Dehydrated bond markets face up to life without liquidity
Worries about bond market liquidity went from specialist interest to global best-seller in 2015. The Bank of England and the Federal Reserve published extensively on liquidity problems in bonds; European politicians lost their appetite for regulation, fearful about doing further damage to the frail but crucial animal spirits of the bond markets. But the last year saw precious little done to solve the problem. Owen Sanderson asks whether 2016 will be better.
Liquidity worries come in several flavours. Investors worry about buying and selling bonds in size. Dealers worry about dwindling volumes and rising costs.
Central bankers worry about raising rates, collapsing prices and liquidity mismatches. For the primary markets, price formation is the problem, while securities regulators worry about the mispricing which a slow-moving and opaque market allegedly conceals.
But all are dimensions of the same issue — it has become harder to do secondary market bond deals in large size without moving the price.
Would-be bond market physicians ought to note that it has become easier than ever to do primary deals in size. Three of the five largest bond deals in history were in 2015 (all US-based acquisition financings). Whatever problem the bond markets have, then, it is not a problem of appetite for bonds.
After that, though, things get muddier. Dealers tend to favour blaming investors, who are unwilling to pay the bid-offer needed in the new world. Regulators get short shrift too, for raising the capital costs associated with holding bonds, and for raising the cost of compliance, culture and the people that work trading bonds.
Investors usually prefer to blame dealers, especially when they’ve fired the managing director that used to cover them, and now they get a copy-pasted Excel run every morning from a keen but callow associate. Investors also tend to favour blaming other investors — as the big beasts of fixed income have taken over more of the market, more investment decisions move in the same direction, and fewer accounts are willing and able to take the other side of the trade.
Some people even dispute that there is a problem. Liquidity conditions are different to those pre-crisis, but it’s questionable what the “natural” level and cost of liquidity is, and whether the market is close to that level or not.
Only the leverage-juiced prop trading of the 2000s normalised expectations of vast, costless liquidity. Unwind the pre-crisis prop books and price liquidity properly, and the bond market gums up again, unless investors are willing to pay more for liquidity.
The rise of regulation
But the big change from the pre-crisis landscape is the rise of tight trading regulation. This takes two broad forms — bank prudential regulation, which raises the cost of banks using balance sheet, and market structure regulation, which reshapes market practice.
Discussing in detail all the ways in which it costs banks more to deploy balance sheet would take days — the Basel III counterparty credit risk charges, the Fundamental Review of the Trading Book, Basel III and its implementation, the leverage ratio, TLAC, and MREL all have an impact. Some hit distressed trading hardest, some hit sovereigns hardest, some of it mainly hurts derivatives, squelching bond liquidity by raising the cost of hedging.
This is pushing banks to change their business models, or to leave the market entirely. Where the leverage ratio binds, banks will abandon low risk, low return business — Credit Suisse’s closure of European government bond trading, or Deutsche’s abandonment of agency mortgage-backed securities trading are recent examples.
“The business is changing; balance sheets dedicated to bond trading are now carefully monitored by all financial institutions, which is why we’ve seen such high volatility recently — such as the reaction to the rate and credit markets during the Greek crisis in May,” says Allain Gallois, head of fixed income at Natixis in Paris.
When risk-based capital ratios cost most, other businesses fall aside, such as correlation trading, credit structuring, or single-name CDS market making.
“By far the biggest [capital] increase applies to credit, with the single largest being single-name CDS, a business area we expect to fall away almost completely,” says Deutsche Bank’s research team. Deutsche itself shut down single-name market-making for large swathes of the market.
In the businesses that the banks have kept, regulation has also changed how banks operate. The cost of holding bonds goes up, so banks try to do it less, finding the other side of trades before executing, getting out of the way when the market turns down, and backing off bids before getting hit. Some argue this worsens market volatility, as prices disappear entirely in downturns, or appear to rapidly gap wider.
Do you see what I see?
The market structure regulations, however, are more fundamental, and threaten to upend pre-crisis trading practices entirely. Those who back the rules claim they could generate more liquidity; those fighting a rearguard action say the opposite.
The Markets in Financial Instruments Directive — MiFID II — makes the biggest difference to those in the business of trading cash bonds, by requiring equity-like transparency to be introduced to the bond markets.
Banks which trade bonds now get classified as “systematic internalisers”, and regulated as trading venues, as well as regulated as risk taking institutions.
That means they need to disclose their prices to the market at large, and publish the size and price of trading in public afterwards. Regulators get better data too — banks must print trade details to them, including counterparties. There will be no more guesses about the size, volume or turnover of European fixed income and repo.
At first, this could make trading harder. Regulated entities will be vulnerable to being picked off by the unregulated sector, or their competitors. Bid-offer spreads will be wider, while cliff effects around the changes in liquidity treatment will abound.
Even regulators themselves acknowledge the difficulty — Stephen Maijoor, the chair of the European Securities and Markets Authority said: “We will for instance need to properly fine-tune and balance transparency with liquidity when extending pre- and post-trade transparency to bond and derivatives markets.”
The UK’s Financial Conduct Authority said: “We would expect post-trade transparency requirements to impact the willingness of counterparties to carry out[large and very large] transactions and, therefore, impact market quality.”
But later, regulators could hope, trading will get easier again — with the example of the Trace system in the US bond market proving encouraging. As the market becomes more like that of equities, equity-like liquidity changes should take hold. Bonds will trade in smaller size, with tighter bid-offers and across more different venues.
Banks will offer introductions to a plethora of electronic platforms, exchanges, dark pools and matching engines, and make their money from prime finance and commission. High frequency traders will sit in the middle, instead of expensive, low-frequency human traders who occupy real estate, create compliance risks, and demand compensation.
Do it faster, make us stronger
Some of these changes are already happening in fixed income derivatives, with the EMIR regulation forcing derivatives to be cleared, rather than settled OTC. Citadel, the Chicago-based hedge fund founded by Ken Griffin, is already the top US interest rate swap market maker on at least one platform through its securities arm. It has launched a Treasuries service — and dominated the market — and in 2016, it plans to launch trading operations in euro interest rate swaps and in credit indices.
The firm has been able to break into the market because of regulatory initiatives to force transactions to clear centrally — EMIR in Europe and Dodd-Frank in the US. That cuts through the web of bilateral documentation, CSA agreements and ISDA agreements that underpinned the market orientated around the big banks, and allows a new entrant to compete purely on execution and price.
European government bonds aren’t in the business plan, yet, but for certain large and standardised markets, such as Bunds or repo based on general collateral, a more automated market can’t be far away. Plenty of banks, too, are investing in automated trading technologies in fixed income, with RBS, for example, using its investor day to flag up the quality of its automated trading operations in Bunds and Gilts.
Unless, that is, structural problems in the market are behind the thin liquidity on offer in secondary markets. The top 10 asset managers hold nearly 30% of the financial assets in the world, according to research from the Bank of England, and anecdotally, the concentration is more pronounced in certain bond asset classes such as investment grade corporate bonds.
They also tend to move in similar directions, and in a scale that does not allow them to easily exit positions. Sometimes, these funds can act as a buyer of last resort — Pimco, for example, hoovered up cheap European ABS as it came out of Europe’s banks — but more often they will sit on their hands when the market turns sour.
Some of the larger funds are trying to reshape the market to match their needs. BlackRock argued in September 2014 that corporate bond issuers should start to concentrate their issues on given ISINs, as this would improve liquidity. Issuers, and their bankers, argued in turn that this was self-serving, and would increase costs to issuers purely to benefit BlackRock and other giant buyside firms.
Research done by McKinsey found 60% of US survey respondents and 45% of European respondents “are not convinced that a rise in liquidity premiums would convince companies to standardise their issues”.
For sovereigns, however, the “concentration of liquidity” argument might be on stronger ground.
European government bond trading has seen a concentration of liquidity in listed futures — the long-running Bund future, but also the BTP and OAT futures, launched in 2009 and 2012, and the Bono, launched last year. If investors can cluster around the standardised liquidity on offer in futures, why should they not cluster in the on-the-run 10 year? Governments, too, are free from some of the corporate constraints. They do not have to asset and liability match, and, often, do not need to deal with such rigorous accounting standards. Liquidity in government bonds is a public good, underpinning the smooth functioning of the whole financial system — a point which is hard to extend to, say, Shell.
“There is no single body or person in the organisational infrastructure of the markets which is responsible for liquidity,” says Robert Stheeman, head of the UK’s Debt Management Office. “If liquidity is a public good, who champions it?”
Fixing the bond markets has to go in different directions in rates and in credit. One head of credit trading argues that credit should be seen as closer to equities than to rates, driven, as it is, by corporate newsflow and name-specific investment stories.
The problems, too, are of very different degree. Corporate bonds (or other credit products such as securitization, or emerging markets) is teetering on the verge of becoming an agency or matched principal market. Banks are reluctant to show keen prices unless they have the other side of a trade in place already.
Rates traders, however, are much more sanguine. Liquidity is not what it used to be but it exists and is manageable for on-the-run issues. Finding specific off-the-run issues is challenging, but perhaps, acceptably so.
The solutions, too, need to be different. Excitement around transparency, electronification, matching engines and dark pools is running much higher in credit, which is still heavily voice-based, than rates, where electronic trading in smaller size has been usual for years.
Technology certainly ought to help. Firms like Uber and AirBnB have become huge almost overnight by matching previously unidentified sellers of services with potential buyers, increasing the total size of their markets and lowering costs. Why not in bonds as well?
That’s certainly the techno-messianic pitch behind Algomi, which shares an angel investor with AirBnB.
Stu Taylor, the firm’s chief executive told a conference panel: “Business models where you do not own the assets themselves, but own the network and the information can grow incredibly rapidly and completely overwhelm established business”.
Algomi’s basic idea is simple — systematising information about who has which bonds and what interest in trading should create more opportunities to trade — but the details, of making sure nobody tips their hand first and gets ripped off, are far more complicated, and the biggest obstacle to moving electronic.
Making life easier
But even more humdrum, straightforward tech innovations can help to promote liquidity. Ipreo, which makes the new issue technology used by syndicate desks to co-operate on primary deals, is working on allowing investors to show interest straight into the book — a simple and obvious change, but one which should free up distribution teams to do more than take new issue orders. Salespeople can spend more time gaining an understanding of what their clients want to be shown, and what they might want to sell — creating more opportunities to trade through the existing dealer-to-client, voice-and-Bloomberg system.
“Electronic trading is changing the nature of sales activity, enabling our teams to focus more on value-added business and less on pure execution,” says Natixis’ Gallois. “What we want to see from our sales is more time detecting demand, organising reverse enquiries and optimising both the market and client intelligence. We want to select big orders that allow deals to be printed and come to issuers with an accurate view of market positioning.”
Regulators hold the whip hand
Tech should help, but any big change will have to come from regulatory change. Regulation has increased the cost of bank capital, and that is the major input to the cost of market-making. There is no appetite for regulators to cut bank capital rules again, to admit that the demands have gone too far. But there are signs that regulators and politicians are unbending a bit.
The UK’s chief bank-basher Andrew Tyrie, who chairs the Parliamentary Commission on Banking Standards, called for a study of liquidity in Gilts.
Dealers won the bitter fight over how to measure liquidity in the new European transparency rules, changing the minds of the Commission and regulators from the UK, France and Germany. Liquidity will now be measured bond-by-bond based on trading frequency and turnover, not on the broad proxy of issue size.
Other, more dangerous initiatives such as the Financial Transaction Tax have largely dropped off the EU agenda (a smaller group of countries are pressing ahead), while European rules to split trading divisions out from universal banks have also slowed right down — partly because at least four jurisdictions already have their own, mutually incompatible statutes.
None of this is going to bring down the cost of balance sheet drastically, and businesses which are high volume but low margin will inevitably suffer. Bond liquidity is never coming back to pre-crisis levels, and no amount of “fixing” can change that.
But banks will adapt to the new world order, carefully husbanding their capital, using technology to boost the productivity of their people, and somehow, keeping the business of bond trading going.