Buy-side’s bond makeover

New legislation will fundamentally change the way buy-side firms trade bonds and solutions to help deal with the transformation taking place in this market continue to emerge.

What exactly do you mean when referring to the buy-side as ‘price makers’ for bond trades?

Multiple regulatory initiatives will result in profound changes to traditional fixed income trading methods. Specifically, this will result in less reliance by asset managers on the bond prices quoted to them by sell-side counterparts.

At the moment, a buy-side firm wanting to gain exposure to a bond requests quotes from a number of brokers to compare indicative pre-trade prices. The trader then selects the best price and trades with the counterparty that offered it, typically on a matched principal basis.

New legislation will make it a lot tougher for brokers to continue offering liquidity in this way. Buy-side firms – the holders of the majority of bond liquidity – therefore need to take matters into their own hands, trading and setting the prices of bonds themselves, as opposed to relying on the sell-side.

What is the problem with bond trading as it stands for the buy-side?

The buy-side’s biggest issue with trading bonds is that the quotes they receive from dealers are indicative. This means that after picking a quote, a buy-side trader could find the price they are offered for a bond trade changes when they call to confirm a trade.

What are the key regulations that will effect this change?

·      Basel III: Part of the latest guidelines to ensure banks are suitably capitalised include the need for banks to hold capital reserves based on risk-weighted calculations pertaining to the types of asset they hold. This will make it more expensive for banks to hold inventory used for matched principal trading on their balance sheet, and may cause some to exit the market altogether, especially for illiquid bonds that are deemed particularly risky.

·      MiFID II: The revised directive will expand its scope to include non-equity instruments, including bonds. MiFID II is currently making its way through the Council of the European Union, with a final, high-level text not expected until late 2013.

Pre- and post-trade transparency: Public quoting and reporting of bond trades is pretty much non-existent in Europe. Currently, the Council is seeking consensus on post-trade transparency, including determining an adequate delayed reporting regime that gives brokers enough time to unwind trades they take on risk. The plan is to establish a system similar to the TRACE system in the US.

Trading venue regulation: Another impediment to the ability of banks to facilitate bond trading could be the rules surrounding the organised trading facility, and the potential for matched principal to be restricted, or at worst, prohibited entirely. Brokers that offer single-dealer platforms may face a reclassification of their services to OTFs, subjecting them to new transparency rules and limitations on how they match trades.

·      Volcker Rule: The rule contained in the Dodd-Frank Act, championed by former Federal Reserve chairman Paul Volcker, seeks to limit prop trading and investment in private equity vehicles by banks that take customer deposits, with the aim of reducing speculative trading. The Volcker rule is yet to be finalised and the definition of proprietary trading has been a sticking point for regulators and market participants. If this definition is too far reaching, it will lead deposit-taking banks to scale back the amount of bond trading they do on principal, compounding the impact banks face under Basel III rules.

What solutions are beginning to emerge to ensure bond liquidity doesn’t dry up?

New trading platforms that target the buy-side directly are beginning to emerge. While the role of the sell-side in this market should not be completely discounted, venue operators – including, Vega-Chi – are targeting greater participation from institutional investors.

Brokers themselves are also adapting and launching new services. Goldman Sachs G Sessions runs infrequent auctions for trading corporate bonds, while BlackRock has launched Aladdin, a platform that will allow the buy-side to match bonds trades directly with each other.

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