Liquidity, or the lack thereof, in fixed income markets is prompting some fund managers to deploy more over the counter products when looking to enter or exit a position.

“We’ve started to get some requests over the past year for handling new and different types of derivatives and esoteric assets,” Gary Brackenridge, global head of the hedge funds business at investment system provider Linedata, told Markets Media. “When we went to probe why do they need to support some particular type of OTC instruments, the answer was the liquidity problem.”

From an investment manager’s perspective, trying to manage exposure, including the risk or the cost to unwind positions, is a ‘New Math’ problem. “The old mechanism doesn’t work,” Brackenridge said. “You used to just look at spreads and say ‘The spread looks about the same. Liquidity must still be there.’ But you need to look deeper into the problem and ask how many bids are actually out in the market sitting behind that spread.”

In Europe, he added, fewer than half of bids are available for a given security in fixed income, compared with eighteen months ago.

Although spreads haven’t necessarily widened, there’s a persistent fear that in a moment of crisis, with dealer inventories at record lows, the markets could disappear. “This is a direct outcome of Basel III and the Volcker Rule, where people can’t carry inventory on their books without a big capital cost,” said Brackenridge.

Linedata is devoting resources to coming up with ways for fund managers to derive additional measures of liquidity exposure though depth of order book and other kinds of data. The objective is to come up with “a way to capture [liquidity] in a calculable, mathematical way where you can compare day to day, week to week, month to month,” Brackenridge said.

Firms are looking to gauge their exposure to the market using different instrument classes whether it’s an OTC derivative, a straight contract or some other proxy for gathering the market exposure that they want. Bank debt is an example. “We are seeing a lot of activity in bank debt,” Brackenridge said. “We’re building out new workflows and new functionalities specific to support alternative assets, in replacement of a market that may not have much liquidity anymore.”

The development effort is significant because alternatives aren’t centrally cleared. “They’re bilateral agreements, which means that the terms are whatever you want them to be and these all have to be captured, managed and put into your book and have analytics calculated,” Brackenridge said. “So 75% of our development right now is dedicated just to the expansion of these types of assets. Basically, giving investment managers an alternative because they can do nothing about adding liquidity to the fixed income market.”

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