By Anthony J. Perrotta, Jr., TABB Group
Originally published on TABB Forum
In the corporate bond market, the buy side traditionally has relied exclusively on dealers to facilitate risk transfer. As we move further away from the financial crisis and toward the regulatory regime left in its wake, however, banks are being forced to alter business models, and that dependency is being questioned. As a result, liquidity is at risk. The solution lies not with the banks or trading platforms, but with asset owners. Once they harness and leverage this power, markets can begin to move forward.
Let’s set the record straight: There are some in the New York Fed and other regulatory agencies who suggest US corporate bond market liquidity is fine; I am skeptical. The datasets they are using to arrive at this conclusion are incomplete and misleading. TABB Group research demonstrates that bid/ask spreads are widening (i.e., risk transfer costs are growing), immediacy is contracting, and trading sizes are shrinking.
Of course, regulators may have a different definition of market liquidity. If systemic risk is mitigated in favor of a market that trades by appointment, that is prone to extreme volatility and asset value gyrations produced by single trades, and that is fueled predominantly by new issues, then maybe everything is sanguine.
Perhaps I am getting as long in the tooth as the liquidity conundrum story, but I am of the belief that the US corporate bond market is broken. If it’s not fixed, the wheels will eventually come off the track. We may not be looking at a systemic crisis similar to the one we faced in 2008 (when there was a leverage and counterparty problem), but there is a risk that a lot of “blood” (in the form of negative returns) will have to be shed to get back to equilibrium.
Trading platforms are busily designing innovative protocols, expanding established models, and deploying technology to improve efficiency in an attempt to serve as the release valve for the pressure building up in the system. That pressure is the cumulative result of the decline of immediacy provided by dealers, growing liquidity premiums, and lengthening timelines to move assets from one investor to another.
At the moment, investors have two primary options for risk transfer. First, they can call a dealer and request a bid or offer. Nowadays, however, they likely will get a partial fill and will be asked to leave an order for the balance. Data we recently published suggests a dramatic rise in riskless-principal (or “brokered”) trading since 2006 (see Exhibit 1, below). Second, they can break up their trades into smaller lot sizes, request a bid or offer over an electronic network, and place even more pressure on the system (most dealers agree that the trades they execute electronically are not profitable). Interestingly, both of these options start with the same premise: investors requesting liquidity.
Source: TABB Group
The efficiency of the RFQ network allows one to “scale” the probability of consummating transactions, but it misses out on one major premise: the positive effect of direct externalities brought about when each participant in the system incrementally confers value to each of the other participants in the system, in what is commonly referred to as a network effect.
Recently, innovation has expanded search, discovery, and execution options available to fixed income market participants. All-to-all is an emerging, multi-dimensional class of trading protocols and liquidity pools in fixed income, but too often the market defaults to the notion of it meaning an anonymous, lit pricing, central order book protocol. If we begin to think of all-to-all as trading protocols that allow participants to proactively contribute to the liquidity equation in a fashion that provides incremental benefits to everyone in the system, then the equation shifts. There is an incentive to be a member of the network.
Exhibit 2: All-to-all trading? Respondents who believe it’s possible for corporate bonds.
Source: TABB Group
The market needs to readjust to the premise that asset owners drive liquidity, since dealers have less capital to commit to secondary market-making, and the amount they do have is getting smaller relative to the overall size of the market. Once the market gets comfortable with the idea of buy-side liquidity provision, greater benefits will be derived as participants become more proactive in the equation.