US bond dark pool promises to bring new liquidity to the buy-side

Fixed income is facing a liquidity crisis as banks are reducing market making activity in the asset class. Could a new US-based dark pool for bonds be the answer to the market’s problems?

Fixed income is facing a liquidity crisis as banks are reducing market making activity in the asset class. Could a new US-based dark pool for bonds be the answer to the market’s problems?

Last week, TMC Bonds and Codestreet joined forces to launch a dealer-only dark pool for corporate bonds, called the Codestreet Dealer Pool, in the hope of doing for fixed income what dark trading has done for the equities market.

TMC Bonds, which specialises in running electronic marketplaces for fixed income, believes the new pool will enable trading in size and will ultimately deliver significant benefits for the buy-side, despite its dealer-only focus.

James Wangsness, president of TMC Bonds, told the fixed income sector is years behind equities in terms of its electronification, but that the principles of dark trading are equally applicable.

“Market participants are reluctant to make big trades in fixed income because they risk information leakage and the price moving away from them,” he said.

“If a tier one bank goes to an interdealer broker (IDB) to shift a position, the IDB will call around and leak sensitive information. Market participants keep orders small to not reveal too much of their positions.”

The issue will be familiar to those in the equity trade, but is arguably even more problematic in fixed income. Bond trading is already highly fragmented and illiquid due to the many different bonds available across even a single name. It has traditionally been highly reliant on banks to provide liquidity, though new regulations such as Basel III are reducing their ability to service this market by constraining balance sheets.

Wangsness said teaming up with Codestreet, which provides fixed income sales and trade matching software to 20 major investment banks, was key to finding the liquidity the platform needed.

By connecting to a broad range of banks, the service is able to bring together liquidity from many different places. But this alone is not enough to encourage the block trades that buy-siders and their brokers are looking for.

“We’ve developed an algo which is able to bring together these disparate pools of liquidity, but instead of pushing prices out to a central marketplace, it looks at various aspects such as price, available inventory or order size and creates a score,” Wangsness explained. “Once it has a score, it can match two parties it identifies as having a chance to make a deal happen and then brings them into a private negotiation.”

Once the counterparties are in negotiation, if no deal can be agreed then no information is released to the market. Furthermore, the negotiation process is split to limit information leakage at every stage. Counterparties first negotiate their price, and only once that has been agreed do they consider the size of the trade, meaning neither party needs to reveal the full scope of their order.

However, Codestreet Dealer Pool is only available to dealers and TMC Bonds is resolutely against giving the buy-side direct access. With this in mind, how will it benefit institutional investors?

“The problem with all-to-all platforms is that usually the sell-side has to pay for them, but they enable buy-siders to bypass them completely, meaning the dealers don’t want to be in that market and then you can’t get the liquidity you need,” Wangsness said.

By limiting access to dealers, he believes both sides will be satisfied with the experience, as dealers will be able to maintain their client relationships while the buy-side will have access to improved liquidity and be able to trade large blocks of bonds without the market moving against them.

At present, the platform only trades US dollar-denominated corporate bonds. While Codestreet also has a significant European client base, Wangsness said the platform will continue to focus on developing its dollar business for now but would eventually like to provide a more geographically diverse offering.