Adrian Fitzpatrick, Head of Desk Central Dealing at Kames Capital expresses strong opinions on the current state of fixed income market structure. What needs to be changed to improve the market?
What is driving managers into equities?
A lot of it depends on which market you’re looking at. If you look at the European markets, there has always been a high weighting in bonds. There’s never really been the equity culture to the same degree as you have in the UK. Obviously in the UK a lot of it is driven by the insurance companies that have actuaries to dictate where the split between equities and bonds lies. Before these pensions’ time bombs, the safest investments for most people were bonds. However, we are all working on the assumption that bonds are currently completely overvalued, but as long as there’s Quantitative Easing they are going to hold these abnormally low levels of yields.
The other thing is institutions don’t want to stand out from the crowd. If everyone’s in bonds and bonds fall then you are going to fall together. There’s so much short term-ism in the market, you can’t afford to be an outlier for a long period of time and then not be right. I think risk assets now are relatively cheap; you look at the yields on risk assets compared to the yields on government assets, some of the credit assets like high yield are still quite reasonable. The bond markets are over valued , but it’s probably not going to change until the QE bubble bursts.
So the macro economics is feeding into that bubble?
Yes definitely. It’s like we said about the dotcoms: Why are you buying things that are at that level? We all know if you go back historically and look at bond yields in the UK, they should be around 4½/5%. But at the current level, it’s only sustainable as long as the Bank of England and the government are prepared to keep rates abnormally low because of the state of the economy. So can we see that carrying on to 2013? Definitely. (See diagram on next page)
You’ve got the government printing money, so all you have to say is, “Where are you going to put your assets?” Unfortunately in the environment that we are in you just can’t stand that far away from the crowd for a period of time.
What is the main problem with the fixed income market?
Effectively the market is not transparent, unlike the equity markets, which are. In equities you can see commissions, you can see the prices, you can see what gets printed. In the bond market you can’t. Platforms have been around for a long time, the likes of Tradeweb, Market Axess, and Bloomberg Tradebook, etc. These will keep gaining more traction because you can send them multiple requests for quotes and they are creating a virtual marketplace, which the regulators will like.
It’s not uncommon to send a trade down electronically to one of these platforms, and for all the banks to just pass; there’s no obligation to make a price or to make a marketplace. They make the price when it suits them. Personally, having traded multiple asset classes, that, to me, is not a marketplace.
You end up working with the fund manager to try and find the other side of liquidity. It’s such a captive market that effectively sooner or later, there has to be some outlet valve that gives institutions the opportunity elsewhere. Obviously, when you look at equities you had the establishment of crossing networks many years ago, of which Liquidnet and E-Crossnet were forerunners. Now what you are seeing on the bond market, through Blackrock’s Aladdin and UBS PIN, are various other brokers trying to get that same result.
What they are trying to do is encourage the institutional investor to create more of an electronic market. The biggest problem is in equities you have, for example, Vodafone, but in corporate bonds you can have 12 credits for the one stock; therefore it’s very difficult to identify a specific one and find a natural cross against it. So it needs to be a slightly different approach for bonds, just because it is a different discipline. You have different variables in bonds, the spread, which obviously a lot of fund managers work off, and you have the underlying Government bond.
The banks are going through what happened in equities. But equities aggregation is now the key; tools have been created that aggregated across the different dark pools to allow you to send one order to many venues. I think that what is needed is an institutional crossing network similar to Liquidnet. We need to create competition away from the banks. However, this isn’t necessarily all the bank’s fault because they say “we provide the risk and therefore we should be able to choose when we make prices.”
However, the biggest institutions are very close to the banks; they can dictate when they want to trade.
For us as an institution, it becomes incredibly difficult not just sourcing liquidity, but being able to trade out liquidity when we need to, because you are totally at the behest of the investment banks. In equities you can trade by program, by algorithm, you can ask for a risk price. You may not like the price, but the market will always make you a price and you can decide whether you actually want to take it.
In bonds, a broker will send out what’s called an “axe”. The axe is effectively the bond equivalent of the IOI. You’ll phone to follow up on the axe but they can back out. There’s no obligation.
In government bonds, where the electronic systems are more established you can trade more effectively, and it is getting there, but the credit part of the market is just completely arbitrary.
Who is going to drive reform?
It will have to be driven by the regulators, in the UK by the Bank of England, and it has to be driven by institutions. The problem is institutions aren’t members of the market. Institutions don’t have the IT infrastructure or the IT spend to be able to create new platforms unless you are a Blackrock or a Pimco.
In the US they use TRACE, and we need a similar system as we need to establish ways for institutions to understand who is doing what, so you can target business to the broker or investment bank. And if not, there should be some form of platform that allows institutions to cross up against each other.
How is market fragmentation changing and developing across Asia?
Asia Pacific faces different liquidity challenges to other regions, particularly given that spreads are often much wider and are therefore an even more significant contributing factor to overall trading costs (See Chart). As the trading environment evolves in the region and the focus on managing costs grows, the requirements for transparency and feedback on trading increases. This is happening in parallel with the evolution of new trading venues in the region, particularly dark pools. Buy-side traders now want a greater level of detail on their dark pool fills to help them understand the behavior of their orders and manage their execution venues proactively to get the best trading result.
Understanding Maker/Taker
The initial stages of the financial crisis were characterised by highvolatility and high-volumes. The post-Lehman environment was difficult to navigate for many reasons, but low market volume was not one of them. To some extent this continued up until early 2011, but since then we have seen a steady decline in trading activity, albeit interspersed with moments of fear-driven volume peaks such as last August.
Over the past few years, much attention in Australia has focused on the competition between ASX and Chi-X. But, in fact, multi-venue trading (via dark pools) was available to Australian investors long before Chi-X ever opened its doors back in November 2011. The term ‘dark pool’, however, has now become a catch-all phrase that describes a variety of activities that match trades but do not distribute pre-trade prices. Partly because of their name and partly because they are misunderstood, dark pools have attracted great controversy worldwide, and Australia has been no exception to this. So, what does the Australian dark landscape really look like, who is in it and what value does dark trading really bring to the market?
