As market volatility continues to surge, buy-side firms face a daunting set of challenges when executing their fixed income trades. Achieving best execution is tricky at the best of times, but it has become especially hard in a market where liquidity has become extremely scarce. In a recent webinar with Ergo Consultancy, seasoned fixed income professionals said they had never seen conditions as difficult as they are today, with market fragmentation still increasing and the prospect of information leakage as problematic as ever.
Against this backdrop, fund managers need answers to some pressing questions. Why has liquidity dried up so dramatically and made it so much harder to execute bond orders? What can be done in response? How can funds take advantage of technology to access the remaining pockets of liquidity in a more effective way? And how can they ensure they have the trading expertise and knowledge necessary to outperform?
Despite the tough environment, there are concrete steps funds can take to ensure their execution strategies deliver.
A severe lack of liquidity
Banks began to retreat in their role as fixed income liquidity providers more than a decade ago, largely as a result of regulatory change. But the situation has now reached extreme levels, with trades that once might have taken a few days to complete now taking weeks. “It’s about the worst I’ve ever seen it,” said a London-based head of trading. “Banks’ liquidity, in some cases, has effectively almost stopped, which is the first time I’ve actually seen that phenomenon.”
Banks, which used to warehouse bonds and make a market in them for the buy side, now act almost exclusively as brokers who will find liquidity but not provide it. To compare this on a historical perspective, the head of trading said: “This is worse than the Russian crisis of 1998 and the credit crunch of 2008. On both occasions, it was at least possible to exit the market. It might have been costly, but it was at least possible because banks were prepared to keep fixed income inventory on their balance sheets for extended periods, and in doing so they offered a large, central pool of liquidity that funds could dip in and out of. That is no longer the case.
“Following the 2008 crisis, regulators have clamped down on how banks could use their balance sheets. Over the past decade, buy-side firms in the aggregate have become the actual providers of liquidity. But they are not organised to act as price makers in the same way banks traditionally have been. That has not been part of their mission”.
This state of affairs puts the onus on funds to locate the other side of any trades they want to make. They need to be more alert throughout the day so that they see when there is liquidity. It also requires having close relationships with, or access to, a wide range of potential counterparties that might provide liquidity, both on the buy side and the sell side.
Daemon Bear of Baker Global Advisory said market participants now need to work with counterparties and try to create liquidity rather than just rely on coincidence, i.e., on the possibility that would-be buyers and sellers will encounter each other on one of the various bond trading venues. “Sourcing and lateral liquidity is the only way that you’re going to execute business.”
That means buy-side traders need to act more like the sell side historically has, gaining an appreciation of who else is in the market and who owns bonds they may be looking to sell or buy. They need to understand what is prompting an order and make decisions about what information to divulge, recognising the value and power of the information they retain.
David Berney, founder at Ergo Consultancy, said the shift required an entirely different approach from the buy side, “You need a different skill set today,” he noted. “You’ve got to be thinking now that you’re only as good as the network of counterparties you’ve got in order to find this mythical other side, because you can’t do it with just having five big American banks like you used to be able to do 10- 15 years ago.”
Tech assistance
As traders adjust to their new role in today’s credit markets, one way they can adapt is to take advantage of new trading solutions. Bond trading venues that let the buy side ask for quotes from the wider market – via so-called all-to-all platforms – have become popular over the past decade, but RFQs on such platforms still leave many problems unresolved.
“Any RFQ platform is effectively a way of making 20 phone calls in one go. It’s as simple as that. And there are only certain types of orders that merit that treatment,” said a second head of fixed income trading who also joined the conversation. “Provided your order merits that treatment, then you can do it. But if you’re working bigger than market size, or you’re working less-liquid instruments, voice will still be key. And you’ll still need to be working with your counterparties to find the other side of that trade. However, even when you’re using voice and you are having to make those calls, you still want to have an idea of where you’re going to get them done.”
Technology can help in this respect, by aggregating market information and allowing a fund to narrow down its search for liquidity. David Tattan of TORA says there are three things that fixed income systems need to do to help traders cope with current market conditions. First, the technology needs to offer instant access to the liquidity at the traders’ fingertips. That means having a single screen to send an RFQ or to view the various platforms and the full list of counterparties in the street.
Second is pre-trade data. This goes beyond the kind of data received from sending an RFQ, which can end up showing a trader’s hand. There are vast amounts of data that a trader benefits from and new cloud-based systems can help provide it. Third, there is the question of workflow. Market fragmentation means that time has become a scarce commodity. Traders cannot look everywhere at once to try to find what they need. Having technology that’s able to smartly bring everything together into a seamless workflow thus becomes critical.
Traditionally, the EMS has been used for equity, FX, futures and options. But Tattan says his firm has created special dashboards for fixed income trading which can show traders where they and their colleagues previously have found liquidity across their full counterparty list. “Maybe they’re trying to trade something that’s highly illiquid, but which they traded, you know, three months ago. Having that information there in front of you, when you’ve suddenly got an order, is key. And knowing which broker gave you best value.”
It is not just a question of seeing how market participants have acted in the past, but also when they did not act. For instance, such new dashboards can help a trader see which brokers previously did not give any responses to an RFQ. Tattan says a firm’s own data can be valuable in this way, especially in the case of larger firms.
Blending technology with expertise
“Creating liquidity is the golden nirvana,” said Bear. “It’s the $64,000 question. And technology goes a hell of a long way to assisting you.” But in the same breath, he observes: “It’s great having the technology, but you’ve got to have someone who knows what they’re doing with it.” For instance, there is an art to how a trader issues RFQs. They need to learn how to use them strategically and how to mask their intentions.
The problem this presents for many funds is how to hire the necessary trading knowledge and experience. This is where an outsourced trading provider can help. While outsourced trading has mostly been done for equities historically, Berney said, a range of outsourced trading providers have been increasing the provision of fixed income trading services, with a raft of new enquiries from the buy-side recently.
There is growth in non-core outsourced trading, Berney explained, saying managers are now looking at offloading trading in asset classes or geographies which are outside their primary area of expertise. He called the trend “co-sourcing”.
An outsourced trading provider becomes advantageous not only because of the knowledge of its traders, but also because of the trading relationships such firms have. “I think this is one of the unspoken successes of outsourced trading. Generally speaking, outsource traders have a bigger counterparty list than the clients they’re outsourcing for. And that’s one of the reasons that they can actually outperform on execution,” said Berney.
Focus on best execution and TCA
The lack of liquidity and declining volumes make best execution not only hard to achieve but also hard to even conceptualise. High-yield volumes have been running at about half of what they were this time last year, which was already low. An unnamed trader explained, “I challenge anybody in financial markets to be able to define what best execution is in fixed income,” adding that it can become highly subjective.
The conversation continued that UK regulators allow for six different categories for considering best execution, including the nature of the order, size, cost, price, and likelihood of execution. “They allow the flexibility and to allow people with experience who understand the markets to apply their subjective view as to what is best execution,” he continued.
Given the high volatility of the past year, price might be the criterion in some cases but likelihood to execute might be for others. It just depends on any given day what you know, and how the market is performing, The main thing is that a trader can explain trading decisions to an investor or a regulator. That’s what the authorities want to know. They want to know if you’ve got a culture that says, ‘I’m doing my best’.
Even when just considering price, the fixed income market brings added complications. Bear, for instance, said TCA for fixed income is different than other markets because of the way debt trading works. “You’re looking at the relative value of the bond that you’re trading compared to other issuances where we benchmark or other issuance types along that part of the curve and credit line.”
With the proliferation of RFQ platforms, better data for TCA has been coming out. While trade sizes may be smaller on many of these platforms, the data is still improving, which means that the TCA software is getting better as well. What is key is that a TCA report does not paint a false picture, such as suggesting a job was done poorly, just because the underlying data itself was not particularly representative.
TCA data becomes all the more important for any firms that go down the outsourcing route because they will want to regularly review the performance of their provider.
A changing world
The combination of new platforms, new technology, increasingly scarce liquidity, and new solutions via outsourcing means trading fixed income is entering a new era. Historically the buy side have not been market makers. They were price takers, not price makers. But technology is changing. And the market is changing.
The expansion of all-to-all platforms is making it possible for buy-side firms to start providing market liquidity and focus on finding the other side of a trade themselves.
Also, while a fund may not ever want to become a full-time market maker, it can now at least take advantage of opportunities to selectively make a market, provided it has the right software and trading expertise. That’s a new phenomenon.