BOND TRADING: A BRIGHT, BUT CHALLENGING FUTURE.

By Russell Dinnage, GreySpark Partners lead consultant.

• ‘Yes, the bond market is dead;’
• ‘MiFID II pre-trade transparency requirements killed it, evidenced by declining sellside FICC revenues seen so far in 2016;’ and
• ‘The only solution to the problem is to further delay the implementation of MiFID II or, at best, revise it by reneging on the pre-trade transparency proposals for bonds trading.’

These buyside perspectives on the challenges facing the bonds market – specifically, corporate credit – in the EU in the future are not completely accurate. Yes, it certainly is true that MiFID II’s objective to apply the same standard for pre-trade transparency in the exchange-traded equities market to the bonds market – which largely trades on an OTC basis – will increase the already high degree of difficulty associated with selling illiquid corporate bonds.

The reality though is that – by definition – it has always been difficult for bonds traders of any ilk to source liquidity in and then price illiquid corporate bonds trades; in that respect, the implementation of MiFID II’s pre-trade transparency mandates will only serve to make an already challenging corner of the bonds market more challenging. The nature of that challenge, however, has not changed, and the remedies it requires definitely do have a solution, despite the suggestion of the blog post.

The promise of an exchange-traded future

Naturally, the 42 new electronic corporate bonds trading platforms launched since 2007, according to GreySpark Partners analysis, have a role to play in mediating the liquidity sourcing and price formation challenges posed by regulations like MiFID II. Specifically, it is interesting to note that, while the majority of the all-to-all (A2A) or client-to-client (C2C) corporate credit venues launched since 2013 remain focused on facilitating anonymous block-size trading, many of them now offer users access to lit axe trading or odd lots liquidity pools. Furthermore, some of the platforms in both Europe and the US are now integrated with the leading buyside order management systems to scrape blotters for small-size line items in an effort to automatically lubricate the corporate credit market with a necessary amount of liquidity depth designed to allow it to remain functional at a certain baseline level on a daily basis.

Electronically facilitated block-size trading remains the Holy Grail for buyside, sellside and exchange platform operators alike, and all of those types of market participants frequently freely admit in 2016 that they do not foresee a future in which a trading venue would be able to service demand for such tickets without some degree of bank intermediation via the balance sheet. The goal then becomes, for both A2A and C2C block size-centric corporate credit trading venues, to develop a series of workflow methods or protocols that allow sellside counterparties to increase the velocity at which large ticket trades in illiquid bonds can be shifted off their balance sheets and back into the marketplace.

The rank of banks that can legitimately claim leadership in corporate credit trading across a variety of small and large tenor sizes, instrument types and currency denominations has undeniably thinned in recent months. The bulge-bracket dealers that remain strong in the marketplace succeeded in doing so by either renovating their fixed income business and trading models into hybrid principal-agency models (see Figure 1) or they set out their bonds trading stalls to become the leading corporate credit intermediaries in the marketplaces where their reputations as regional specialists are already established.

However, there remains a large number of bulge-bracket and regional dealers who are unwilling or unable yet to adjust their fixed income business and trading models. This constituency of banks are unwilling or are unable to do so because of the constraints placed on the utilisation of their balance sheets by Basel III to warehouse risk, which prevents them from being able to match the liquidity sourcing and price formation demands of the marketplace in its current form and still maintain the ability to eke a modicum of profitability from every bonds trade that they do on both a principal and on an agency basis.

The necessity of an independent mid-point reference price

In order for the illiquid portion of the corporate credit market to address not only the legitimate, medium-term challenges posed to it by MiFID II pre-trade transparency requirements and the long-term challenges posed to it by Basel III and the Basel Fundamental Review of the Trading Book proposals, the corporate bonds market as a whole must find a way to spawn some form of independent mid-point reference price. Doing so would solve the dilemmas posed by MiFID II and by Basel III that are currently challenging the workings of the market’s structure.

Specifically, an independent mid-point reference price could be used by market participants – along with other proprietary or vendor-provided historical pricing data – to develop values for trades in the illiquid corporate bonds that make up the bulk of the estimated 250,000 ISINs available globally to trade on any given day. As a result, a necessary level of pre-trade transparency required by MiFID II to allow block-size trades in illiquid instruments to shift onto exchanges could reasonably be developed. In turn, the depth of liquidity available to trade on the exchanges could then increase organically over time.

This turn of events could then serve as the trigger enabling a higher level of buyside and sellside support for dark environments in which they are able to not only accurately gauge how to situate pricing for their own indications of interest or firm orders, but also to gauge the pricing waters around bonds they are interested in trading in block-size, breaking parent orders into child orders or trading in bulk based on the presence of fair pricing close to the mid-point received in response to a resting order.

This theory, explored in a recent piece of GreySpark Partners research, is supported by the supposition that a truly independent mid-point reference price for corporate credit trading would ideally emerge from the formation of a deeper and more robust retail market for trading the securities. For example, there already exists a historical market for retail investor bonds trading in Italy that, in 2016, is focused within EuroTLX, which – in addition to retail venues such as the London Stock Exchange’s Order Book for Retail Bonds platform – services retail corporate credit demand across Europe. Likewise, in the US, retail investors gain access to corporate credit liquidity via mutual funds and mutual funds indices. Meanwhile, the rapid growth of the fixed income ETF market witnessed since 2013 serves as a marker for wholesale market support for a wider range of retail-level entry points for investor exposure to the corporate bonds marketplace in both Europe and the US.

Despite these early-stage signs for the potential long-term development of a more robust retail market for corporate bonds trading, there remain significant hurdles to the ability of large buyside investors to link pricing for specific ISINs in retail markets as a means of creating their own independent mid-point reference rates for block-size trades in existing lit or dark electronic dealer-to-client or dealer-to-dealer venues. If these hurdles are ever overcome, it will be as a result of significant changes in the buyside’s cultural attitudes toward fixed income trading price formation workflows in general and toward corporate bonds price formation specifically.

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