Will the Buy Side Become Fixed Income Liquidity Providers?

Buy-side fixed income traders are prepared to play a more active role as price- makers on electronic trading platforms, as liquidity constraints have pushed them to redefine their role.

Institutional traders at Markets Media’s Fixed Income Trading Summit on April 21 agreed that “behavior change” is necessary in light of sell-side firms reducing their market-making capacity and cutting their inventories of bonds.

Experts have been concerned about a potential liquidity crisis in the $8 trillion corporate bond market because of the growth of new corporate bond issuance, which has been in excess of $1.2 trillion in each of the past three years, wrote Rich Estabrook, managing director of taxable fixed income at Oppenheimer, in a report published on March 16.

From 2007 to 2013, investments in fixed income mutual funds and exchange-traded funds have doubled to $3.5 trillion. Yet this growth of the corporate bond market is paralleled by a sharp drop in primary dealer holdings, wrote Estabrook.

As a result, buy-side firms managing trillions in assets are the ones with the capital and will need to start behaving like non-bank liquidity providers, observed a global electronic market maker on the Markets Media FITS panel.

Traditionally, buy-side firms would phone their dealers to receive quotes. But going forward, the buy-side will need to start adjusting its mindset, according to an electronic trading and market structure executive from a leading large asset manager who spoke off-the-record.  This means the buy-side will need to be ready to act as a price maker at times when there are liquidity constraints in asset classes, or at times of stress when the same level of sell-side intermediation is no longer available.

But the buy side’s new role was met with some skepticism.

While a market maker provides continuous prices on both sides of the market, that’s not what the buy-side has in mind. Asset managers can adjust prices based on the credit within their portfolios.

“I think everyone is too optimistic about the buy-side making liquidity, as opposed to taking it. Most of the buy-side have the same directional view, so even if they made markets it may not really solve their net liquidity needs,” commented Venky Vemparala, Vice President, Fixed Income Execution Management at FlexTrade. “To the extent that they hold different views, such liquidity can be easily crossed in the current crop of crossing networks,” he noted.

One of the obstacles impeding the buy-side from price making is the lack of pre-trade transparency data from the electronic trading venues, said officials at the Markets Media event.

Regulators are also placing more emphasis on best execution, so the buy-side needs more access to pre-trade data, trading tools, and aggregation of data from electronic trading venues.

Since the buy-side must demonstrate best execution, it needs to know the prices of bonds and analyze pre-trade data before it can bid for bonds.

Whether it’s TRACE, SDR, or data from indications of interest, there is an opportunity for trading technology firms to provide data to the buy-side on an aggregated basis, noted the buy-side trading source. Currently, there is no venue that is providing this to the buy-side in a way that it can easily consume, suggested the buy-side trading source referring to the Financial Industry Regulatory Authority’s Trade Reporting and Compliance Engine and the Depository Trust & Clearing Corporation’s swap Data Repository.

E-Trading Proliferation

To fill-in the gaps in liquidity, institutional traders said they are considering some of the dark pools in fixed income.

“The traditional dealer system can no longer provide enough liquidity.  Among the factors are leverage restrictions, capital regulations and reduced appetite for warehousing risk.  They’ve changed their business model,” said Constantinos Antoniades, Head of Fixed Income at Liquidnet, who spoke on a Greenwich Associates webinar in March. Liquidnet launched a fixed-income dark pool last September to provide peer-to-peer trading among asset managers. “There is very little liquidity beyond the top 500 most liquid bonds,” he said. “The goal is to reduce the gap between the actual liquidity and the potential liquidity. We also want to create more liquidity in the less active bonds beyond the 500.”

If the buy-side wants to trade electronically there is no shortage of systems to choose from. Ninety-nine electronic bond-trading platforms have popped up across all sectors to facilitate trading, according to a Bloomberg article. The proliferation of so many e-bond trading venues reflects the opportunity to seize market share from the dealers, but could also exacerbate the problem.

Citing the problem of fragmentation, one trader overseeing a giant mutual fund manager said his firm is trading on seven electronic trading venues, adding he doesn’t know if the other 92 are better than the seven.

In February, the Securities Industry Financial Markets Association (SIFMA) released a survey of 19 electronic bond-trading platforms, citing a significant increase in the number of venues competing to grow the market for corporate and municipal bonds.  Of the 19 interviewed by SIFMA, seven entered the market in the last two years and four more intend to launch in 2016. The 19 platforms are offering 42 different protocols, including streaming prices from dealers and mid-point pricing for matching sessions. Some require sponsored access by dealers so that the dealer is disclosed but the buy-side remains anonymous.

However, the buy-side has been slow to adopt these new platforms. Only 20 percent of U.S. investment-grade volume was executed electronically in 2015, estimates Greenwich. The 20% is mostly on traditional multi-dealer platforms, like MarketAxess, which has the lion’s share, and includes a few new entrants like Liquidnet and TruMid, said Kevin McPartland, head of market structure and technology at Greenwich Associates.

Network Effect

One of the issues slowing adoption is technology integration.  Given that desktop real estate is limited, the buy-side is not going to connect to 10 different platforms, noted Zack Ellison, director of US Public Fixed Income at Sun Life Investment Management, speaking at a Tabb Forum fixed income event in January. An aggregation tool will be necessary at some point to siphon off existing liquidity, he said.

Connecting all of these venues to participants and providers of goods and services is part of the network effect, said Anthony Perrotta, Tabb Group’s partner and global head of consulting and research.

“How those connections become all-to-all and how they come together and form an ecosystem of participants” is going to impact the structure of fixed income markets, said Perrotta.

Liquidnet’s head of fixed income, Constantinos Antoniades, said that critical mass for trading venues hinges on connectivity to order management systems.

“Large asset managers operate out of their OMSs. You need to be able to protect information and make it very clear to the buy-side how their orders are handled and their information is protected,” said Antoniades, speaking on a panel at the Tabb Forum event.

In a sign that OMS integration is key to gaining order flow, Liquidnet’s Fixed Income dark pool, which went live with 120 asset managers, surpassed $1 billion of volume traded after just five months of trading, the company announced in mid-March.

Buy-side firms are also seeking to aggregate data from their execution management systems. “We can take all of our EMSs, aggregate them, strip out the data and figure out how to be a better price maker,” said James Kramer, Head of Fixed Income Trading, North America, State Street Global Advisors, at the Tabb event.

“However, new liquidity has to come into the market as well, to fill in, at least partially, the gap caused by the banks retreating in the market making/capital commitment space,” said FlexTrade’s Vemparala. “There is a need to foster more and more non-bank and non-buy side shops to make markets, he added. This will address concerns that if the buy-side provides liquidity it will not be continuous or two-sided, he said.

“Creating the tools and incentives for such market making will become more effective than the buy-side providing the liquidity. And such a thing will be directly from the playbook of equities and options where hordes of market makers provide liquidity alongside banks,” he said.

But given the complexity of the post-crisis environment, buy-side panelists said there are no silver bullets, and many expect liquidity constraints to continue for the next several years. Traders point out that they have expertise in evaluating credit determining which bond to buy or sell over another. Many are talking about the need for data scientists and architects for plugging into all the fixed income venues.  As dealers pull back from their dominant role as risk takers, asset managers are gearing up for a market structure that will look different in three to five years.