Everyone is incentivised to fix corporate bond liquidity
A European Commission study has confirmed what every corporate bond market participant already knew was true — the market has a liquidity problem. Everyone is responsible, the EC says, but no one has any incentive to fix the problem. They need to pull together to improve liquidity while there is time.
Corporate bond liquidity is like broccoli. Here is why.
Everyone needs their vegetables to prevent malnutrition, even if at the dinner table, the threat of coming down with an illness mostly encountered in ancient tales of the sea rather than in modern life — scurvy — may seem far flung.
But the risks are higher than you might think. In the last 10 years according to a report by the Health and Social Care Information Centre, reported cases of scurvy in children has risen 27%.
Similarly, it is oft repeated that corporate bond markets should be liquid in the case of an economic downturn. But, there has not been one of those for many years and Europe’s economy appears to be growing.
But downturns happen, and crises are crises because they crop up out of the blue. What if there was a run on corporate bonds? It seems conditions are not ideal for those who will suddenly need to off-load risk.
The European Commission says there are several reasons why the corporate bond markets are at a disadvantage over liquidity.
Bonds do not trade on an exchange like equities do, it says. This makes price discovery less efficient. There are electronic platforms but the sheer number of them adds to the problem of inefficiency — Algomi, Ipreo, MarketAxess, Tradeweb and others are all similar in the EC’s view, and serve to fragment the market.
A study in February from the UK’s Financial Conduct Authority found a decline in dealer quote rates on electronic bond trading platforms, wider bid-ask spreads, higher prices for round-trip costs, and longer trade times. Failed and rejected trades rose in the last two years.
Meanwhile, the banks that used to be the biggest market makers now face higher costs to doing that business thanks to heavier capital and regulatory requirements.
The Markets in Financial Instruments Directive (MiFID II) will change the business of trading cash bonds, by requiring equity-like transparency to be introduced to the bond markets, but no one knows how that will play out when it comes into force in January.
Nobody’s fault but everyone else’s
Blame has been dished out hither and yon. GlobalCapital has heard the same sell-side firms that love to crow about ‘high quality, real money’ investors blame them for bare-faced cheek to buy and then hold their assets. Regulators, have jabbed an accusatory finger at the dealer banks blaming them for the creation of the liquidity-crippling rules that they wrote and enforce. The buy-side, meanwhile, has complained about lack of access to the market, incentives to show up in the first place and, as ever, about having to pay for anything.
Sir Robert Stheeman, head of the UK’s Debt Management Office summed the problem up when he said, “There is no single body or person in the organisational infrastructure of the markets which is responsible for liquidity. If liquidity is a public good, who champions it?”
In the case of vegetables and public health, there are many champions, but ultimately, people learn they have good reason to eat their greens. When someone contracts scurvy, no matter how unlikely, they will have to look at their lifestyle choice and wonder if they picked the right things out of the fridge in better times. It will do no good to blame the parents, the government or Big Food at that point.
The same is true of the bond market. Each constituent must realise they have an incentive to boost liquidity and that they can each do something about it. With Europe enjoying an economic bounce of late, the need may not be pressing, but regulators, dealers and investors should take preventative measures now to ensure that when the pressure builds later — as it inevitably will — there is a suitable release valve.