A New Market Structure For Fixed Income?

Lee Sanders, Head of Foreign Exchange and Money Market Execution for AXA Investment Managers’ Trading and Securities Financing Division.

When you go down the waterfall to investment grade bonds away from rates, trading is not easy. Once you’re looking at high yield instruments it’s getting really tricky. There is a lot of stuff at play here. First of all, the banks have been told to rein in their balance sheets. They’re not throwing as much capital at running market-making operations as they did pre-Lehman or even a couple of years ago. The amount of capital they have to put aside to be active in these businesses is not helping liquidity at all. The market breaks down into two kinds of banks. The first is a bank that makes the most of its money out of the primary market, and it has to be in a secondary market to support the primary business. Then there are the banks that are more active in the secondary market. The result of this is that you have a striking difference in opinion in how the market should change direction. When I have a conversation about changing market structure to the banks in the primary market, they’re all for it, and the secondary banks are less open to a reform agenda. The problem being that despite certain banks asserting that everything is fine, on the buy-side we know we still can’t get everything done. Looking at the big houses, they can’t do 15 by 15 million trades switching one bond to another anymore.

I thought that maybe an order book might be the solution to the illiquidity, where we can all come together in a common central limit order book and execute our business there. But the end user banks were not ready for that, not even the ones who are financing their secondary business through their primary business. So looking through the data, I began to have thoughts towards the development of venues similar to dark-pools or liquidity matching engines, almost like a UBS Pin environment, where we have a piece of technology that will scrape an order book and tell a trader that there’s a potential match, or even on a level smarter than that, scraping portfolio and management systems or wish lists and then creating a conversation. I definitely see more organised sessions similar to the G sessions environment where people come together at one point to trade one particular bond or one maturity of a sector.

I definitely feel that we haven’t got any kind of safety and comfort going forward in just thinking that the market is going to price all of our secondary business. What’s happening as a result is that turnover numbers are just dropping off. We used to trade three to four times our portfolio because it was one bip bid/offer but now the spreads are 20-25 bips in liquid corporate bonds. Now we’re trading significantly less than that. So to get the market working, you almost have to stimulate it. A really interesting point said by one senior investment banker at a big UK house was that about six months ago, they had 80 percent of their balance sheet caught up in bond holdings of less than one million, which were deemed to be illiquid or slightly off market, and they couldn’t get out of those positions because they couldn’t find the other side. And as I say to all my counterparties, fixed income has got to be about finding the other side of a trade. Now, that’s good for people who believe in the kind of market that I believe in, but there are people who believe that they could take advantage of opportunities due to this illiquidity.

In a recent conversation with a big American bank very active in credit, I said, “Surely, the idea is to write a ticket with a person who is willing to write the short or the long” to which he replied, “I look at these opportunities to get short or long and to make money out of those positions.” And I’ve seen that more and more. So you have some who are very pro-market structure changes and you’ve got some who are very anti market structure changes. Success is going to need everybody to be behind an initiative. There have to be some concessions to the firms who are looking to be more active market makers, but I think what will happen is that the buy-side quite like the model of going to a bank, so, if the banks, really embraced ‘all to all’ systems it will give them more balance sheet to service the bigger institutions.

We will continue to use the phone or the ECN but not like we’re doing at the moment, we will get more liquidity because they will know that they can recycle on these more organised venues; it looks likely that you could end up with fragmentation.

The way that we’re going to go forward is more with an EMS style of management. I’m currently moving our FX onto an EMS, and we have the ability to use TradingScreen EMS for fixed income.

We feel that if we’re going to place an order via the EMS, there could be access to two or three aggregators to see whether there is potential matching business there. Then a firm could see streaming prices, have the ability to RFQ, to leave a limit or an order and the trader could then gain access to all of the improved functionality which could look a little more like an equities operation. If the market does become very fragmented we could also look at smart order routing. We’d like to see trading hooked up within an EMS rather than just orders via FIX in three or four different systems because we’re never really sure of getting the best fill in any one of those systems.

Market making model vs venue reform
These two elements are quite complimentary. You can have more volume going into the market via a wholesale market making model. There is a little bit of bank paranoia that is reticent to this change, but if we get the pricing, the buy-side has always said we’re quite happy to talk to the banks. It’s a great relationship. We get the research, we get their pricing, we get all the bits to go around the edges and we know we pay a little bit for that in the spread. But when we pay large spreads it makes us think twice about trading. If the market was more organised and traders knew that they could recycle and then use these new venues to gain more liquidity they would get their balance sheet a little bit more in order to price the bigger trades, and that would make them more efficient and probably more profitable.

What they don’t want to be doing, which happens in the fixed income markets, is that we look at the relationships with our top banks and say, “Your hit rate trading is 15 percent, 20 percent.” So the senior relationship manager and the salesperson that head the trading tell them to get more business with us, which just means that the bank is getting positions that they don’t want, inflating their balance sheet; it’s self-perpetuating. However, with the right reforms, if they know that the market is developed or develops quickly in that arena then they’ll be a lot happier about pricing bigger trades and then having a particular session around it. And then, the information they get from the session goes to re-price that particular issue or that part of the curve or sector.

Are other asset classes becoming more like equities, or vice-versa?
The crux is that these asset classes are very different from each other. With equities, there is a bit of a tail but it’s concentrated on roughly 500 to a thousand stocks, as opposed to the 100,000 items we have in fixed income. I think where the real success may come in terms of changing market structure or using equity innovation for fixed income would be from the likes of Liquidnet. If they came in, they would look at it very closely for how they match people up buy-side to buy-side or all to all. I don’t think buy-side to buy-side is a winner, but I don’t think you want to make fixed income like the equities market. But what I think you want to do is pick out the efficient part of those equity initiatives and try to see whether they would be credible in fixed income as a way of gaining more liquidity because, whatever happens, the liquidity is not going to miraculously appear. Banks aren’t going to all of a sudden throw a load more balance sheet at this any time soon.

I think it just takes everybody to buy in to some change in market structure and that’s going to be the hard work.

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