In this article, Mike O’Hara, publisher of The Trading Mesh – talks to Paul Reynolds of Bondcube, Peter Fredriksson of Baymarkets, Stu Taylor of Algomi and Andrew Bowley of Nomura to discuss ways the financial industry can work with the buy-side to address some of the structural problems that have led to chronic illiquidity in the fixed income market. Also, from the buy-side perspective, Gianluca Minieri of Pioneer Investments spoke with Mike about the issues buy-side firms face in today’s market.
The fixed income market has undergone a dramatic transformation in the years since the global financial crisis. Banks have shrunk their balance sheets massively and stopped warehousing large holdings of bonds, a trend which has prompted a sharp decline in secondary market trading. In the meantime the overall size of the market has grown by 50% and recent reports suggest there is a remaining supply short-fall of as much as $400bn. Meanwhile, attempts to emulate equities and create fixed income central limit order books have yet to gain traction. Bond holders are reluctant to post orders via Requests for Quotes (RFQ) or fully lit Central Limit Order Books (CLOBs), liquidity remains fragmented and both the buy side and sell side struggle with how to make the market work to everybody’s benefit. The solution, some firms say, can be found in two words: innovation and collaboration.
“We are now in a situation where RFQ works very well for liquid bonds and small orders, but RFQ does not serve large and illiquid orders due to too much market risk.”
Paul Reynolds, Bondcube
Paul Reynolds, CEO of trading platform Bondcube, says the extreme volatility in all asset classes seen in October 2014 offers an important lesson. Whereas before, many participants believed the problems holding back secondary market trading were restricted to the relatively less liquid corporate debt market, during this bout of market instability the situation became so dysfunctional that even US Treasury bonds stopped trading.
“There was the living proof that, actually, this is a major market malfunction. Everyone needs to get round the table now, not just banks, not just buy sides, not just technology, but regulators as well. It has got to be a four-cornered discussion.”
As it currently stands, the market is so fragile it can buckle under pressure and at times fail to accommodate even the most basic needs. This is not for lack of new ideas. A number of new trading platforms have come on stream in recent years. Some, like Bondcube, aim to create ‘all-to-all’ markets where the buy-side can post orders and trade with each other. Other firms, such as trading systems vendor Baymarkets, have sought to preserve some of the best features of the traditional OTC model while addressing structural issues that have held back secondary market activity.
Bondcube and Baymarkets are two examples of firms that are offering modern solutions to long-running problems. Bondcube, in bringing buy-side players together, is using some of the successful concepts employed by social media companies to offer investors a way to navigate the market. Baymarkets, in opting for a hybrid model where the sell-side retains a central role, also focuses on information flows and aims to provide enough information to trade without fully emulating a lit market such as equities.
The temptation to make fixed income markets look and act like equity markets has been strong. If only someone could build a venue where everyone felt comfortable posting orders and could enjoy a wealth of information via a Central Limit Order Book (CLOB) and various data providers. But there are good reasons why large fixed income investors are wary, says Peter Fredriksson, CEO of trading platform vendor Baymarkets.
“The values are so large that investors fear tipping their hand the moment they post a price. They don’t want to tell anybody where they are, what they want to do and how much,” Fredriksson says.
The answer to many structural issues, according to Reynolds, starts with technology but it doesn’t end there. “Technology is extremely good at networking people and collecting data and making data available. We have got to turn this market into something that looks a bit more like Amazon or eBay.”
One of the problems is figuring out how to create a method to give the right people the right information. For instance, imagine a firm is looking to unload a large amount of bonds. For a sell-side firm, that information becomes valuable as it can have an effect on the price of future sales. But another buy-side firm just wants to know the latest price and volume for valuation purposes. The latest quote may be available and is useful, but it is potentially not as useful as the latest dealt price and volume.
The US market recognised this with the development of TRACE (Trade Reporting and Compliance Engine) in July 2002. All broker/dealers who are FINRA member firms have an obligation to report transactions in corporate bonds to TRACE under an SEC approved set of rules. That means that the US corporate debt market is more transparent, Reynolds says.
Stu Taylor, founder of specialist fixed income data provider Algomi, says a buy-side firm typically has little information to go by when it seeks to execute a transaction. “If they want to do it in any kind of size, then who do they go to? How do they get a two-sided quote rather than a one-sided quote? How do they know who might have the other side of the trade that they want to do?”
“Nowadays, the best of the online businesses – the Googles, the Facebooks, the LinkedIns of this world – essentially put the individual in the middle of the universe and they surround them with information and data and let them draw their own natural connections.”
Stu Taylor, Algomi
Reynolds says investors are coming up with interesting ideas to gain new information. One Bondcube client is looking to scrape any chat, voice conversations or email in real time.
“The very nature of fixed income, with all these 100s of 1,000s of securities that never trade, is it has got to be data driven. And we have the technology. It has existed for years. Why don’t we use it? It needs to be done in a collective way,” Reynolds says.
Information flows are paramount, adds Taylor. “What you’ve really got to do to solve the problem is to get the right information to the right people at the right stage in the transaction, whether that’s pre-trade, during the trade or post-trade. You’ve got to also join the dots and connect people together. We think that’s a natural extension of what the sales role is today. We think it’s a natural extension of the client.”
Bondcube works by having users submit indications of interest. Matching IoIs is performed darkly, such that everyone may be asked if they are a match, but the only person aware of the match is the person who is on the other side of the I oI. Buyer and seller then work out size and price, with the execution price between the bid and offer.
To have those conversations, participants still need a sense of where the market is and where it has been. Bondcube helps address the problem by allowing investors to see historical volume for each bond. For less liquid bonds that rarely trade, participants can see old orders that have not been filled and rejuvenate them.
The model borrows from social media firms by essentially putting each market participant at the centre of his or her network. Trades are not just about putting prices on screens and matching buyers and sellers.
“Nowadays, the best of the online businesses – the Googles, the Facebooks, the LinkedIns of
this world – essentially put the individual in the middle of the universe and they surround them with information and data and let them draw their own natural connections,” Taylor of Algomi says.
There are three main ways that bonds get traded. The first is the interdealer market, which excludes the buy side. Second is dealer-client, but an interdealer trader cannot participate there. Finally, there is all-to-all, which is the model that Bondcube has offered.
What has kept the fixed income market going is the constant stream of new debt. Primary market volumes have reached record levels as borrowers seek to take advantage of historically low interest rates.
“You have got a new issue spigot that is pouring new bonds into the market every day. It only stops when a hurricane blows through town. As soon as the hurricane is gone, it is pumping away again. The market gets bigger, and bigger, and bigger, and yet, its infrastructure is crumbling around it,” Reynolds says.
In those periods when new issuance dries up, the market, as it currently stands, is in trouble. But it’s not all doom and gloom.
Andrew Bowley, head of market structure strategy for EMEA at Nomura, says there is a wealth of development taking place, with new, and potentially disruptive, ideas being floated to address the conundrum the fixed income space finds itself in. “And if there’s any time that is a good time to bring in new, alternative platforms, then with the structural issues and with the regulatory change coming, now is probably the best time to do so,” he says.
“If there’s any time that is a good time to bring in new, alternative platforms, then with the structural issues and with the regulatory change coming, now is probably the best time to do so.”
Andrew Bowley, Nomura
Despite some of the stark difference between fixed income and equities, Bowley says the latter still offers some pointers for the debt market. “It’s around things like best execution. It’s about the commercial construct and relationships and things that perhaps haven’t been considered in depth before in fixed income,” he says.
But to create a market where the concept of best execution is even possible, more information is necessary.
Taylor says the liquid part of the bond market is not the problem. There are a good 500-1,000 issues that are regularly traded, where various bond trading platforms and voice-broking solutions meet investors’ needs.
In that respect, Taylor says that rather than reinventing the wheel and trying to create a totally electronic market, a hybrid-voice model makes sense. “Quite frankly, it’s how the trades are happening today. It’s just, can we make that process work better?”
For Baymarkets, the way to make the process better has been to create what it calls a “twilight” pool, which is somewhere in between a lit market and a dark pool. Participants can see some aspects of the market, but not all the information in a traditional lit market.
“It gives a flavour of where the market is. If there’s a reference price somewhere or a mid-price somewhere and then there are indications that there are activities in the market, then at least people know the rough price level and that there is activity around that level,” Fredriksson says.
Taylor says Baymarkets is a good example of a hybrid model. “The whole point is designed around a broking concept and it’s designed to complement electronic with running voice process for certain trades,” he says.
Another idea is to try to concentrate liquidity at set times with secondary market auctions, based on sectors or geographies.
“Instead of having a CLOB or an auction running all day, typically you run auctions for 15 minutes only for a sector,” Fredriksson says. “You focus liquidity to a much smaller time during the day.”
Such auctions allow investors to find counterparts in a much shorter time. Taylor says bespoke auctions have a good deal of appeal. “You’re combining what is a partly electronic market and extending it by allowing the sales people to take control, invite selected clients into a negotiation process while still giving the benefits of matching technology but without completely taking the sales person out,” he says.
“Instant transparency is probably what the buy-side doesn’t want. They don’t want to tell everybody about their intentions.”
Peter Fredriksson, Baymarkets
Providing transparency in the way that other markets do is not the answer, according to Fredriksson.
“Instant transparency is probably what the buy-side doesn’t want. They don’t want to tell everybody about their intentions,” he says. “Even though it’s good to have a price level defined but I doubt that the buy-side wants too much transparency in that.”
Fredriksson says one route to consider is the idea of ‘work-ups’, where traders establish a price level and then keep trading until one of them is done. “Then the remaining interest goes out to everybody else in the market. There’s your reference data,” he says.
“That’s one way to attract liquidity because once the price level is established other people may want to join in.” Baymarkets provides this feature and Fredriksson says it is similar to the RFQ process.
Another concern: too much disintermediation. Eliminating the ‘middle man’ is often thought of as a good thing, but the bond market needs some mediation. “We think that any solution that’s going to work needs to be done with the support of the major dealers, not fighting against them,” Taylor says. For its part, Bondcube has welcomed dealers onto its platform to act as the intermediary between buy-sides.
Finally, the sell side, buy side and vendor community have to recognise that the fixed income market has its own set of requirements that mean the equity market model is of limited value.
“You can’t just apply the equities structure and the equities type technology to the fixed income market because they’re two very, very different beasts,” Bowley of Nomura says. “What is really going to be required is some really interesting innovation as to how the technology can be brought in to apply to the way the fixed income market operates.”
The idea that fixed income markets can migrate en masse to a CLOB-style structure is widely rejected, but central limit order books could have a role to play. More likely in the market’s evolution is a system based on participants’ roles, such that agency- and principle-based businesses can operate side by side.
“It’s less about the platforms and more about the infrastructure and the environment. To me the more interesting part of the landscape is actually the desktop that we have here and the information available to our traders and our sales people,” Bowley says.
People may think of fixed income as an RFQ market, but transactions within the buy side are often coming through to the buy side dealer as order flow. “As the buy side technology landscape evolves, that order handling of the buy side would actually be easier to use and follow through in an order-handling framework,” the Nomura executive says.
“So the combination of various structures in the RFQ world and the interaction of the RFQ world and the order handling world are going to be the trickiest dynamic for people to try and get their heads round and link up.”
Financial markets in the post-crisis era have generally been wary of regulatory reform. While many have accepted that stricter oversight was inevitable after such a jarring period of market upheaval, the costs and disruption from so many new rules and requirements has been a running concern for much of the market.
But the fixed income world may be different. Its structural problems, and the disincentives for some parts of the market to change the way they do business, means that this is one area where an external nudge could be welcome.
As it is now, much of the data that investors want and need to conduct transactions gets hoarded.
“Unless we begin to address this fundamental infrastructure, we are never going to get there,” Reynolds says.
Regulators, he says, should offer a quid pro quo, where the sell side is encouraged to disclose more information in exchange for greater latitude in other areas. The message would be something like this: “You start producing data that is available like it is in other asset classes. That will help people understand where bonds are trading. We will give you a little bit of bandwidth on what you can do.”
MiFID II is starting to drive people to think about where they want to position their franchise in the landscape, Bowley says. Regulatory pressure will be an important dynamic in areas such as where best execution obligations may sit in the future.
As order books do develop, or even if the dominant model remains RFQ-based, buy-side firms will still need to decide which and how many platforms they will want to be part of. In some cases, that means exchange membership, which brings with it oversight, regulation, supervision and due diligence. Bowley says Euronext offers a good example of buy-side participation in an order book-led market. Buy-side firms are typically intermediated by a sell side firm that sponsors their access to the exchange.
“MiFID II is not only bringing these structures more clearly but is also increasing the due diligence that an exchange has to put on its members, for instance. So I think the dynamic between some of the platforms and the buy-side is going to have to evolve as a result of the status of these platforms,” Bowley says.
Numerous question marks remain from all four corners of the fixed income world – the sell-side, the buy-side, vendors and regulators. Will regulators push for change? Can the sell-side work side by side with market innovators to alter traditional trading practices? Is the buy-side ready to do business in a new way? The answers to many of these questions will take time. But what is clear is that the fixed income market is undergoing a major transition, one that holds out the promise of a fairer, more effective trading environment.
Gianluca Minieri is Global Head of Trading at Pioneer Investments, one of the world’s biggest investment firms. The group has nearly 200 billion Euros under management, 60% of which is invested in fixed income. Gianluca spoke to Mike O’Hara about the issues buy-side firms face in today’s market. Below are some of his thoughts.
On ‘equitisation’ of fixed income markets:
Policy makers and regulators have to understand there are differences between the fixed income and equity markets but also there are a lot of differences that exist within the fixed income space itself.
The structural problem is that you have a lot of markets acting within the same market. This issue came about when the regulators started to think about how they could impose the same level of transparency that is currently being enforced on the equity market to the fixed income market. It’s like trying to cure two different illnesses with the same medicine.
When I consider the equity markets of today, I see a market that is fragmented, where liquidity is difficult to find and where there is open space for speculation. I don’t see a market that can be taken as a benchmark, or as an example of an efficient market. On one hand, you have a market that is traded on exchanges, on the other hand one that is still predominantly traded over the counter.
I have been part of a group that has worked with the European Commission. We have said on many occasions to policy makers that we are not against transparency. We are in favour of it, where it is strictly correlated with liquidity. We also support the development of certain electronic books, for example for very liquid instruments, where the platform could operate in a similar fashion to an equity-style exchange-driven order book, which actually would help to take the noise out of the market and increase transparency. In the more illiquid markets, this challenge cannot be solved through an electronic platform as liquidity is all that is required.
On technology, liquidity and standards:
Technology can help in two ways. On the most liquid part of the market, technology can help develop an electronic platform similar to an equity-style order book. On the most illiquid side, technology needs to be utilised to try to minimise the protocol differences that exist in many exchanges. At my last count, we have approximately 35 different venues – in the fixed income space alone – where you can execute your trade. Each wants to have its own space in terms of liquidity, the connectivity standard and their protocol language.
It’s a nightmare as the burden is placed on us to look for liquidity. Every time our traders need to buy and sell a bond they have to look into 35 different venues and spread their trading intentions to the wider community. The reality is the market making model is now completely useless in fixed income. Why? 97% of the inventory is actually held by the buy-side. Every time we want to buy or sell a bond, we have to find another buy side that has the opposite trading intention that we have and can match. The result is that market makers are only needed as an intermediary between two buy sides.
Don’t get me wrong, you need an all-to-all electronic platform that can aggregate liquidity. As a buy-side firm we have been very proactive in supporting a number of initiatives that are precisely aimed at standardising, to establish a credit market network on a utility basis. The key objective would be to create a network that can act as a carrier and assist buy-side and sell-side but without having the problem to look into different venues and speak in different languages.
On Bondcube, Algomi and other projects:
They are aimed at providing participants with the possibility of accessing many different pools of liquidity at the same time, through a single user interface as well as integrating access, inventories, IoIs, RFQs all in the same place. How do you do this? You do it by commoditising the network connectivity.
We are seeing a change in the way that the sell-side is relating to us on the buy-side. They realise what they have to do, if they don’t want to miss future opportunities.
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