside firms and exchanges, large and small, on an almost daily basis on how best to utilise new e-commerce and e-trading toolkits to eke out the last vestiges of profitability from a corporate bonds market structure that is increasingly not-fit-for-purpose. The solution on the tips of the tongues of the vast majority of these companies, simply put, is more e-trading, not less – assuming GreySpark’s observations are both broad and accurate.

For example, through e-trading and, albeit, currently costly central clearing avenues, the revitalisation of the single-name CDS marketplace can occur. Specifically, through financial engineering efforts supported by exchange operators such as ICE and the Eris Exchange, OTC single-name CDS liquidity can be replicated within hybrid CDS/CDX credit swap futures markets designed to standardise the contracts and shift them away from the long-standing bespoke, dark nature of the OTC marketplace in which banks traditionally set the price and made-the-market.

Meanwhile, other exchange operators such as Liquidnet, MarketAxess or the SIX Swiss Exchange are creating essential new funnels through which a baseline of axed, odd lots or round lots liquidity can be exercised on a daily basis by both the buyside and the sellside. While these venues do not necessarily create new liquidity, they do serve an important purpose in creating the space that is needed now and into the future on broker-dealer balance sheets to continue to warehouse the reduced amount of risk that banks can still take, which remains essential for the execution of block-size trading on a client-by-client basis.

Somewhere, Over the Rainbow

In the end though, GreySpark believes that it is the shadow banking entities – especially those whose business models are not averse to risk-taking – that ultimately hold the key to a revitalisation of not only the corporate credit corner of the fixed income market, but for the fixed income market as a whole. Take, for example, the current state of affairs in the US Treasuries market, where non-bank liquidity providers now constitute the leading market-makers in an environment increasingly challenged by record low interest rates and a consistent lack of liquidity depth.

Therein the narrative underpinning the structure of the leading marketplace for government bonds liquidity is akin to the narrative that has played out in the flow or spot FX market over the last 10 to 15 years. The less that it becomes profitable for banks to make proprietary bets on the outcome of global macro and micro economic events within cash markets, the more banks become willing to open the doors leading to gold-plated liquidity to their smaller, non-bank competitors via the provision of prime brokerage services in an effort to keep liquidity ticking along at a healthy pace.

In a fashion, GreySpark believes the government bonds/flow FX e-commerce, e-trading narrative will inevitably be repeated in the corporate bonds market, possibly in the form of a healthier market in the future for retail-size corporate debt trading. For that potential new normal to materialise, however, both the buyside and the sellside still have a long way to go in acclimatising themselves to the business and operational benefits that can be gleaned from technological innovation as a means of progressing the facilitation of risk-taking and risk management toward a wider audience.

About the author

Frederic Ponzo, Managing Partner, GreySpark Partners

Frederic is the managing partner of GreySpark Partners, where he focuses on providing leadership, direction and vision to the company, ensuring that the firm’s clients receive best-in-class services. Frederic’s position as a leading expert in e-commerce, e-trading, risk and risk management solutions for the wholesale financial services industry is grounded in over 20 years of work in which he has personally advised over 50 financial institutions – including 19 of the top-20 investment banks – along with numerous Tier I and Tier II buyside firms, exchange operators, fintech start-ups, inter-dealer brokers and technology vendors.
Frederic holds an MsC in telecoms and IT from Telecom sudParis.

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