The Fixed Income Status Quo, And Project Neptune

By Sassan Danesh, Managing Partner, Etrading Software

Sassan DaneshToday, reading about the challenges faced by the credit market is a tale with recurrent themes of tightening regulatory controls, changing business models, market structure, and discussions about the increasing impact of electronic interaction in the marketplace.

Historically, the credit market was an OTC voice-traded domain. In the last decade, technological advances have prompted an increase in electronic transactions in this space. Yet, this dematerialisation is largely disjointed as market participants have implemented bespoke technologies in a silo approach to regulatory reform. Digitisation of the credit markets is proving both a cause and a solution to fragmentation.

As dealers’ inventories are reduced in the wake of regulatory changes, so is their ability to act as effective market makers – making liquidity more difficult to both source and leverage. For investors, further challenges are found in the distribution and sorting of pre-trade data; this is the data distributed by market makers that allows investors to locate and obtain the best price on assets for their portfolios. Currently, they receive this data from multiple sources in multiple formats and have to rely on a range of methodologies to sift and collate the data.

In a broader sense, the credit market could be seen as being in good health. Since 2007, corporate bond issuance has increased – growing from $600bn in that year to $1.8tr in 2012. This has coincided with a decline in direct bank lending and a very low interest rate environment. However, the start of 2015 has seen the lowest levels of corporate bond issuance since 2010, down around 20% from the same period in 2014. There appears to be some correlation with the growing uncertainty in the macro-economic environment. Falling oil prices, divergent monetary policy in developed countries, reduced growth in developing markets including China are having an effect. Political instability is also a factor in the Eurozone and Greece and even the UK. A jittery market is a difficult place for issuers to feel they have value but it’s still too early to tell whether or not issuance is slowing. Should it slow, it would be another pressure on the liquidity of the credit market as bonds mature and companies reduce their debt profile.

The regulatory landscape is also changing this year. MiFID II rules will be firmed toward the middle of 2015 with Basel III and EMIR also phasing in during the year. Basel III’s particular focus on the liquidity coverage ratio and its treatment of corporate bonds as ‘High Quality Liquid Assets’ with a haircut of 50% will further push banks away from holding these types of instruments. Whilst this is only true for issuance with a credit rating between A+ and BBB, this nevertheless covers a significant portion of the corporate bond market. Demand for high quality corporate bonds will increase further as EMIR’s centralised clearing for OTC derivatives begins in Q1 this year. Lower quality corporates will incur a higher haircut charge as non-cash collateral, should they be eligible at all.

All of this means that addressing the issues of liquidity is paramount in the credit market and there are a number of initiatives attempting to fix the problem. Some are trying to simply change the market structure – for example by enabling the buy-side to trade directly with each other in a ‘trusted player’ market place. These are proprietary, closed markets that have specific access rules and behaviour. This should help access the large portion of assets that are currently sitting as inventory on the buy-side. However, for those bonds which only trade infrequently in the open market there is the significant issue of finding a price. Not all investors are willing to become price givers. Evaluated price generation is becoming increasingly popular but it is difficult to validate ‘best execution’ for many illiquid assets.

A number of other initiatives lean on existing execution venues or trading platforms. They encourage the sell-side to publish their inventory onto the platform and then will aggregate it for the buy-side. The best approach is still under contention with some saying that the focus should be on the most liquid part of the market whilst others saying the opposite. One thing does appear to be clear – almost all of the current set of initiatives are closed, proprietary plays to enhance existing enterprises despite some large participants and regulators claiming that standards are the key to solving the current challenges in the credit market.

Project Neptune is an initiative married to the standardisation ethos. Sponsored by institutions from both sides of the market, the project’s first phase in Q4 last year was focused on developing open standards, using the FIX protocol, to support the workflows of structured pre-trade data exchange. With these now completed and ratified under FIX governance, the project is now moving into an implementation phase. The idea is not to compete with trading venues or liquidity platforms but rather create a network that can be used as the basis for pre-trade communication. The collaborative nature of the project ensures that there’s no attempt to capture advantage – all sponsors are clear that this is just opening a direct channel between banks and their clients that uses open standards. This means that, rather than as they do today with their customised delivery mechanisms, banks can deliver structured data to whomever they wish without having to support complex data mapping and transformation systems; improving control whilst reducing risks and costs.

The use of open standards in this way – development, ratification followed by a shared implementation points us towards a different approach of dealing with market structure issues. Many of these issues have, as mentioned earlier, come about because of the swift implementation of technology – that rapid growth left little room for standards especially in the OTC space. With the new focus on costs, liquidity and fragmentation, it seems that it is now time for standards to play a stronger role in restructuring the marketplace and bring supply and demand together.

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