Changes Ripple Through Fixed Income Markets

Terry Flanagan

The fixed income markets are undergoing rapid transformation brought on by regulations and market dynamics. The impact of incoming capital markets regulations in the EU and U.S. on the market structure for fixed income products like bonds and interest rate derivatives could be significant. Market participants are expecting more electronic trading in these asset classes, and signs of the technological tipping points are growing more pertinent every year.

“The key issue facing the fixed income markets today are structural change, brought about by catalysts such as regulatory mandates, changing business models, and the adoption of electronic trading,” said Anthony Perrotta, CEO of Cornerstone Resources, which provides strategic business development, business plan construction, operational implementation planning, and tactical deployment consulting in fixed income.

The U.S. Dodd-Frank Act is creating more cohesion between the OTC and listed derivatives markets.

“The buy-side relies on legal teams to interpret Dodd-Frank legislation,” Perrotta said. “Our business provides the consultative services required to implement the rules into their daily business operation. Clearing requirements have already been introduced. Trading requirements will be implemented in 2014, essentially changing the manner in which firms have to conduct their regular business.”

The corporate bond market is a large market, with $11.4 trillion outstanding as of 2010, according to Federal Reserve data. That’s larger than the U.S. government and municipal bond markets combined.

It’s also highly illiquid. Of 47.629 “TRACE-eligible” bonds, more than 18% had no trades over 1,156 trading days between 2002 and 2007, according to a presentation by Michael Goldstein, a professor at Babson College. Traded bonds had a median of 121 trades during this interval, meaning that the number of non-trading days can be quite large.

In such a market, the conventional wisdom that liquidity and transparency are directly correlated may be incorrect.

“Over long periods of time they may move up together, but in the short run they can be inversely related,” said Dexter Senft, managing director at Morgan Stanley, at an SEC roundtable earlier this year. “This is particularly true for a large trade size. if you think of liquidity as the ability to get the best price for your transaction in a short period of time, then it can be different for small trade sizes and large trade sizes, and therefore the impact of greater transparency can be different for those, too.”

“Because they can move inversely, it’s important to understand which one is your objective, because you can’t maximize both in the short run,” he noted.

Morgan Stanley is “trying to get the best execution for our customers and therefore will side with better liquidity every time, and if that happens at the cost of reduced transparency, then so be it,” Senft said.

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