Natural Liquidity in Bonds: Fact or Fiction?

Terry Flanagan

Does ‘natural liquidity’ exist in the bond market, where a security can be bought or sold without the services of an intermediary broker, and without materially affecting the asset’s price? Not in the same sense as equities, perhaps, but it can be simulated, according to companies that are building platforms for bringing together buyers and sellers.

Electronifie, a New York-based alternative trading system operator, is scheduled to launch later this year with a platform to unite institutional bond traders as natural liquidity suppliers to one another. Both market makers and investors will provide liquidity and route orders to the Electronifie trading venue.

“Natural liquidity is squarely within Eletronifie’s focus,” Nicole Olson, chief strategy officer at Electronifie, told Markets Media. “Trading without moving the asset’s price is the ‘Holy Grail’. That would make every institutional investor happy and more profitable. You need to bring together willing buyers and sellers in one place. Second, you need the methods for them to communicate so they can transact safely. Theoretically, with those two things operating at 100 percent, you could eliminate market impact.”

Large sell-side banks, historically the primary liquidity providers in bond markets, have been constrained by regulation and cost-containment efforts in recent years. That has left an opening for emerging platforms such as TMC Bonds, Electronifie, and Liquidnet, the equity-platform mainstay that recently moved into fixed income.

Electronifie will have execution mechanisms that facilitate round-lot and block-sized transactions while limiting the dissemination of order information. It will not sell or otherwise reveal subscriber order information or transaction data to other parties.

“Electronifie will have smart execution mechanisms that enable participants to trade in large size while giving up just the minimal information needed to effect that trade. We’re looking to bring together liquidity from all participants,” said Olson. “You need the mechanism in place to allow them to interact safely. Our goal is to enable institutions and dealers to interact directly with one another.”

It’s difficult in the current market, where trying to find a price is contingent upon sharing information about a prospective trade. Electronifie has “decoupled pricing formation from liquidity formation,” Olson said. “We will have a limit order book that anyone can provide prices and quantities to. We’re going to have designated market makers, who will be quoting two-sided firm markets. Those prices are immediately executable; however, they will be used as reference prices for much larger transactions.”

Electronifie’s CEO, Amar Kuchinad, who worked at the SEC for 18 months after running part of Goldman’s flow credit trading business in the U.S., observed that 20 percent of the transactions that occurred in 2012 were potentially crossable, where clients bought and sold the same security on the same day in the same size.

The company is conducting a research project on how crossable the market is. “Our initial findings are that there is a significant crossing opportunity, meaning that on the same day a client buys a bond and another client sells the same bond,” said Olson. “We consider this a part of a larger data-driven initiative.”

Electronifie has had multiple discussions with institutions and market makers. “There’s a strong appetite for new technology that enables buying and selling of bonds that does not move the market,” Olson said.

Featured image via iStock

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