In the broad expanse of the fixed income market, there are liquid securities and there are illiquid securities.

Generally speaking, the most liquid, on-the-run or recently issued bonds trade with greater efficiency and often in electronic environments, versus off-the-run bonds that end up trading in smaller size orders and/or over the telephone and through bilateral relationships.

Meanwhile, increased regulatory pressure has reduced balance sheets and liquidity, as recently demonstrated by the New York Fed, and made it more challenging to find a diverse range of counterparties as market makers.

According to some market participants, this may be the inflection point that pulls more trading of securities away from the incumbent bilateral trading model and toward electronic central limit order books (CLOBs) that are the purview of the active on-the-run Treasury market.

“We have seen some evidence in the system, that lead us to believe that instead of keeping these two businesses separate forever, ultimately we’re going to have some convergence in market structure,” said Billy Hult, president at Tradeweb Markets. “We are at the beginning stages of this convergence.”

Six years ago, about 60% of buy-side trading activity in Treasuries went through seven or eight of the biggest banks, Hult noted. Today, the same proportion of trading volume is handled by just three or four banks.

“The sell-side firms at the top of the list have gained market share, and this shift could pose a potential challenge in a number of ways,” Hult said. “I think it will lead to a search for more counterparties, and many of those counterparties may ultimately be found in the CLOB or all-to-all models.”

“You’re going to have a portion of the buy side that will continue to do their business through the RFQ model, but at some point there’s going to be integration with or into the CLOB model,” Hult continued. “The basic reason behind that are not the liquidity concerns that exist in the credit market, but a different kind of concern — what I would call counterparty consolidation.”

The dwindling number of sell-side counterparties in fixed income has prompted traditional buy-side asset managers — the BlackRocks, Vanguards and Wellingtons of the world — to seize more control of their trading and make, rather than take, prices on some transactions. But in Hult’s view, the real script for new counterparties entering the U.S. Treasury space is being written by principal trading firms, in contrast to all-to-all trading with more buy-side price makers in credit.

New Player

Electronic market maker Citadel Securities launched a credit-default swaps (CDX) business in April 2016, 17 months after entering the interest-rate swaps market. The Chicago-based company has also expanded its U.S. Treasuries desk from an interdealer, electronic and on-the-run business to targeting end-user investors and off-the-run issues.

Dodd-Frank, the sweeping financial ruleset that has been unfolding since being signed into law in 2010, was the tailwind for Citadel’s entry into fixed income and derivatives, according to Nicola White, the firm’s global COO for fixed income market making. “The open access criteria under Dodd-Frank facilitated changes in market structure that allowed us to start providing liquidity to clients and get access to interdealer markets,” she said.

“We are very focused on liquidity,” Nicola White told Markets Media. “While some liquidity providers have retreated from warehousing risk and can no longer justify extensive balance sheet usage, we’ve focused on providing clients with firm pricing and streamlining our approach to ensure efficient balance sheet usage.”

“We are not trying to replicate the bank model,” Nicola White continued. “Our value proposition is our ability to provide liquidity to clients and warehouse risk using our core quantitative and technology strengths. We’ve recently replicated that approach in Treasuries on the back of customer feedback and we will continue to expand our offering in response to client liquidity needs.”

Diversity of market-making participation is an important gauge of a market’s health. In today’s fixed income market, that is often overlooked in favor of bid-ask spreads and the like, noted Chris White, CEO at advisory firm ViableMkts.

“Is having a lot of volume concentrated in a few dealers a good thing for the market ecosystem? We don’t seem to be asking that question,” Chris White said. In corporate bonds, “most of the electronic liquidity providers are traditional dealers who are still using voice brokering to trade blocks with the buy side. The one thing that has started to change is all-to-all being a part of the electronic liquidity provision process in the RFQ set.”

Who can step in to provide liquidity to illiquid markets? Chris White noted that traditional buy-side fund managers are constrained by their needs to manage regular inflows and outflows and meet daily redemptions, and thus cannot take the execution risks attendant with market making.

“If you’re a buy side and you can wait to trade, then your behaviors can translate more to price-making, and you may even be able to cross over into market making…Hedge funds potentially can step in and be market makers because they don’t have same-day redemptions,” Chris White said. “Waiting time is an important nuance and a key element of this discussion.”

With regard to trading models, Nicola White of Citadel expects CLOBs to continue to gain traction for certain smaller and programmatic/algorithm-driven fixed income trades, which explains the emergence of dozens of new trading platforms in recent years. But any broader shift will take time.

“Many clients still see value in dealers’ risk-warehousing trades. For those clients it’s unlikely they take big risk-transfer trades onto CLOBs anytime soon,” she said. “The market is not as mature as it is in equities and it will be a while before it gets there, especially for the less liquid products.”