Electronic Corporate Bond Trading at the Crossroads

The conversation in electronic corporate bond trading has shifted away from focusing strictly on liquidity to gathering data and analyzing relative bond pricing.

“The Holy Grail in the marketplace is pre-trade transparency and it’s very hard to get that transparency,” said James Switzer, head of credit trading at Alliance Bernstein speaking at Tabb Group’s Fixed Income 2018 conference.

On the panel, buy-side traders debated whether more pre-trade transparency is needed to boost their activity on all-to-all electronic platforms, which allows buy-side traders, dealers and hedge funds to trade with one another. “So the chicken and egg of data and trading is that the data really has got to come before the trading?” asked Larry Tabb, founder and research chairman of TABB Group, who moderated the panel.

By grabbing this data from platforms and data providers, asset managers can see what percentage of flow is out there and have more confidence in routing orders to venues. At least that’s the theory.

However, heads of fixed-income trading desks from major banks (Citi and JP Morgan Asset Management) on an earlier panel said that too much transparency could hurt the ability of banks to hedge their positions and get a decent return on capital. While broker dealers are mandated to report their corporate bond transactions to FINRA’s TRACE system, there could be attempts to expand that transparency to pre-trade as with Europe’s MiFID II. “The argument should be around the calibration of that transparency,” said Brian Archer, managing director and head of credit trading at Citi, noting that clients need enough time to enter their positions.

In terms of e-trading adoption, the buy side suggested that pre-trade transparency and automation of small trades are driving their decisions.

“I believe it’s about efficiency first, liquidity will follow,” said Switzer on the Evolving Nature of Execution panel.

“Efficiently consuming information that is coming into the firm and creating technology around that is really part of our DNA now and that is how we process it,” said Switzer, referring to a bond software package that he co-developed in 2015.

In 2015, AllianceBernstein began using Automated Liquidity Filtering & Analytics, or ALFA, to monitor electronic trading venues and alert users when there is activity on the bonds they want to buy or sell.

Instead of looking at multiple screens, Switzer said the firm is utilizing ALFA to aggregate information from electronic trading platforms, whether it be MarketAxess, Tradeweb, Liquidnet among others, or utilities such as Symphony and Project Neptune.

Demand for more fixed income data and analytics is a reflection of the evolving market structure, and how the buy side is adapting to technology.

“There is a lot going on right now for fixed income that didn’t exist three or four years ago, and we’re all still trying to figure it out,” said Gregory Heller, director of global fixed income trading at MFS Investment Management. Choosing from among dark pools, all-to all, and RFQ platforms, the buy side is finding the balance now, he said.  “We’re just getting used to direct feeds from brokers,” he added.

Despite the entrance of competing players and protocols, the buy side’s adoption of electronic bond trading has been slower than anticipated. Only 20% of corporate bond volume on a notional basis is execute electronically, which means that 80% is still going through voice and chat messages.

In AllianceBernstein’s case, 80% of the tickets are done electronically or 20% to 25% of the notional volume, and “that has been pretty consistent and has not changed,” said Switzer.

What has changed, however, is the way in which the fund manager is using electronic platforms, said Switzer.

Efficiency Game

Asset managers see the benefits in routing small trades to electronic venues, as much as possible, so they could focus time on bigger trades.

“We can be using electronic trading to handle trades that don’t need to be touched,” said Gregory Heller, director of Global Fixed Income Trading at MFS Investment Management. Rather than waste time, traders can put trades into an electronic platform and 90% to 95% of the time they can be executed, said  Heller.

Auto-routing can be controlled by size, different asset classes, and structured around valuations, he said. “But if a trade kicks outside of that, somebody has to look at it,” noted Heller

AllianceBernstein is using electronic platforms to book trades for low-touch trading and auto-execution. “We’re using these platforms just to push out stuff that we don’t want to touch, so that we can spend more time on the harder trades,” said Switzer on the Tabb panel.

In addition, many firms are attempting to build or buy ‘continuous evaluative pricing systems or CEPS, said Switzer. “The market is solving with algo pricing to come up with a liquidity score,” said Switzer. On a scale of 1 to 10, a bond that has a 10 is the most liquid while a score of one is illiquid. Assuming that most algos are the same, scores in the 5-10 range would have a high confidence that exposing those bonds to the market would be okay, he said.

However, panelists did not discuss how they are handling their larger corporate bond trades, which could be in illiquid bonds.

For instance, institutions invest in new issues, which are the most liquid bonds, but there are 12,000 corporate bonds that are less liquid and trade infrequently.

TABB Group CEO Anthony Perrotta cautioned that focusing on electronic trading was not a panacea to liquidity concerns in the corporate bond market. The riskless principal nature of the corporate bond market structure means that dealers are relied upon to provide immediacy.

“Balance sheet capacity is now concentrated in the hands of five or six US banks. The impact of dealer liquidity has fallen 2.5 times since the financial crisis,” said Perrotta, who cautioned that dealers have less capacity to offer immediacy to buy-side clients.

As for where the market’s development is headed, asset managers have hired alpha generators and that is the way they are trying to push the business going forward, said Alliance Bernstein’s head trader.

While there has been talk that the buy side will be the new market makers or price makers, it’s not true, said one trader. “We are the new price maker when it fits us,” said Switzer. “Relying on us to fill the buffer capital that has been destroyed from regulation of the prop desks and hedge funds is probably not the way it to do it.

As the ecosystem for electronic bond trading evolves, some buy-side traders talked about using ETFs as a means of being able to price bonds and where to transact. “We’re starting to look at moving risk differently,” said Switzer.  Corporate bond ETFs which track an index are centrally traded on exchanges, and let firms get exposure to a broad diversified index of bonds.

Heller of MFS Investment Management said his firm had considered creating a basket trade in emerging markets for liquidity purposes, “rather than selling 20 pieces of 500s one at a time.”  The firm didn’t mind taking a little bit of risk across a whole bunch of names and then trading out of bonds with its counterparties, he said.

With regulators having formed the Fixed Income Securities Advisory Committee, the SEC is looking at the fixed income market structure.  As a member of FINSAC, Tabb asked panelists what he should bring back to the committee.  Switzer said it’s pre-trade transparency. “If we could find a way to get more pre-trade information we bring more confidence into the market, and trade more.”

Constantinos Antoniades, head of fixed income at Liquidnet, said liquidity is most important and to have a more modern, diverse, resilient market structure. He wants regulators to recognize the use of all-to-all platforms, given that they are most likely to be central limit order books or CLOBs, and are better systems for the buy side.  Second, he’d like to see regulators encourage the use of market-driven metrics to create better pre-trade transparency sets to improve more confidence and create more trading opportunities.

Regulators could also impose a best execution rule for fixed income to protect individual investors. But traders preferred not to see anything too proscriptive like Europe’s MiFID II come to the U.S. “The industry is working together, is cooperating on sharing technology, discussing the hurdles we face. The industry is trying to figure it out,” said Switzer.