Bond Trading Resists Electronification, But for How Long?

Unlike other asset classes, the fixed-income market is still battling the logical and natural evolution toward the electronification of trades. As Jake Thomases highlighted in his two-part feature published in the June 2013 edition of Waters, the current protocols and trading models have done little to convince the buy-side crowd that e-trading of bonds is the way forward and most trades still take place over the phone.

Banks have also struggled to answer the needs of their clients and have reduced their exposure to the fixed-income markets to a bare minimum as a result of lower yields and greater capital costs. The feature explained that the bond market witnessed a revolution in the late 1990s when a number of execution platforms sprang up, although after a bright start, almost all of them disappeared due to bad technology or funding problems. But the primary reason they failed was that they tried to achieve too much, too soon.

In the wake of the financial crisis, a second wave of bond-trading platform has emerged, although it is only logical to wonder why those venues stand a better chance for survival and success than their predecessors, especially now that liquidity has become even more sparse as single-dealer platform continue to scale back their activities.

Confident that their trading models will introduce much needed liquidity to the bond market, firms like Liquidnet and ITG—two brokers that originally offered dark pools to the equity market—have entered the fixed-income space, believing they have the right technology to re-ignite the hitherto dormant bond market.

A Deserted Place?
The current narrative around the bond market is that there are significant liquidity issues caused by the contraction of broker-dealers’ bond inventories. A recent report published by Tabb Group, Bond Liquidity Crisis Lurks as the Market Is Lulled, announced a 21 percent decline in dealer balance sheets compared to before the global financial crisis of 2008, and a 30 to 40 percent decrease in inventories.

“Technology is an important addition to the bond market. Dealers will always play a key role in this market given the lack of liquidity, but there is a need for additional sources of liquidity, which match up the bond holdings of institutional investors.” Frank DiMarco, ITG

Those numbers, although nowhere near the rumor that the dealer community would have withdrawn balance-sheet commitments and reduced their inventory by more than 75 percent, are still a significant setback. This has attracted several market operators that have announced over the past few months that they would be adding bond-trading capabilities to their existing platforms.

Liquidnet, which bought Vega-Chi last year, is now hoping to go live with its bond trading dark pool platform as early as January 2015. Similarly, ITG is working on its Posit technology, an equities dark pool, to adapt it to fixed-income instruments, and hopes to see it up and running by year’s end.

The Bondcube matching platform has received regulatory approval to facilitate the electronic trading of bonds in the UK and is hoping to undertake a dual launch in the US and Europe in November, depending on regulatory approval from the US Financial Industry Regulatory Authority (Finra). Additionally, the Bonds.com alternative trading system was bought by fixed-income trading platform MTS, part of the London Stock Exchange Group, in March 2014, while other stock exchanges like Deutsche Börse and Nasdaq are considering similar initiatives.

The diminished power of single-dealer platforms that had dominated the space for the past decade should provide the impetus for any new liquidity source entering the market. But the question remains: Are dark-pool mechanisms the right fit for fixed-income trading, given the market’s historical reluctance to change?

A New Market Structure
“For diverse regulatory reasons, the banks are focusing on a small number of products, and on a small number of clients,” says Paul Reynolds, a former bond trader for Deutsche Bank and now CEO and co-founder of Bondcube. “But what about all the other products that still need to be traded and all the other clients that need to be serviced?”

Since dealers have traditionally ruled the bond-trading roost, asset managers have been forced to hope that they are in the right pool at the right time if they want to trade their preferred bonds. But larger bond trades that are likely to move the market or bonds that are only traded a few times a year have been left idle. Because of this scenario, the buy side is now holding record amounts of bonds in their portfolios that can’t be traded.

Reynolds explains that the prevailing liquidity crisis in the bond market that everyone is talking about is not so much due to a shortage of liquidity but rather bad market infrastructure that doesn’t allow buy-side firms to access that liquidity.

“From a market-making perspective, the sell side is contracting, but at the same time, the buy side keeps getting bigger and bigger,” says Michael O’Brien, director of global trading at Eaton Vance. “The traditional model where buy-side firms ask a few banks for quotes in order to get the best price isn’t working anymore—we need more alternatives.”

As the market moves away from a principal-based model, pressure is increasing on the current trade protocols—the voice-based and electronic request-for-quote (RFQs) or central limit order book (CLOB) systems—that are dependent on principal-based trading. What the buy side is looking for are more ways to connect to the people who actually own the assets—their peers.

Dark Pools Rising
“Technology is an important addition to the bond market,” says Frank DiMarco, head of ITG’s Posit FI. “Dealers will always play a key role in this market given the lack of liquidity, but there is a need for additional sources of liquidity, which match up the bond holdings of institutional investors.”

Firms like Liquidnet, ITG, and Bondcube are trying to leverage their technology to bring together buyers and sellers. “Those types of new technologies and methodologies are a good thing for the fixed-income markets,” says Eaton Vance’s O’Brien. “Some buy-side-to-buy-side models have been successful, but they can’t be operated by a bank. I am sure the banks are protecting the information they get from us behind various compliance walls, but it is still not the most comfortable position for buy-side firms to be in.”

If firms like Liquidnet, ITG, and Bondcube are successful in their bond market plays, it will be because they are third parties agnostic to the investment itself and are facilitating trades for two parties on each side of the trade—a buyer and a seller.

O’Brien, who uses Liquidnet for equities, says the firm has an advantage in the sense that it doesn’t have a huge balance sheet to trade against him. “It operates as a third party so I am not worried about sharing my information,” he says.

By offering to introduce indications of interest (IOIs) into the marketplace for others to view and act upon anonymously, these new platforms are hoping to unlock dormant liquidity.

A Buyer for Each Seller
According to Anthony Perrotta, a principal and director of fixed-income research at Tabb Group, although dark pools are viable platforms that could solve certain issues around liquidity in the fixed income-markets, the buy-side-to-buy-side model still has one problem: With most of the assets concentrated in the hands of like-minded investors, their investment strategy and philosophy is therefore dictated by the same macroeconomic laws. Those firms will all be looking through the same investment prism, so connecting them to one another might not actually solve the liquidity issue as they will all want to buy and sell at the same time for the same reasons.

“In this situation, the question is who the alternative investors would be. Who will be the other side of the trade? My fear is that the mechanism, which is theoretically sound, might fail to gain traction in the current macro environment because of this concentration of assets with like-minded investors,” Perrotta says.

He explains that the current macroeconomic environment is probably not conducive for dark-pool mechanisms to gain traction, although if the investment community believes the mechanism can work, it is probably better to roll it out now that market sentiment is still favorable, rather than when there is a less favorable environment, with rising interest rates, expected once the Federal Reserve decides to end its quantitative easing program.

In a recent report published in September 2014, entitled Corporate Bond Market Structure: The Time for Reform Is Now, BlackRock, which holds more than $1.3 trillion in fixed-income investments on behalf of its clients, says that today’s secondary trading environment for corporate bonds is “broken,” and that the extent of the breakage is masked by the current environment of low interest rates and low volatility, coupled with the positive impact of QE on credit markets.

BlackRock analysts are calling for more all-to-all trading venues, and not just dealer-to-customer or dealer-to-dealer platforms. It also calls for the adoption of multiple electronic trading protocols, not just RFQ or CLOB systems.

This is not news to the industry. Constantinos Antoniades, head of fixed income at Liquidnet and former CEO of Vega-Chi, says not every trade is suitable for his firm’s trading model and platform.

“We fill the gap in the current market structure by enabling our clients to execute trades in ways that have not been possible until now,” Antoniades says. “Our focus is on executing trades by finding the natural contra side from another buy-side firm anonymously.”

Dark pools might therefore have their place in the current market structure, as they add a much-needed component to the equation—liquidity. It is therefore likely that they will gain momentum in the foreseeable future, although the marketplace will need wider structural changes before it can finally operate as a fit-for-purpose corporate bond market. And that includes more e-trading venues and new trading protocols, as well as a change in investors’ behavior.

Salient Points

• After years of resistance to electronic trading, the bond market is finally moving away from a principal-based trading model, which involves buy-side firms asking dealer for a quotes. The inefficiency of this model and poor liquidity has forced the buy side to seek alternative systems that would allow them to trade without moving the market and without informing the banks of their intentions.
• Dark-pool mechanisms might solve this issue as they allow liquidity holders to connect to one another anonymously.
• However, a dark pool full of like-minded investors might not be the most efficient answer to a liquidity issue, as it might make it even harder to find a buyer for each seller.