BEST EXECUTION? IT DEPENDS ON YOUR DEFINITION.

In 2014, achieving best execution for over-the-counter trades in secondary corporate bonds is seemingly a logical non sequitur. The market for the securities is largely illiquid, and thus it does not lend itself easily to the benefits that technological innovations like algorithmic execution and transaction cost analysis are bringing to the sovereign bonds space. Russell Dinnage, Senior Consultant at GreySpark Partners discusses how a best execution-less reality for corporate bonds trading is not for want of trying on the part of broker-dealers and institutional investors alike.

After successfully developing the first mass-produced automobiles of his time, industrialist Henry Ford famously said: “If I had asked people what they wanted, they would have said faster horses.” In 2014, Ford’s statement on the power of innovative thinking applies to the concept of best execution in the fixed income market, specifically in the now largely illiquid market for corporate bonds.

E-trading advances in recent years made price slippage – the loss of investor value on a trade through inefficient execution – a phenomenon of the past in markets for equities, futures and spot FX. In those markets, algorithmic execution and transaction cost analysis tools provide broker-dealers and buyside investors alike with copious amounts of quantitative measurements of the timing and effectiveness of point-of-transaction and settlement decision-making by traders.

This reality for a large portion of the capital markets universe of products thus begs the question: What does best execution look like for the illiquid corners of the market wherein e-trading solutions are limited by the technology of their time? In those corners of the market, e-trading solutions are not yet able to solve best execution-related problems because the final form of the solution has not yet been developed. Some fixed income market participants have attempted to bring their platform-based solutions to the fore in recent years, but all of those attempts have so far been met with only varying degrees of success.

Recently, GreySpark Partners surveyed 12 buyside firms asking them how they define best execution when seeking and consuming corporate bonds liquidity.

The survey found that 11 of the buyside firms have in place written, fixed income-specific best execution policies, but not all of those written policies contain specific practices and procedures for best execution. For all of the 12 firms, a formalised auditing program is in place to validate post-trade procedures on a regular basis in an effort to verify that an effort was made by the firm to provide best execution on client trades.

However, the survey also found that the buyside firms’ assessments of the application of best execution onto client trades are typically quantitative in nature. In not yet developing qualitative assessments to measure the quality of best execution protocols on client trades, the buyside firms surveyed said that, in illiquid instruments like off-the-run corporate bonds, best execution is typically based on the buyside firms’ long-standing knowledge of their counterparties’ ability to find liquidity at an attractive price. This means that, of the buyside firms surveyed by GreySpark, their knowledge of which counterparties typically provide fair pricing and which do not – within the spirit of best execution regulatory requirements – provides a better measure for the optimal outcome of a trade for a client over any quantitative tool to measure best execution available in the market in 2014.

In corporate bonds e-trading, most of the buyside firms surveyed said that three RFQs per order are sufficient for fulfilling best execution obligations. However, the quality of execution for every illiquid corporate bonds trade depends on the level of liquidity in the market for each type of bond security and the ability of the buyside firm to strip out speculators from lists of quotes. But, at only three RFQs per corporate bonds order, proving best execution is questionable at best for trades in the approximately 3,000 to 4,000 off-the-run corporate bonds that make up the highly illiquid tail of the credit market.

On the surface, it appears that buyside standards for corporate bonds best execution are still focused on the need for faster horses. But what good will faster horses do for buyside firms in the EU and US that now warehouse an estimated 96% to 99% of the USD 250bn of corporate bonds liquidity held by banks in the two regions in 2007?

Some electronic historical market data-centric solutions to the conundrum of the corporate bonds liquidity dilemma are emerging; Figure 1 (below), shows GreySpark’s informal assessment of the capabilities to-date of four of those solutions.

These ‘information management system’ solutions partially serve sellside and buyside needs for assistance in developing new corporate bonds trading models and accompanying analytics necessary for transitioning an illiquid market away from voice trading and more toward e-trading. But these systems do not automate trade execution methods, nor do they provide means for capturing best execution.

Enter HSBC – in October 2013, the bank launched* a corporate bonds block trading electronic order book called HSBC Credit Place. By segmenting the corporate bonds market into a venue wherein block trading alone is the goal, HSBC has used its clout as a flow house broker-dealer to create a platform on which the interests of all the counterparties interacting with one another there – either manually or automatically – are aligned. Theoretically, as the frequency of buyside corporate bond orders entered into HSBC Credit Place increases, so too does the statistical likelihood of achieving a match for that order, and the potential for success in ever-larger orders increases.

For now, overall volumes of corporate bonds trades done in fully automated, client-to-client matching execution electronic order book venues are low. The volumes are low because off-the-run corporate bonds liquidity streams rarely ever match up anyway in a precisely like-for-like manner, hence the predominantly voice-traded nature of the market for the securities, despite the recent emergence of numerous technology solutions designed to automate voice trading processes. Instead, ventures like HSBC Credit Place are suggestive of what the automobile-centric future of best execution in fixed income could look like – one in which technological advances would allow for the seamless crossing of illiquid corporate bonds flows.

In that future, the overall corporate bonds marketplace could then be siloed into specialized pools of liquidity – like large-size corporate bonds order pools, for example – that are governed by broker-dealers on behalf of willing client participants.

In such dealer-controlled environments, best execution in illiquid fixed income products of any ilk is more easily secured because both the interests of the venue’s stewards and its participants are aligned toward the idea of fair value, achieved in an efficient manner.

And while the buyside may not yet know precisely what their ideal standards for best execution for those products looks like, liquidity crossing venues like HSBC Credit Place that are governed by broker-dealer expressions of client imperatives are essential experiments on the road to designing the best execution automobile of the future.

 © BestExecution 2014