No Silver Bullet for Fixed-Income Iliquidity

Shanny Basar

A range of solutions including changes in portfolio construction, more standard issuance, buyside to buyside trading and financial technology are needed  to help tackle lower liquidity in fixed income according to a panel at the European Fixed income and FX Market Liquidity Conference.

James Wallin, senior vice president, AB, said on the AFME panel in London last week that it has become harder for funds managers to get trades done as banks have shrunk their balance sheets and become less active as market-makers in bonds. “You can see an opening but getting through is not always possible,” he added.

Wallin continued that not all the solutions are related to trading as fund managers also need to change the construction of their portfolios and use more derivatives.

“Regulation has moved liquidity from being capital-dependent to being driven by technology and connectivity so there is no burden on the financial system,” Wallin added. “The lesson from history is that new liquidity providers will grow organically.”

Stephen Grady, head of global trading at Legal & General, said on the panel that banks are changing their businesses to increasingly follow an agency model and so are less likely to interact with clients who are balance sheet intensive and expensive to serve.

“There is no single silver bullet and the amount of buyside-to-buyside trading will differ between firms,” Grady added. “10% of turnover is beyond the realm of the possible but there could be a 1% to 2% improvement.”

Grady said there will also be behavioural changes from market participants as the size of bond trades come down, holding periods go up and the types of new issues reflect underlying liquidity.

“There is an opportunity for the buyside to change behaviour and we have got to be part of the solution ourselves,” Grady added. “There is a long way to go with technology and the choice of fintech partners will be critical.”

Zar Amrolia, co-chief executive of electronic market-maker XTX Markets, expects banks to partner with new market participants who can manufacture liquidity. “Banks have to choose which part of the value chain to provide to clients and have to be really good at that part,” he added.

Amrolia expects smaller banks to opt out of liquidity provision and for corporates to change behaviour as more new issues become standardised.

“Nature abhors a vacuum and new technology-driven liquidity providers will arrive who do not face conduct issues,” Amrolia said. “Client expectations will also change and they will become smarter about who they choose to execute with, which will not just be based on the bid-offer spread.”

XTX Markets is a quant-driven firm which makes fixed income markets without any traders. Last month the Bank for International Settlements issued a report on “Electronic Trading in Fixed Income Markets.”

The report said the use of automated trading (including algorithmic and high-frequency trading) has grown in fixed income futures and parts of cash bond markets, and innovative trading venues and protocols have proliferated as new market participants have emerged.

“For some fixed income securities ‘electronification’ has reached a level similar to that in equity and foreign exchange markets, but for other instruments the take-up is lagging,” added the BIS. “Technology improvements have enabled dealers to substitute capital for labour.”

The study continued that electronification is also changing the behaviour of buyside investors and deepening their use of execution strategies, in particular complex algorithms.

“Large asset managers are further internalising flows within their fund family,” said the BIS. “And a number of asset managers are supporting different competing platform initiatives that are attempting to source pools of liquidity using new trading protocols.”

The BIS highlighted the rise of electronic all-to-all trading platforms which have around 5% of electronically traded investment grade and high-yield bond trades according to market participants. “This has pressured buyside participants into reconsidering their position in the market, and some of them have acted to develop infrastructure that allows them to respond to trade enquiries,” added the report.

Investors are also adapting their execution strategies, especially for large volumes, in order to minimise the cost of transacting.

“From a purely electronic perspective, some buyside firms have deployed trade execution algorithms of their own, while others rely on the algorithms of agency brokers,” added the BIS. “The expansion in the number of new platforms and data providers in the fixed income market has also provided investors with new means of transacting directly with each other or more transparent information with which to source potential pools of liquidity.”

The BIS continued that another form of electronification is the use of exchange-traded funds as ETFs can be traded throughout the day – even if the underlying assets are not traded frequently. The report added that it is still unclear whether ETFs fundamentally improve the liquidity situation.

“This liquidity transformation may imply that investors are facing some degree of basis risk and may possibly also result in a form of liquidity illusion,” added the BIS. “Moreover, on a market structure level these inflows into instruments that give instantaneous liquidity may also increase the risk of disorderly moves due to the potential for herd mentality.”

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