Luis Carvalho, Head of Investments, Credito Agricola Gest examines ongoing liquidity challenges in fixed income.
The trouble with liquidity
Sourcing liquidity is becoming more and more challenging every day. Five years ago a 20 million dollar position on a corporate issue would take two hours to get done. Now, it will take two weeks. These days the best answer you can receive when asking for a firm level on a euro government bond is “I can price you 5 million if you give the remaining balance to work”, but in truth, this preferred answer is rare.
“Can I work an order” or “my trader is out of his desk, tell me your size and I’ll get back to you as soon as they are back” are the most common responses I hear when I ask for liquidity. While we wait for the trader to come back, we just watch the price on screens being adjusted against us in 15-20 cent intervals before the trader arrives at their desk and replies with a price.
Since the global financial crisis liquidity has been severely impacted by regulation, which diminished a bank’s ability to maintain inventory. Also under the current low interest rate environment, combined with the positive impact of QE on credit markets not to mention low volatility, volumes have decreased. As a consequence, price transparency on the corporate bond market has also decreased. It is easy to find examples of issuers that saw their CDS spreads increase because of news that affected their business sectors, but the cash bonds of those issuers continued to grind tighter just because there were no sellers of bonds.
Regulation is forcing banks away from acting as a principal to acting much more as agency brokers, as their balance sheet size is severely reduced. Smaller broker balance sheets transfers the execution risk from the dealers to the investor. This is pushing the buy-side increasingly into reducing our limits per issuer to avoid being caught with an exposure size that will take too long to reduce.
Where to look?
As liquidity is becoming more fragmented, execution complexity moves in step. The challenge is not only where to find liquidity but also to print at the best execution price as liquidity fragmentation increases the risk of slippage against the price on the screen.
Finding liquidity means taking more time mining the list of axes we receive every day and checking the reliability of those published axes. Again, it is very common to call someone that published an axe on a specific bond and when we reveal the amount we need to trade, the answer is “oh my apologies, but my trader got hit a minute ago on that bond, they’re not axed anymore”. There goes the price on my screens.
Trying to achieve best execution price in this environment is difficult, even though we analyse all the data of previous trades. We are yet to develop formal transaction cost analysis as it is rather empirical, but by looking closely at previous trades we get a close idea who are the best counterparties for specific bonds or issuers. Of course, for certain issues, liquidity is more fragmented than others, and in those cases ideally the analyst has to find a similar risk by choosing another issue or issuer that has more liquidity.
Electronic trading platforms provide important help by incentivising dealers to publish inventories with firm prices that can be traded on a click-to-trade basis rather than on the traditional RFQ system. Electronic platforms have been developing information for trading cost analysis, which will not only be needed to meet MIFID II requirements but can also be used by the execution desk on a pre-trade basis. Last Deal information showing interdealer trades for a given time period is also a valuable indicator.
Buy-side on all-to-all
Buy-side investors still seem a little reluctant in adopting all-to-all trading venues. There have been efforts to develop this method but trading volumes remain rather small. However, all-to-all RFQ protocols that gather interest from dealers and investors would increase liquidity. Trading platforms featuring historical execution details are increasing pricing transparency.
A few investors claim that the behavioural change should be broader than just the buy-side. Fixed income markets are very fragmented in terms of the number of issues by nature. Those who seek behavioural change argue that issuance should be more standardised, which would allow for a reduction of the number of issues, hopefully increasing liquidity.
New measures, technologies
Technology is evolving fast, but electronic trading platforms still have a long way to go. For corporate bonds in particular, market fragmentation makes it very difficult to replace or reduce the interaction between execution and analysis, as per the example given above when an issue is found to be illiquid and a substitute has to be found. The technology to underpin an increase in electronic trading exists and there are already a number of different venues. The question, rather, is how to convince dealers to move towards a more transparent form of showing liquidity and potentially compromise firm pricing.
The aim of the buy-side is to analyse and implement investment ideas that will potentially result in positive returns for their clients or institutions. If those ideas include less liquid assets the premium demanded for holding those assets will be higher, which has a cost effect on issuers. The buy-side can, for instance, lead efforts that would result in an increase in liquidity by sharing more of their execution intentions on the available venues, be it on an auction platform or an anonymous RFQ, but the responsibility should be on those who charge fees for new issuance and benefit from a bid/offer spread. Issuers should also be persuaded towards a more standardised market. Then they would also not be penalised in times where the liquidity rarefaction can limit their ability to raise new financing on markets.
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Finding Liquidity In Bond Markets
