A WIDENING LIQUIDITY GAP.

As banks withdraw from fixed income markets and profits continue to fall, the buyside is actively hunting down liquidity. Dan Barnes takes stock of the situation.

Buyside firms are having to work harder to fill orders, with many investing heavily in technology and investigating new access models for the market. From the perspective of the trading desk it is clear that liquidity is reducing; banks are not making prices like they used to.

“Structurally the market is changing,” says Mike Lillard, chief investment officer at PGIM, an asset manager with $1trn in assets under management (AUM), and head of Prudential fixed income. “You are finding liquidity from different places within the markets and liquidity in the markets is lower. If you looked at the markets pre-crisis, relative to what it is today, it’s clearly lower that it used to be.”

The consensus amongst market participants is that the old way of doing business, with banks taking risk trades to support turnover, is not coming back. In Q1 2016, sellside revenues for fixed income, currencies and commodities were half of that seen in 2011, standing at $17.8bn according to analyst firm Coalition. Credit has been worst affected within the fixed income space, falling to $2.9bn in Q1 2016, from $7.2bn in Q1 2014. Headcount across Fixed Income, Currency and Commodities (FICC) fell by 11% over that same period.

Despite the reduction in staff, expenses are rising. Boston Consulting Group estimates that FICC sales and trading IT budgets have more than doubled since 2012 while regulation is offsetting the benefits of cost cutting programmes. The Fundamental Review of the Trading Book (FRTB) being conducted by the Basel Committee is intended to harmonise the approach to market risk. However the US based consultancy group believe the new rules could collectively increase the risk weighted-assets held on banks’ balance sheets by 28%, driving down the return on equity for investment banks from 5.7% to 3.4% against a cost of capital of between 10% to 15%. Dealers are working hard to fight against this tide say buyside firms.

Nicholas Greenland, managing director and head of Broker-Dealer Relationships for BNY Mellon Investment Management, which has $1.6tn AUM, says: “They continue to work closely with us and are trying to find ways of working even more closely with us. Part of this is being data driven as they look at the host of metrics by which they can analyse our clients’ business with them to understand if there are any areas that could be fine-tuned.”

Access all areas

Several dynamics are now in play that may create a chance to increase liquidity. The first is to mobilise buyside liquidity more effectively.

This will see the firms who hold the most assets – institutional investors – increasing their turnover and making prices in order to facilitate trading. Buyside firms will also have to react to moves in the market more quickly.

“We have always empowered our trading desks to do that so we have to be responsive to the market, we have to look for the opportunities when they present themselves – we take advantage of those,” says Lillard. “So to the extent you would say that makes us act more as a liquidity provider to the market absolutely, I am ready to buy and sell securities all the time.”

Another needed change is the accessibility of markets. A point being discussed in the US treasuries and credit markets is the potential for investment managers to begin accessing interdealer markets. Currently these are restricted to sellside firms, proprietary trading firms and certain hedge funds. Gaining entry has long been a political issue for the market operators as dealers see this as disintermediation, yet traders have reported several plans by interdealer brokers to open up to buyside trading.

One option being explored in order to avoid the political problem is the use of a sponsored access model. In many exchange-driven markets, such as equities and futures, dealers provide a ‘pipe’ to the trading venue for clients, with certain pre-trade risk checks required to ensure the market rules are not broken. This allows the brokers to remain a conduit, albeit on a sub-agency basis.

Viable solutions

Existing market operators are delivering new ways to match buyers and sellers. Tradeweb has introduced actionable axes for credit, exchange traded funds and government bonds, with the axes being displayed on Tradeweb or sent to order management systems (OMSs). By 1 June 2016 the firm reported the number of clients using its axe functionality had increased by 131% since the start of the year.

“We see two common themes developing across fixed income markets in Europe; one theme is around the need to improve the exchange of information between the buy and sellside with respect to where trading can occur. We invested in a series of technological solutions that enable market makers to communicate to clients whether they are axed and which side,” says Enrico Bruni, head of Europe and Asia business, Tradeweb. “Secondly we have developed tools allowing clients to search axes across different types of securities in different markets, and direct requests for quote to a specific set of dealers.”

MarketAxess has launched its Open Trading all-to-all protocols in the US and Europe, and in May 2016 reported that its global clients had traded a record of $944m of European credit products via Open Trading protocols in the first quarter of 2016, up 140% from the fourth quarter of 2015.

Numerous trading platforms have – and continue – to launch, in the credit and rates markets, from equity market operators such as Liquidnet, to start-ups such as Electronifie and Trumid. Traders are keen to see the struggle amongst platforms for liquidity is resolved.

Buyside trading desks are seeking tools that will enable them to find liquidity and measure performance, so they can participate more actively and suffer less when liquidity works against them. Trading opportunities are often fleeting and traders need to jump on them when they get the chance.

From an innovation perspective this creates two demands; the first is for venues and connectivity to venues that allow traders to get access where liquidity does occur. The second is for data – and data analysis tools – so that they can value opportunities accurately and manage their participation in the market as price makers.

“We built our transaction cost analysis (TCA) solution against our consistently available trading composite; we spend a lot of time monitoring how client transactions are executed relative to this composite to check its validity and precision, and we have used that as basis for TCA,” says Simon Maisey, managing director and global head of business development, at Tradeweb. “We can measure TCA against the composite both in basis point terms or cash terms, and as a percentage of the bid-offer spread to account for the different levels of liquidity in different products. You can get a really good comparison of how you are executing and what different parameters are influencing the kind of pricing level you are getting.”

Getting strong pre-trade and post-trade information is crucial to traders who have to switch between electronic and voice, with considerable uncertainty as to how the market will pan out. In Europe the MiFID II rules, coming into effect in 2018, will create greater pre- and post-trade transparency, beyond that provided by the TRACE system in the US. The US Treasury is discussing greater post-trade reporting for the US government bond market.

Firms like Algomi and B2Scan have developed tools in the pre-trade space specifically, and while uncertainty exists around platforms, traders will see the need for this information grow. Analyst house Greenwich Associates found that there was a reversion to voice trading in European corporate bond markets last year, with a fall in total volume of electronic trading from 50% in 2014 to 46% in 2015. Although the trend is towards electronification, flexibility on the trading desk will be crucial during the period of transition.

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