Bond Markets Undergo Structural Change

Terry Flanagan

The capital constraints imposed on banks by Basel III has caused many of them to exit the market making business, which means the traditional client-to-dealer RFQ model is giving way to open trading.

“There’s a market structure that exists in the corporate bond market,” said Anthony Perrotta, CEO of Cornerstone Resources, a consulting firm. “Institutional investors rely on traditional liquidity providers to give them immediate risk transfer via the request for quote model, whether voice or electronic, and clearly That RFQ model is a trading protocol that is completely dependent on a principal-based market structure.”

MarketAxess’ Open Trading environment for corporate bonds offers a range of protocols, or trading workflows, in addition to MarketAxess’ request-for-quote model, such as Market Lists, an order book providing all-to-all execution based on disclosed and anonymous trading across trade sizes (odd, round and block).

Perrotta called Open Trading as “the most crucial development in 2013.”

Where the RFQ mechanism was once a client-to-dealer inquiry and response tool, MarketAxess “is pushing the envelope and expanding the protocol, allowing clients to both send/receive inquiries from the entire marketplace, he said. “Most significantly, it allows investors to deal directly with one another utilizing the platform’s broker/dealer as agent in the transaction, bypassing traditional liquidity providers.”

The RFQ model implemented by MarketAxess, Tradeweb, Bloomberg and other platforms represents a shift from voice-based trading to electronic, but is still based on the traditional principal-based paradigm.

“MarketAxess is the dominant electronic trading mechanism for institutional investors,” said Perrotta. “MarketAxess has succeeded in taking the voice-based model and moving that to an electronic medium. But there has been no structural change, even though we’ve gotten more electronic.”

The Open Trading protocols, on the other hand, do represent a structural change. “By serving as an intermediary for risk transfer, MarketAxess is crossing the threshold from a principal-based to an agency-based model, without going to a traditional agency model, which is sponsored access, central limit order book-type model,” Perrotta said. “It’s a significant break from the traditional mechanism that exists in the marketplace.”

Traditional liquidity providers “will be very much impacted if this type of trading catches on,” he added. “MarketAxess still derives half of its revenues from distribution fees that dealers pay them. The question is will dealers be willing to pay for that connectivity if MarketAxess is now circumventing them in the distribution process.”

During the company’s fourth-quarter conference call on January 29, MarketAxess chief executive Rick McVey took pains to point out that the company is not looking to disintermediate traditional market makers.

“None of our institutional clients wants to be in the market making business,” he said. “We are seeing a change in behavior in terms of willing to lead with a price when they see a potential match in the system. That behavioral change is still in the first inning, but it is underway. But in no way do we see any investors that are trying to directly compete with the market making business.”

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