European bond trading: Destination unknown

The fixed income market is embarking on a new era of innovation, but will initiatives to automate bond trading further fragment liquidity?

Beyond the most frequently-traded of corporate and sovereign debt issues, fixed income has long faced liquidity constraints. But recent regulatory and market developments have worsened the situation, even to the extent that the Bank of England (BoE) recently launched a consultation to look at ways to improve the functioning of the market.

Basel III is seen as the key culprit. By limiting the ability of banks to hold risky assets on their balance sheets, the new global capital adequacy framework has caused many erstwhile liquidity providers to reduce the inventory of bonds they are willing to hold, often focusing on the most liquid products around. For institutional investors, this poses a serious problem of how to trade in fixed income
cost-effectively when your bank counterparty is no longer willing to take on risk for you.

Of course, problems always beg solutions and this one has prompted a wave of innovative ideas to tackle fixed income’s liquidity crisis. In Europe alone, three new platforms – BondCube, TradeCross and Liquidnet – have launched or are set to in the coming months. “There is a definite need for new trading venues in the fixed income market,” says Bradley Wood, partner at consultancy GreySpark. “The market is responding to the current situation by refining the way buyers and sellers of bonds are brought together.”

Ups and downs

But while these new initiatives could provide buy-side firms with the liquidity they are desperately seeking, there is a potential downside. “The market is coming up with solutions to the problems the fixed income market faces, but these solutions create an additional challenge, that of fragmentation,” warns Sassan Danesh, managing partner at Etrading Software. “Some of these ideas will work and will attract liquidity, and some won’t. The question is: how does the market cope while the winners of this race are being decided?”

Danesh is playing his own part in trying to make it easier for market participants to make the most of the myriad trading options now available in the fixed income market with Project Neptune, a new connectivity utility that will, initially at least, focus on the automation of OTC fixed income trading. Neptune is a low-cost connectivity network to transmit pre-trade data between investors and dealers. “The market is suffering from paralysis due to a lack of integration and a lack of connectivity. If you can make it easy to access inventory wherever it resides then you will have greater flow of information and a stronger market structure,” says Danesh.

New services may emerge to help investors to navigate the new fixed income landscape, just as a wave of innovations transformed equities trading in parallel with the imposition of MiFID in 2007. Aggregation services that pull together currently disparate market data are seen as being a practical way to give the buy-side broad pricing information and will be bolstered by more flow moving into transparent, electronic platforms, rather than banks’ voice-based request for quote (RFQ) systems that had traditionally dominated the asset class. Some even expect that fragmentation of fixed income trading could also prompt the development of smart order routers for bonds.

A shattered market

Views on the extent to which the multitude of new venues will fragment the market vary wildly, with some fearing fixed income will suffer in a similar way to the post-MiFID equities market, where a plethora of lit and dark platforms competed to take market share from national exchanges, while others believe it will actually become more consolidated.

Gareth Coltman, European product manager at fixed-income electronic trading platform operator MarketAxess, expects any initial fragmentation will rapidly consolidate.

“I don’t foresee fragmentation being a major problem, because it’s just so difficult for new initiatives to get off the ground and attract the critical mass of liquidity they need,” he says. “There were a number of new initiatives in the equities market starting around 2007.  Connecting to all of these platforms proved to be very expensive and in the long term was not a cost effective solution.”

Coltman believes institutional investors will instead wait to see which venues win out, with activity soon coalescing around a few major venues.

Liquidnet’s new head of fixed income, Constantinos Antoniades, agrees that ultimately only a few venues will remain, but says current developments are reducing fragmentation. “The fixed income market today suffers from extreme fragmentation, because every broker-dealer only talks to its own clients and you effectively have more than 30 venues which are very opaque,” he explains.

“As banks move out of the market and liquidity moves onto new electronic platforms offering an all-to-all trading model, we will actually see a more centralised model that will be better for the buy-side.”

Gaining critical mass

Antoniades joined Liquidnet earlier this year when the firm, which has specialised in block equity trading among asset managers, acquired his fixed income trading platform, Vega-Chi. He says the combination of Vega-Chi, which was among the first platforms offering all-to-all trading in bonds, with Liquidnet’s existing order book scraping technology, means the fixed income platform is able to benefit from rapid client onboarding. “When we performed a recent liquidity drive that involved switching on some Liquidnet clients we had 85 added on day one,” he says.

But for platforms that are starting from scratch, gaining that level of liquidity is a major challenge. “It’s impossible to get the critical mass of clients needed to be successful within the timescales required,” Antoniades adds. “This is why we wanted to work with Liquidnet, because the clients we are targeting are already onboard, we just need to switch on the functionality for fixed income orders.”

But one man’s fragmentation is another’s specialisation. Michael Schmidt, chairman of Algomi, which provides technology solutions to help fixed income sellers and buyers form trading relationships, says niches in fixed income may flourish through greater automation. “What we will see is more specialisation, and individual firms will need to focus on a smaller range of more profitable products and push out their pricing data explicitly to suitable customers,” he said.

Meanwhile, GreySpark’s Wood expects the buy-side trading desk to experience some déjà vu and asserts that prior experience of fragmentation could provide valuable insights into liquidity aggregation across multiple venues. “Lessons learned from the equity market could enable some very clever solutions for fixed income, such as liquidity-seeking algorithms and smart order routers to be developed,” adds Wood.

New ways of accessing market data are likely to evolve as well to help investors gain a greater insight into pricing and to achieve best execution in bonds. “The US market has had TRACE for some time and this has struck a good balance between providing enough transparency on fixed income market data without negatively affecting liquidity,” explains Danesh. “MiFID II is going down a similar route with regard to post-trade transparency and this will fuel the debate on how to aggregate that data effectively.”

Setting standards

It’s not just the industry that is examining how to improve liquidity in the new fixed income landscape. In November, the BoE launched a consultation on how bond liquidity could be improved through electronification and standardisation.

Standardising corporate bonds, which can currently have a vast range of different rates and maturities, has long been discussed as a way to improve the secondary market. By having tens or even hundreds of different issues in one name, it can be near impossible for two sides of a trade to come together as each counterparty has slightly different requirements.

The BoE has suggested that standardising bond issues could be beneficial for both issuers and investors, but it may not be a universal panacea. “People say you can standardise bonds, but for 90% of the market this simply doesn’t work. It might be practical for the big names, but smaller corporates have particular finance needs that mean they have to be in control of their issuance,” says Schmidt.

Clearly, the transformation of the fixed income market is still in its early stages. The current wave of new platforms is just the first step and most market commentators agree that it will take years before the market reaches a new equilibrium. In the meantime, there will be challenges but also opportunities for the buy-side to look at a new way of trading fixed income that gives them independence from the banks.