Electronic trading in European corporate bond markets essentially broke down at the peak of the recent pandemic volatility, according to a new study from the International Capital Markets Association (ICMA).
Traders were forced to revert back to voice trading during the period as the market became too volatile and illiquid for dealers and liquidity providers to risk offering prices across electronic platforms, ICMA said.
Some banks even moved to shut down their algo trading completely at the time, while others opted to continue auto-quoting prices, although with much wider bid-offer spreads. However, buy-side respondents told ICMA that prices found on platforms were unlikely to be executable, and electronic request for quotes (RFQs) did not return quotes.
E-trading volumes reduced dramatically compared to voice, but many bond trading venues reported record volumes at certain points during the crisis. At the same time, other protocols proved more popular with traders as it became more difficult to find three or more quotes, which is often required under internal best execution policies.
All-to-all RFQ functionality, trading in dark pools and portfolio trading were all highlighted as being more popular at the peak of the crisis, alongside ‘processed trades’ which are typically negotiated over the telephone or chat systems before being posted on a platform for settlement and reporting.
ICMA’s study found that while most banks were able to continue providing liquidity and making markets, overall dealer capacity shrunk at the height of the volatility when it was most needed.
Stricter capital rules and smaller balance sheets may have impacted dealer capacity, although ICMA also noted that internal bank policies aimed at reducing market making activities, and less experienced desks experiencing the surge in volatility, could have played a part in the trend.
“The Covid-19 crisis would appear to have provided a useful opportunity to strip-back the layers of technological development of the past decade to reveal its intrinsic core: a dealer-based market, where market makers remain the primary source of executionable prices, and liquidity is reliant on their capacity to assume and recycle market risk,” the study said.
Settlement fails also surged at the peak of the volatility, prompting further concerns about the incoming CSDR mandatory buy-in regime in Europe and its impact on the market if the rules were in place during the crisis. ICMA has been outspoken about concerns with the buy-in regime under CSDR, urging regulators that the move will have a detrimental impact on bond liquidity.
“This crisis provides a clear reminder that despite increasing electronification of trading over the last few years, the role of market-makers in creating liquidity remains at the core of the secondary markets. Reducing the ability of market-makers to provide this service will inevitably impact market liquidity and efficiency, especially in times of market stress,” Martin Scheck, ICMA chief executive, commented.