By Fabien Oreve, Global Head of Trading, Candriam Investors Group
Large institutional investors have been trading with more electronic tools in the credit markets since the financial crisis. Over the last five years, the low interest rates that have stimulated investors’ appetite for yield have taken corporate credit issues to very high levels. Investors have never held so many bonds. As a result, multi-dealer trading systems have innovated and new functionalities have been introduced around pre-trade information and price discovery. Today, buy-side traders instinctively consult runs messages, indicative quotes and dealers’ axes in those platforms. Some asset managers have taken the opportunity to upgrade their order management system and enhance straight-through-processing to absorb large order flows without increasing costs.
The most popular electronic trading tools are the multi-dealer platforms that have attracted a large spectrum of dealers, from global banks to regional banks. Some regional banks have managed to increase market share in their home market. Technology has been important in helping asset managers gain access to a wider range of liquidity providers. More competition and more specialization in business segments have forced the largest dealers to improve efficiency and technology using dynamic pricing algorithms for small orders in liquid instruments. Unlike smart order-routing in equities, electronic trading is rather uniform in the bond markets, where small-to-medium size transactions occur mainly through requests-for-quotes (RFQs) to dealers. Despite a wider presence of dealers in these platforms, the reduction in secondary market liquidity has been more visible since asset managers started to focus on transaction cost analysis. Asset managers’ trading desks have also received more demands from pension funds and mutual funds for price improvement inside the bid-ask spread disclosed by the existing platforms.
The liquidity issues in the secondary corporate bond market and the number of “rejected” or “passed” orders have been more frequent recently – for a couple of reasons:
- Banks have reduced their inventory of bonds due to Basel III regulations: they have less capacity to take bonds in their balance sheet and they may have less willingness to trade sometimes due to more stringent risk management.
- Post-trade information in European bonds is insufficient: asset managers can only rely on their internal statistics to target the dealers that are most likely to transact specific instruments. Information is not optimal for investors on instruments they have never traded before.
As the new regulations require banks to take fewer risks with their own resources, it is important to add fluidity in the credit markets. Agency trading through order books can be an interesting means of gaining access to a wider range of participants in the secondary market; it can also add transparency to the calculation of transaction costs. However, agency trading will be a sustainable solution for asset managers only if order book providers continue to innovate.
For small-to-medium size orders, technology is the most important part of direct execution in equities, but you need a combination of technology and a relationship with the broker-dealer in corporate bonds. If you place a limit order and you are best bid or best offer, you will get some human support from the broker-dealer’s team behind the system, but at the same time your order should be reflected automatically across conventional multi-dealer platforms. As many bonds structurally are not for sale, the probability of an order fill in a particular instrument may be low. A smart device should therefore also suggest that you replace the current order with another one in a similar instrument available in the trading system.
The evolution of market structure in the European credit markets is on-going but it will take some time to make electronic trading in the less liquid corporate bonds more efficient. Post-trade transparency for this asset class is another important feature that will help investors improve transaction cost analysis. However, the challenge here is transparency calibration or how to produce publicly post-trade reporting with an appropriate time delay for less liquid trades and large-size transactions. There are many more corporate bond issues outstanding than equities, which would be a permanent challenge for any European entity in charge of providing post-trade data. The ESMA (European Securities and Market Authority) consultation paper about MIFID II & MIFIR regulations contains a section on the “post-trade transparency requirements for non-equity instruments” and is a great opportunity for asset managers to outline their practical views.
Making alternative trading systems coexist with conventional multi-dealer platforms and voice-trading will bring more flexibility and efficiency to the execution of corporate bonds. Adding transparency to the European post-trade data with different levels of information – depending on the nature or size of the trade – will make corporate bond liquidity more likely to happen in the secondary market.
This article originally appeared on the Candriam Investors Group blog