“Our dilemma is that we hate change and love it at the same time; what we really want is for things to remain the same but get better.” – Sydney J. Harris
“I cannot say whether things will get better if we change; what I can say is that we must change if things are to get better.” – Georg C. Lichtenberg
By now, anyone who is remotely involved in the corporate bond market has found oneself in the middle of a conversation whose sole purpose is to explore and explain the dramatic change that is currently underway. After several years of debate focused on Dodd-Frank, derivative reform, and SEFs, last year appeared to bring the conversation back to cash corporate bonds.
The movement of execution from the traditional voice-based model to electronic platforms has been underway since 2002. Progress has been significant, with around 20% of the market utilizing some form of electronic execution to transfer risk. Despite this electronification, the structural makeup of risk transfer in corporate bonds remains unchanged. While retail investors have utilized executable liquidity pools and the agency model for years, the request-for-quote (RFQ) protocol and the principal-based model remain the dominant choices for institutional market participants.
As institutional investors increasingly express frustration over the ability to find “immediacy” (the ability to transfer risk on-demand), and traditional liquidity providers are handicapped by regulation and the increasing cost of capital, the need for alternatives is undeniable. The current narrative surrounding the growth of electronic trading is somewhat disingenuous, since the trend is to simply electronify the RFQ, a protocol that naturally relies on the current principal-based model.
Cornerstone Resources takes a look back into 2013, highlighting some of the events in the corporate bond market that will undoubtedly have an impact moving forward into 2014, as the market seeks to identify the problems, develop solutions, and shape the conversation.
- The “Boston Tea Party”. The inaugural event actually took place in the summer of 2012, but subsequent events followed. Traditional asset managers invited large dealers to a meeting in order to discuss their concerns over liquidity issues in the market. The meetings have yielded little, but signify a growing frustration among the buy-side and requirement for change.
- BlackRock and MarketAxess announce the creation of a unified electronic trading solution in the U.S. credit markets. Following the failed attempt by BlackRock’s Aladdin business to build a matching network (Aladdin Trading Network), the investment manager’s technology business (BlackRock Solutions) cedes business operations to MarketAxess Corp., the market’s leading electronic trading platform for credit. While BlackRock was already MarketAxess’s biggest client and significant shareholder, the initiative is unique in that it brings together the world’s largest asset manager and provider of the Aladdin OMS (OMS utilized by many of the world’s larger asset managers) with the leading credit ECN in an electronic trading partnership.
- Late spring credit sell-off. Perhaps triggered by Fed Chairman Ben Bernanke’s announcement to retire and fears of QE tapering, the market sell-off and dramatic spread widening may simply have been “a thirty second preview of the forthcoming feature event”, according to one dealer. Many market participants believe we may be headed towards a “Great Rotation”, where higher interest rates will lead traditional asset managers out of bonds and into equities. Without a significant structural change in the market, the currently preferred on-demand RFQ model is ill- equipped to facilitate the level of risk transference that will be required if the feature movie ever gets released.
- Dealer inventories fall to lowest levels in 10 years. According to NY Fed data, dealer inventories declined from $235 billion in Oct 2007 to $56 billion in Mar 2013, a 76% reduction. Where dealers typically controlled between 4-5% of the outstanding market, they now control less than 0.5%. The significance of this trend cannot be underestimated, but the narrative this trend has created is misleading. Current dealer inventories simply do not matter as much as their reluctance to commit capital to provide immediate risk transfer. The real issue is the future impact on dealer balance sheets, which have been constrained by regulation, increased capital requirements, and declining profitability. Consider the following, it would have taken a 50% outflow of corporate bond mutual funds in 2007 to lead to a doubling of dealer inventories. Today, a meager 5% outflow would have the same impact.
- Verizon sells record shattering $49 billion corporate debt. Part of a record year of issuance ($1.5 trillion), this deal basically confirmed that investors can fill their appetite for corporate bonds through the new issue market. The VZ deal was three times as large as the previous record set by Apple. The question arises – if new borrowers make 16.7% of the outstanding corporate debt market ($9 trillion) available to investors, what is the incentive to trade secondary bonds? Obviously, each particular trade has its own set of circumstances, but overall, investors are satisfying their broader appetite for corporate bonds through the purchase of current coupon, often slightly cheaper, new issues.
- Retail ATS consolidation. Tradeweb purchases BondDesk. After several years of rumors, the world’s leading retail ATS for corporate, municipal, and agency debt trading is finally sold to one of the leading fixed income ECNs. The purchase elevates Tradeweb to a leadership position in the retail electronic trading business (Tradweb Retail previously had ranked last among four competitors) and provides a presence in corporate bonds, a segment of the market where Tradeweb has historically struggled. The retail market is now serviced by three platforms – Tradeweb Direct, KCG BondPoint, and TMC Bonds – all jostling for share of the $125 million market (corporate bond revenues are approximately $48 million). With the institutional market estimated to be worth as much as $500+ million, these firms will undoubtedly be examining ways to diversify their business and leverage their liquidity pools.
- Bonds.com blazes a trail, runs into obstacles. The company has been a pioneer in the anonymous, limit order book and hybrid trading platform business for corporate bonds. Since 2010, the platform has been widely used by the dealer community, but efforts to extend the LOB protocol into the traditional institutional investment community have been slow to develop. In the fall of 2013, the company was rumored to have hired a banker to assess strategic options, which may include a sale. The company has proven LOB trading protocols can work for segments of the corporate bond market, while also highlighting the complexities of providing protocols that fit institutional investor workflow requirements.
- Wall Street Journal reports Tradeweb is developing a “new” institutional corporate bond platform. According to reports, Tradeweb is developing an institutional corporate bond platform with the support of several large shareholding dealers and a significant dealer investment. Sources indicate the platform concept revolves around firm pricing for larger trade sizes (new) and will also include an RFQ mechanism (status quo). Strategy aside, Tradeweb’s involvement in the market signals a shifting tide of opportunity in electronic trading for credit, and their presence is a constructive force for innovation, competition, and change.
- Exchange Consolidation. NASDAQ buys ESpeed and ICE buys NYSE. While neither of these transactions has a direct impact on the corporate bond market, we expect both entities to look at the opportunity as soon as the dust settles. After all, its hard to ignore the fact that Marketaxess broke the $100 million net income mark on just under $250 million in revenues by trading odd-lot corporate bonds (average trade size less than $500 million) in 2013.
- MarketAxess announces “Open Trading” initiative. By definition, this point may be an extension of Event #2, but is actually the most critical development in 2013. Where the RFQ mechanism was once a client-to-dealer inquiry and response tool, the firm is pushing the envelope and expanding the protocol, allowing clients to both send/receive inquiries to/from the entiremarketplace. Most significantly, it allows investors to deal directly with one another utilizing the platform’s broker-dealer as agent in the transaction, bypassing traditional liquidity providers who may no longer have an appetite for providing on-demand liquidity.
The question remains – will traditional asset managers begin to change their behavior and augment their workflow, embracing a new market structure and alternative trading protocols? To date, the answer has been a resounding “no”, as investors continue to demand immediate risk transfer from traditional liquidity providers. Some are leading the innovation charge, but is change their ultimate goal?
We suspect a structural change is required. To what degree has yet to be determined. With several catalysts at work, the outcome is far from clear. The one certainty is the fact that simply moving execution from the phone to an electronic platform, while utilizing the same trading protocol, will not solve the issue of a contracting universe of immediacy providers.
“Change before you have to.” – Jack Welch
Cornerstone Resources Consulting LLC is an independent advisory and consulting firm focused in the areas of fixed income market structure, Dodd-Frank Title VII, and electronic trading.
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