Fixed Income Liquidity to Become More Centralized

Shanny Basar

Fixed income trading could become more centralized around a larger number of exchanges or exchange-like liquidity hubs provided large market participants change their behaviour according to capital markets consultancy GreySpark Partners.

In a report today, Trends in Fixed Income Trading 2016, GreySpark predicted how the structure of the fixed income market could change as a result of regulation, reduced market-making capacity from banks and new ways of trading bonds and swaps.

Russell Dinnage, GreySpark lead consultant, said in the report: “Some attempts by a range of market participants – including banks, inter-dealer brokers, buyside firms and exchange platforms – to subvert these challenges by creating new trading models designed to increase the velocity at which bonds can be traded off a bank’s balance sheet are showing early signs of success. However, the corporate credit market in particular is attempting to continue to eek profitability from a market structure that is increasingly not fit-for-purpose, and a range of new types of instruments may emerge in the future that are designed to reinvigorate the securitization industry, which would change the face of the fixed income market forever.”

The consultancy has predicted that the government bond market will become all-to-all in nature and include non-banks as market makers; interest rate swap liquidity will transfer into the futures markets as central clearing takes hold; the corporate bond market could develop a larger and deeper retail market to give the buyside an independent forum for transparent pricing; and single-name credit default swap liquidity will increasingly be transferred into indices or exchange-traded funds, allowing for the creation of greater levels of options.

The report said the predictions are based on an analysis of how the depth of liquidity available to banks and the investors has become thinner over the last five years as new regulations constrain the ability of banks to warehouse counterparty credit risk on their balance sheets, especially for large block trades. As a result some banks are changing from principal businesses to hybrid agency-principal business models for bonds and swaps trading.

Bill Street, senior managing director and head of investments for Europe, Middle East and Africa at State Street Global Advisors, the investment management arm of State Street Corp., told Markets Media in an interview last month that the fixed income industry is shifting from a principal-based business leaning on inventory and risk to an agency-to-agency model and the buyside-to-buyside trading model will continue to develop, but remain very limited compared to trading involving the taking of principal risk.

“State Street has been at the fulcrum of discussing technology that has helped facilitate buyside-to-buyside trading and that continues to improve efficiency at finding liquidity,” he added. “There are questions over whether they creates more true liquidity or just make it easier to hunt out pockets of liquidity and we are probably somewhere between the two.”

Greyspark said that in addition corporate credit and government bond exchanges or trading venues are seeking to diversify the range of different types of liquidity pools and clients that they service.

“These efforts by exchange platform operators represent an effort to protect their market share from new, emerging venues or from direct disruption from market participants seeking to trade more directly with one another,” added Greyspark.

The Desk’s Trading Intentions Survey 2016 found that respondents reported using 28 liquidity aggregation platforms for credit trading in 2016, up from 19 in 2015. The survey had 70 responses from North American, European and emerging market credit desks spread across 34 investment managers, with an aggregate of €15.4 trillion in assets under management.

The Desk said: “The launch of new liquidity aggregation platforms over the last twelve months has led – as expected – to a fragmentation of the market. It is the buyside and alternative liquidity providers who are most expected to make a change that generates additional liquidity which suggests that platforms who are open to alternative liquidity providers may offer a new way of doing business that is acceptable to investment managers.”

In the government bond market the US Treasuries flash clash in October 2014, when the yield on the US 10-year note fell 34 basis points in minutes, highlighted possible structural problems. Greyspark argued that sourcing of liquidity and price formation needs to be extended to a wider range of trading venues capable of including large asset management and institutional investment firms alongside banks as trading members in a similar fashion to market for flow foreign exchange trading.

“Relying solely on the potential of an ever-expanding community of hedge funds utilising algorithmic or high-frequency trading strategies to support liquidity depth in the marketplace during periods of duress is seemingly illogical,” said the report. “However, the long-term ability of non-bank liquidity providers to generally support a nominal level of liquidity depth and pricing cannot be overemphasized.”

However for an all-to-all market for government bonds trading to succeed, large asset managers and institutional investors need to increase the sophistication of their liquidity aggregation tools so they can accurately compare the depth of liquidity in the cash market to pricing in the futures market added Greyspark. In addition the FIX Protocol association has pushed for the adoption of the standard messaging language, where possible, instead of voice trading.

“Both factors suggest that both buyside and sellside fixed income traders would be willing to expand the number of dealer-to dealer and dealer-to-customer venues that they can trade on electronically in lieu of both sets of market participants being able to efficiently aggregate liquidity on an equal basis,” said Greyspark.

In the corporate bond market, the consultancy argued that a larger and deeper retail market could provide buyside firms with an independent forum for transparent pricing, enabling more client-to-client interactions, although it acknowledged that a viable timeline is not clear.

The Greyspark report also said that interest rate swap liquidity will transfer into the futures markets to compensate for the costs associated with European Union and US central clearing mandates. In the US central clearing began to be implemented in 2013 and is due to begin in the EU this month on June 21.

“Efforts by banking industry groups and the leading futures exchanges are underway in 2016 to experiment with new forms of listed interest rate swap futures,” said the report.

However the consultancy acknowledged that USD-denominated interest rate swap futures volumes across all exchange platforms are infinitesimal compared to global cleared US dollar interest rate swap volumes.

In addition Greyspark said single-name CDS liquidity will increasingly be transferred into CDS indices or ETFs, allowing for the creation of greater levels of options products. The EU announced in March this year that it would join the US in mandating the central clearing of single-name CDS once the SEC finalizes a regulatory framework.

“However, unlike interest rate swaps, there is little possibility of existing levels of over-the-counter single-name CDS liquidity in either the EU or US being transferred into futures markets once the central clearing mandates are implemented,” said the report. “Simply put, no futures exchange has succeeded yet in developing a hybrid single-name credit swap future contract that is designed to accurately account for the probability that counterparties to a trade in the product might default.”

More on fixed income liquidity:

Featured image by foto_images/Dollar Photo Club

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