CREDIT BEST EXECUTION.

aka “the block trade and the screen price fallacy”

Caroline Brotchie, Sales manager and Neil Murray, Head of European Sales at Algomi, discuss credit best execution.

The changing face of the credit markets has been discussed ad infinitum in recent years. Everyone recounts the good old days of 2005 when traders didn’t pass on a trade, and always stood up to a price. BWICS and OWICS with line items of EUR 5-10m barely caused a shrug. But times, have changed. The real risk takers no longer sit on sell side trading desks, they are the big institutional money managers. “Flow” products are increasingly tough to trade in any real size. Prices on the screen sometimes don’t work whichever side you try.

Against this backdrop, the trading process is under increasing scrutiny, and the need to prove best execution is hovering over every trade. This has underpinned the explosion of electronic trading in the past 5 years, where a dealer can demonstrate that the process and outcome of execution was indeed “best”. A number of competing quotes can be found and documented and account splits are automated. Best execution nirvana, if you will. Trustees, compliance, risk and regulators all sleep easy.

But of course every system has its limitations, and for eTrading, the most important limitation is size – the average ticket is sub EUR 1m. Proving best execution for voice trades – either larger size or less liquid ISINs – is more challenging, and the common solution has been the “three quote rule”, which works well for a sweet spot of bonds and sizes, say 3-5m in a decent percentage of the bond universe.

So far, so manageable. But here’s the rub. We know money managers own more of the bond universe than ever before. Logically that means they have more risk to move, and bigger sized trades to execute. And yet it has arguably only become harder to trade blocks and, more pertinently, to prove such trades were executed optimally. What does the price on the screen really represent? Runs are often stale or work in small size. How exactly can a dealer know where any given trade should or could be priced? In some cases, just knowing he can execute a trade at all is a shot in the dark.

Perhaps ironically, just as the economics at stake increase (through bigger size or bigger bid/offer) so does the difficulty in proving best execution.

The process of price discovery is in itself, fraught with danger. With banks unable to warehouse risk in the way they used to, their credit franchises have moved towards broker-like models, with desks looking for the other side of trades wherever possible. The risk of “noise” around a trade has increased exponentially, decreasing the chances of execution, let alone best execution. This naturally makes a dealer all the more wary of showing their hand where there is a block trade or illiquid name in play.

So if you have to tiptoe around the market to avoid making noise and there is no executable price – what exactly is there?

The starting point is still the two-way runs and balance sheet axes shared by market makers. Ostensibly the former represents the estimated current trading level of a bond in “market size” (which, as we know, is smaller than ever). In reality, runs and screen prices are often stale and serve as a marketing tool more than anything.

The “price” is not a real price. It is a shop window. It aims to inform clients that a trader is active in a bond, and invites him to press for further, “live”, information if he has something to do in that ISIN. That requires him to show his hand, with all of the danger that entails. Plus, let’s not forget there is very little in the way of verification of this data. Runs are littered with disclaimers aimed at reducing the litigation risk of any prices being pulled.

So a dealer’s situation is this: a block trade that can’t be traded electronically; that he can’t speak to multiple dealers about for risk of ruining his market; and screen or run prices that are at best workable for smaller size, and at worst, stale, irrelevant and unverifiable. If said dealer finds a price, how on earth can he practically assess whether that price is reasonable, and whether execution at that price would be “best”?

Bizarrely, given the paradigm shift in the regulation and balance sheet capacity, one thing has resolutely remained unchanged. The way banks market to their clients has barely changed in twenty years; two way runs, balance sheet axes and client relationships.

In the meantime other markets have transformed the way buyer and seller interact. Look at online retail: Amazon knows which books you might like to download onto your Kindle; Ocado understands you prefer your bananas green; and your phone can now show you the way home. But in fixed income, it’s still good old runs and axes.

So what can be done to bring fixed income markets into the 21^st century? The investment community need to be able to have a better understanding of the context of a bond. That context is about runs and axes, yes, but also knowing how to evaluate them. Which bank or broker has been in the flow? That might mean their runs are more solid. Who has printed or seen enquiry in the bond? Whose analyst has published on the name recently? What about the rest of the curve – have there been prints in similar bonds that might help price this one? This is about understanding a franchise’s ability and knowledge of a bond as a whole. It is recognizing that while the money managers are today’s market makers, banks and brokers still have the information to facilitate the movement of risk. It is just about time that data was used and communicated more effectively.

Once, and only once, a dealer can see the full context around a screen price, can it serve as a truly useful metric for evaluating execution for size.

© BestExecution 2014