A long and grinding road

Is a more complete view of market data the answer to concerns about growing illiquidity – and thus higher trading costs – in the fixed income markets?

Wide distribution of multiple price points ought to lead to greater investor confidence, which in turn should result in increased volumes, tighter spreads and lower trading costs. If it were possible to generate a more complete view of market data, it might be possible to offset the reduction in liquidity most expect in response to Basel III’s imposition of tougher capital rules on banks.

But the relationship between transparency and liquidity is a complicated one and varies between asset classes. 

Many fixed income markets are notoriously opaque. That’s not because investors or their intermediaries are shady characters with dubious motives. Far from it. They are simply trying to achieve the best price for their clients when buying or selling an instrument that may not have been traded for days or weeks and as such does not necessarily have a reliable price.

A market source recently quoted to me a research paper from seven years ago which contrasted activity levels in the equity and corporate bond markets. The study cited an equities universe of 9,000 instruments traded 400-600 times a day with a total of 300,000 different corporate bonds, each of which traded on average one and a half times a day.

Even if these figures have since changed (or were only a broad approximation) they still reflect the reality that every bond trader knows: it’s a wonder some fixed instruments ever get traded at all, such is the dearth of information on which to base a trading decision.

Is it possible to increase transparency without damaging liquidity?

The comparatively sedate pace of trading in many fixed income markets compared to say equities is compounded by the lack of a single reliable source of information on trades executed, in Europe at least. The US has TRACE, the Trade Reporting and Compliance Engine, a utility operated by Nasdaq OMX on behalf of the Financial Industry Regulatory Authority. All regulated firms must report their bond trades to TRACE, but it was a long and grinding road to the current iteration, which many observers now credit for greater liquidity in the US fixed income markets compared to Europe.

MiFID II intends to impose greater transparency on Europe’s fixed income markets in the hope of emulating the achievements of the US. The problem faced by European market participants and regulators is that too much transparency or too fast a migration to a new regime will simply frighten off both buy- and sell-side firms, thereby having the opposite effect from that intended. 

In particular, brokers are concerned that a price issued to one client may be regarded as being fit for all under the directive’s current proposals. Although there is a dialogue with regulators about introducing delays in reporting certain types of transactions, there is no consensus yet on which instruments should be protected.

This sounds like an example of regulatory burdens increasing, but the market being left short of the solution it really needs. Or is that too pessimistic?

On the one hand, MiFID’s timetable for introducing a consolidated tape for European fixed income trading seems a little pedestrian: only once it has been proved to be a success in equities will a consolidated tape for bonds get the green light. On the other, new solutions are already emerging to fill the void and at least the problem of incumbent exchanges’ market data revenues will not arise. Moreover, the sheer volume of debt issued by European corporates and governments since the crisis might just concentrate minds on the task at hand.