Why will the buy-side be relying on brokers to aggregate liquidity?
As the role of the sell-side as price makers in the fixed income markets slowly starts to diminish, the market is in a period of flux, looking for ways to adjust to the way this asset class is traded in future.
This has impacted the buy- and sell-side differently. Brokers are looking for new ways to make up for the revenue shortfall, while the buy-side need new ways to source fixed income liquidity.
Brokers have controlled the fixed income market for many years, setting prices for their buy-side clients over the phone or quoting in smaller size over electronic platforms. But the added capital burden from new regulations like Basel III and the Volcker rule will drastically reduce the profitability of this business, spurring rapid change to the dynamic of fixed income trading.
Buy-side traders that have typically relied on relationships and their knowledge of who holds liquidity need to devise new ways to hunt for fixed income flow, while brokers need to find a way to claw back some of the revenues they stand to lose by devising new ways to access this market.
How will brokers choose to aggregate liquidity?
Most brokers have opted to realign their internal liquidity pools to shift the emphasis on their role as price makers to the buy-side.
Essentially this means that instead of offering liquidity based on the assets held on their balance sheet, brokers will use technology to aggregate the trading interests of their buy-side customers.
Goldman Sachs launched G Sessions last June, a platform that conducts short, auction-style matching sessions in high-grade and investment-grade corporate bonds. The bank only uses its own capital for residual portions of orders that may remain unmatched.
Citi has launched a similar system for Latin American sovereign bonds, while UBS’ PIN-FI enables buy-side traders to send marketable order enquiries for corporate bonds and CDS instruments that can be executed against UBS’ internal liquidity, or display price levels to other PIN-FI participants on an anonymous basis.
These types of systems are likely to be more effective than tools like smart order routers, which are used in equities to split trades among the trading venues offering the best price. The liquidity characteristics of bonds – thin liquidity, a high number of issues and instruments that are typically held to maturity by the buy-side – make it harder to hunt for liquidity in this way.
What consequences will the launch of multiple bank platforms have on the trading of bonds?
The most obvious drawback is fragmentation of liquidity, making it even harder for the buy-side to figure out the most optimal destination for trading a particular instrument. This was an issue that guided Citi’s Latin American sovereign bond focus.
“Fragmentation will offer market participants different trading protocols but might be detrimental to liquidity,” said a Citi spokesperson when details of the venue first emerged. “The market may end up with platforms that instead focus on different niches, and a splitting of liquidity across multiple venues.”
Moreover, institutional investors are realising that, as the majority holders of bond liquidity, they could eliminate the role of the sell-side completely and trade amongst themselves. This is a path taken by money manager BlackRock, which is launching its Aladdin platform for buy-side only bond trading. But whether buy-side traders are happy to reveal positions to competing firms remains to be seen.