Bond Markets Will Never Be Liquid. Or Will They?
“Pinning down the causes of bond market liquidity is not easy,” according to Northeastern University’s Kurt Dew – and never has a truer phrase been said.
One of the biggest obstacles in getting to the root cause of liquidity, or often lack of liquidity in the case of corporate debt markets, is that asset classes are resolutely tribal. Futures, FX, Equity and Fixed Income folk rarely mix and discuss market issues.
There are various differences and similarities, but the underlying principle is that connectivity, data transparency and aggregation drive volumes and lower costs. This paradigm applies to any marketplace, whether it is comparison sites, auction sites or media distribution, we are all now utterly acclimatized to technology improving our lives.
Except, it would seem, in Fixed Income. Somehow the bond markets have managed to let the greatest era of technology innovation largely pass it by. While electronic volumes are slowly improving, they are not really keeping up with market growth and are seriously failing to be effective when it comes to large size transactions. It doesn’t matter how many times one mentions AI, machine–learning or blockchain, nothing will change unless the industry applies the principles of connectivity, data transparency and aggregation. The only real success story in Fixed Income is bond ETFs where, of course, there is a conspicuous absence of the normal over the counter (OTC) bond market trading infrastructure.
The bond ETF market is not controlled by new issue desks, bond trading desks or asset management Order Management Systems. In most cases, bond ETFs are traded on Equity exchanges with specialist liquidity providers like Jane Street or the Equity desk of a Broker Dealer. The market trading infrastructure is easy to connect to, data is transparent, volumes are high and costs extremely low. Even in bouts of market volatility, when the OTC market completely shuts down, bond ETF volume shoots up and even becomes a viable proxy for OTC trades. The multiple Armageddon theories of the bond ETF market failing, have so far proven to be misplaced. The bond ETF market rejected the OTC bond trading market infrastructure and has far outstripped the underlying market. With this in mind, the key question is: Could bond markets be more liquid if the trading infrastructure changed?
The good news is yes, and there is some encouraging evidence to support this claim. The answer is not necessarily better new issue design or a central market organization, although that may help. It does, unsurprisingly, lie in connectivity, data transparency and aggregation. These dynamics have revolutionized accommodation, ride–hailing and consumer products marketplaces. So, what is stopping the mighty Fixed Income market from unshackling itself from the dark ages and emerging into the white heat of twenty-first century technology innovation?
It’s simple really. There are some very large incumbent components of Fixed Income market structure that completely dominate everyone’s lives. Every asset manager has an OMS that provides essential functionality for the operational integrity of the business. There are three totally dominant trading platforms that cover roughly 95% of all electronic bond volumes. The key is to apply a connectivity, data transparency and aggregation interface to this infrastructure for buy-side traders to take their logical role in bond market liquidity, as they do in say equities and FX.
Two decades ago, when most of the present infrastructure was in its infancy, it was regarded as threatening and disruptive. Shortly thereafter however, the benefits were irrefutable and those who embraced it have managed to enjoy fruitful careers. Like all innovation revolutions, the time has come where a further reset is needed.
In the same way that a comparison site manages to harness all available offers from major service providers, the Fixed Income major players can participate positively. Bringing with them the next phase of connectivity, data transparency and aggregation, to enable Fixed Income transactions to proliferate.
It is happening already and there are more than a few signs of encouraging evidence. A number of buy-side participants are now able to capture, in one place, all of the inputs required to determine the most beneficial way of engaging the market and sourcing liquidity. They can even action trading opportunities by executing directly with a dealer (voice and electronic), responding to all-to-all RFQs or routing orders to trading venues for all of the available electronic protocols. Having all of these tools available in one, cohesive place greatly improves the speed to market and helps ensure liquidity opportunities are never missed.
Ultimately, advancements of this nature improve transaction costs and efficiency for all users, but they will be especially helpful for those larger buy-side desks looking for all of the available market intelligence, flexibility and scale. Incumbents haven’t been disrupted and neither have their business models. A market infrastructure has simply been optimized in a way that none of the incumbents could ever do singularly or collectively. Just as in the past there are those who feel threatened by change, but the reality is this change has brought them more business, greater efficiencies and a pathway to revenue uplift.
It is too early to tell if it has improved bond market liquidity overall, but the early results emphatically suggest so. With significant improvements in pre-trade intelligence now available and consequential gains in execution opportunities, speed, cost and volumes.
With Joel Kim, Head of International Fixed Income and CEO Asia ex-Japan, Dimensional Fund Advisors
With Louise Drummond, Global Head of Investment Execution, Aberdeen Standard Investments
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