Finding Liquidity: Today’s Greatest Challenge
Gianluca Minieri, Global Head of Trading, Pioneer Investments examines the main overarching theme in today’s debates around trading.
If there is one overarching theme today in debates around trading it is certainly the progressive and consistent erosion of secondary markets liquidity over the last few years. I do not think we exaggerate if we say that finding liquidity has become today the biggest challenge on trading desks. Especially for a large asset manager like us, it is becoming increasingly difficult to deal in large sizes unless a particular bank is “axed”. Markets have become very shallow and prices and sizes shown on the screens can no longer be taken as “firm”. The consequence is that moving large amounts of bonds without impacting the spread can prove very challenging. Traders have to be much more strategic than before and carry out a sophisticated activity of market intelligence and price discovery before they decide how, where and when to trade.
The European bond market has dramatically changed over the last few years mainly due to a tighter regulatory environment which enforced stricter capital requirements for market makers. This makes it extremely expensive to hold bonds inventory and has led to a severe reduction of leverage. Broker-dealers have responded by changing their models: the larger bulge bracket firms continue to commit capital but are much more cautious about the positions they take and for how long they keep them on their books. The smaller firms shifted more towards working client orders on an agency basis rather than making markets, progressively stepping away from principal trading. Overall, the level of inventory held by the sell-side has dramatically reduced. Although smaller inventories have been to some extent offset by an increase in inventory velocity, we think that the old market-making model is definitely broken and that banks will inevitably become agency brokers.
On the contrary, the buy-side has been consistently growing over the last few years. Buy-side firms are believed to hold in excess of 90% of bonds inventory in issuance today. This means that when we want to buy or sell a bond today very often the main challenge is to find another buy-side firm on the other side and a broker can facilitate the trade between us. The problem that we need to address is therefore not who is going to intermediate the bond but what initiatives can be taken to defrost that significant percent of bonds inventory currently held by the buy-side. We think that unlocking buy-side bond inventories can be done through a more efficient dissemination of pre-trade information between market participants.
So while we understand that electronic venues will not be a substitute for liquidity, especially on the less liquid side of the market, it is very much the future. In such a fragmented environment, we think that electronic venues should look at changing their objective and elect aggregation of liquidity as the most important service they can offer. One of the hot topics is the concept of all-to-all trading, i.e. not limiting the trading flow between buy-side and sell-side firms but to have a more open, all-to-all market.
Given the above, many electronic venues and vendors have sniffed out the business opportunity and have come to the market with new ideas on how to find alternative sources of liquidity in such a challenging environment. Today there are probably in excess of 30 new fixed income trading initiatives being launched to the market, all with the same objective of sourcing liquidity. In Pioneer we are in favour of such initiatives and always try to be engaged as early as possible where we feel that the right business model is proposed. In fact, while all-to-all platform and buy-side-to-buy-side trading might be a potential solution, it is important to remember that the objective is to unlock and supply liquidity, not just bringing people together. I do not believe in a bond market that is completely disintermediated. Eliminating the sell-side tout-court is not a solution, because bond markets need some level of intermediation. Also, it is wrong to assume that bringing buy-side together onto the same venues will automatically unlock that frozen liquidity, for the simple reason that large asset managers do not want to share or disclose their trading intention to their competitors, especially on their larger positions. So the problem here is not to bring us around the same table but rather how to ensure a more efficient dissemination of the information. How do you create a method that gives the right information to the right people at the right time?
Shared initiatives will be a must in coming years because the cost of the necessary infrastructure to compete in such a fragmented market is too high to be borne by one single company. So everyone, including ourselves, is now looking at shared architecture or utility to reduce the cost and develop a new way of connecting between the sell-and buy-side.
We continue to be very proactive with vendors, peers and the sell-side on every proposal that is aimed at enhancing quality of execution by standardising connectivity through multi-participant networks. We believe that the buy-side should continue to have an active role in this space and together with all market participants should push for an industry-led solution. This includes the sell-side and exchanges, which so far have not always had a proactive approach in addressing these issues.
However, we cannot wait until the perfect solution is put in place. That is why one year ago we decided to centralise all our trading on a common platform by deploying a Global Trading Model. The concept behind this model is the capability to route orders to regional desks and execute them in local time zones leveraging local market expertise at no additional cost. This model will increase opportunities for synergies, enhance our ability to support growing demand for global products and allow for superior price discovery and market intelligence, leading eventually to less alpha slippage and better performances for our clients. It will also result in a quicker decision-making and improved execution, letting the firm react faster to market changes, which may require a change in the trading strategy.
As said above, tighter regulations around the world have profoundly changed the financial markets landscape over the last few years. While in many cases new regulations have contributed to bringing more clarity, in many other cases they created more ambiguity and uncertainty. Usually the normal approach provides for evidence and argument being discussed among various parties through lobbying.
This is done with the knowledge that the outcome might not be optimal but the underlying objective is to make financial markets more competitive and more efficient. Instead, we observed the difference in the consultation and engagement process between Europe and US. In US there seems to be an open and ongoing dialogue between regulators and market participants to ensure that the regulations achieve their objectives and do not produce unintended consequences. In Europe, this has not been the case. We have tried to be as proactive as possible during the last regulatory reform approval process but the outcome clearly shows that hardly any of the feedback given by the industry to policy-makers has been taken on board.
Take transparency for example, which soon became a philosophical topic for policy-makers that worked under the assumption that transparency and liquidity are the same thing. The reality is that especially for large sizes, transparency can be the enemy of liquidity. If information is made public too early, you will have the market trading against whoever is trying to unwind the risk and that will eventually result in a worse execution for the end investor since it will force market makers to price under a worst case scenario. We are in favour of regulation but we hope that going forward market supervisors will support a greater interaction with all market players. Regulators needs to get more involved in the ongoing discussions with all parties to create and maintain a trading environment in which best practise is encouraged through greater transparency, comparability and choice between service providers.
The hot topic nowadays seems to be the so-called equitisation of the fixed income market. If equitisation of the fixed income market means forcing full transparency, irrespective of the asset class traded, liquidity, the type of order or the market conditions, then I think it is wrong. It will deteriorate rather than improving the price formation process. We remain convinced that transparency, especially in fixed income, is strictly correlated with liquidity and would not work for all markets. We are in favour of the development of electronic books for certain very liquid bonds where the platform could operate in a similar fashion to an equities-style exchange driven order book which would take the noise out of the market and increase transparency. In the more illiquid markets these challenges are harder to solve through an electronic platform, because all you need is real liquidity. We feel that the extension of pre-trade transparency without a proper calibration to the less liquid part of the market could have a number of undesirable effects.
As things stand, we do not feel that the bond market is ready to handle a sharp correction. The combination of a few large asset managers holding the majority of inventory, the banks less able to absorb positions, and that we would all be on the same side of the market were there to be a problem in secondary liquidity is probably the worst possible mix.
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