Asset class focus : Fixed income trading : Dan Barnes

Buyside desks will redefine relationships in fixed income markets.

Firms who are not adapting to the new ways of trading will see weaker access to liquidity and yield. Dan Barnes reports.

The size of bond market activity in 2020 was extraordinary. In the US, TRACE recorded $9.2tn of corporate bonds traded between January and November, more than the $8.6tn traded throughout the whole of 2019, with both March and April each tracking over $1tn in traded volume. In addition, bond issuance to end of November 2020 was 59% higher than the same period in 2019, according to the Securities Industry and Financial Markets Association (SIFMA).

This meant buyside desks were under more operational pressure than they had ever been before, as they sought to balance the demand for buying and selling from their portfolio managers with access to the market.

Yet investment banks have stepped back from their market making role in secondary markets, leaving gaps in liquidity provision.

“I would say dealer relationships have moved to become less adversarial over the years, to more of a partnership,” said Dwayne Middleton, global head of fixed income trading at T. Rowe Price, which has US$1.3 trillion in assets under management. Speaking at the Fixed Income Leaders Summit US in December, he said, “Clearly dealer community business models have changed from that of a primary risk taker in the market, and controlling all the inventory which has been transferred to the buyside.”

There is a bifurcation between asset managers, which some market participants tie to the size of their business. In general, fixed income trading has evolved as a function in the front office allowing traders to contribute more effectively to alpha generation. Meanwhile, development of new investment products in the back office has enabled some asset managers better access to liquidity and yield on behalf of investors.

Necessity has been the driver – dealer withdrawal and platform innovation have moved the goalposts for anyone wanting to score in the bond markets – but the writing has been on the wall for some time.

Developing new relationships, reconfiguring existing relationships and reducing reliance on third parties have all been key skills to develop the trading function.

Laurent Albert, deputy CEO and head of Global Trading Desk at Natixis TradEx Solutions says, “Our company manages flows from several clients and we receive orders from external clients and internally from the BPCE Group. Our internal data team defines predictive models via our order management system, Charles River, and we get that information pre-trade, creating a decision tree for execution. We built these analytics internally, so we are less external-provider dependent.”

In 2021, as asset managers and banks continue to see pressure upon their margins and cost bases, they will need to innovate further in building out the alliances and maintaining flexibility at the operational and cost levels.

New ways of working
The adaptation to working outside of the office environment is expected to continue this year, as face-to-face meetings are unlikely to happen until vaccine roll-outs are complete. Although distributed working has presented more issues for the sellside than the buyside, cloud technology has largely overcome any deployment challenges for system operators.

A more apparent change is in the evolution of trading via platforms and bilateral channels. Fixed income liquidity is sporadic, and reaching out for a quote by phone, IB chat, email or an electronic request-for-quote (RFQ) platform guided by non-executable prices has long created obstacles for bond traders.

This is changing as a result of several factors. Technology developments are not only facilitating more complex ways of electronic trading but new counterparties – including exchange traded fund (ETF) market makers and other buyside firms – are also making prices in the market.

These trends are clearly visible in the growing electronification of bond trading, but create their own challenges for traders as they try to manage new ways of working.

“The hurdle of evidencing best execution has been raised higher and higher, and this burden sits squarely on the shoulders of the buyside traders,” says Carl James, global head of fixed income trading at Pictet AM. “Therefore, buyside traders need to be absolutely convinced that the trading methodology they utilise will easily be able to evidence this. A bond traded on RFQ, provides a simplistic level of evidence. However, a portfolio trade will require a more holistic, nuanced review, which some less informed PMs or compliance departments may find difficult to grasp.”

Increasingly, buyside traders are looking to provide strong process and quantitative evidence to better support execution decisions which requires getting reliable sources of data.

“We set up a specific team in our company whose mandate is to manage and analyse data,” says Albert. “They can compare the cost of bond trading, for example trading electronically against trading by voice. If a platform increases the cost of trading they could lose out.”

Those who are adapting to the need for increased agility, with a greater networks of providers and new relationships with those firms with which they do engage, are seeing greater diversity in execution models than ever before.

“Being able to react quickly to discrete liquidity opportunities if you have the proper systems on the buyside and you are able to react [means] you will be in that conversation of getting a good look ahead of the market,” said Middleton. “I think we saw that in the volatility; even though the electronic platforms broke down, the pro rata slices of portfolios were still hitting the dealers, so they were still getting the same amount of enquiry, they just didn’t have the capacity to deal with it. And for accounts that could help them manage the kind of risk they were seeing, and off-lay that risk, I think that was an advantage.”

What 2021 might hold
In the UK and Europe, Brexit will demand a duplication of services within the two regulatory regimes whether or not an agreement is reached, due to the last minute deal-making and need for certainty.

Asia Pacific has seen greater electronification of China’s markets through both Bond Connect and innovations like Tradeweb’s China Interbank Bond Market (CIBM) Direct which provides access into China’s bond market for foreign buyside firms using a disclosed RFQ mechanism.

The US is building a more structured bond market through regulation and its ongoing development of utility databases that bridge the gaps left by the absence of exchange-like structures.

“As with most advancements to market structure, regulation will likely be a driver and in turn lead to increased transparency initiatives,” noted Michael Ruvo, CEO of software provider BondWave, in a recent commentary. “Any resulting changes, however, must certainly consider the few remaining firms who still take risk and are vital to maintaining market liquidity. Therefore, a focus on pre-trade data seems to be a logical next step in providing the data foundation to enable a Reg NMS for bonds.”

Up until this point, US market regulator the Securities and Exchange Commission (SEC) has not expressed interest in such a development.

Larry Tabb, Head of Market Structure at Bloomberg Research says, “When we brought up things like a Reg NMS for corporate bond trading, there has been no pick-up on that theme.”

However, as Ruvo added, “As someone who has heard this idea discussed for the last 10+ years, I ask myself, ‘Has the time finally come?’”

©Markets Media Europe 2021

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