Electronic bond trading is the best thing that has happened for the bond-based ETF market.
As more trading of investment-grade corporate bonds occurs electronic-trading platforms, the spurts, stutters, and shortcomings of his migration will drive more investors towards alternative investments, namely bond ETFs.
The benefits of electronic trading have been overstated by some in the bond market, especially in the investment-grade corporate space. Many observers assume that electronic trading delivers better price discovery and liquidity — but it doesn’t necessarily do so, which belies market structure issues.
Electronic trading improves speed and efficiency, which if anything means that investors will experience the bond market’s market-structure shortcomings all that much faster.
Market fragmentation is only going to get worse. According to the authors of the recent SIFMA Electronic Bond Trading Report, the are currently 15 electronic-trading platforms that service the IG corporate bond on munis markets with another four set to go live in 2016 — Clarity BidRate, CodeStreet Dealer Pool, DelphX ATS, and ICAP’s I-SAM.
As the adoption of electronic trading in the IG corporate market continues to grow, the number of platforms likely will increase and further fragment the market further. However. most liquidity likely will stay with the incumbent trading venues.
But if investors want to trade a specific CUSIP, they will wind up checking multiple electronic platforms. This will cloud price discovery further by introducing phantom liquidity, or redundant orders, across the platforms and increasing the trader’s and portfolio manager’s frustration.
Bond-based ETFs, on the other hand, benefit from the cash-equities market structure: simpler price discovery and relatively greater liquidity. Instead of chasing elusive CUSIPs, investors can gain credit exposure from the ETF’s underlying portfolio of assets.
Yet ETFs do come with their own set of issues for investors, namely no direct control over the contents of the underlying portfolio as well as being a derivatives product, as the events of August 24 demonstrated.
However, if investors face the choice of gaining exposure via an ETF or having no exposure at all, they’ll go with the ETF.
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