THE QUEST FOR LIQUIDITY.

Sassan Danesh (below left), Co-Chair of Global Fixed Income Subcommittee, and Tim Healy (below right), Global Marketing and Communications Manager for the FIX Trading Community, report on the challenge of finding liquidity in fixed income markets. 

The markets have always hated uncertainty, whether it’s a macro event, a micro event, cyclical changes or something more systemic. The structure of the fixed income market is certainly undergoing some dramatic changes brought on by regulations such as Dodd-Frank, MiFID II, Basel III and uncertainty surrounding the future has highlighted liquidity constraints. Couple those concerns with the prospect of rising interest rates and an aversion to risk by the banks and you have the almost ‘perfect storm’ for an illiquid market.

The new SEF world

 Mandatory SEF trading began on 15^th February and currently there are about 20 Swap Execution Facilities (SEFs) registered with the US Commodity Futures Trading Commission (CFTC) through which participants can trade. Even at this early stage, there has been some consolidation in the market and a number of key players have emerged in the rates and credit space.

Almost 95% of all Interest Rate Swaps (IRS) volume executed on SEFs since the start of the year has been
attributed to ICAP, Tullett Prebon, BGC Partners or Tradition. Bloomberg, Tradeweb and GFI have also seen some decent volume. For credit default swaps, Bloomberg has emerged as the clear winner capturing more than 70% of the total volume since the start of the year; GFI and Tradeweb have also gained some traction.
However, brokers are faced with a decision; do they connect to all SEFs or just the popular venues and take the risk of being unable to access certain pools of liquidity?
The problem of liquidity fragmentation in the swaps market has been further exacerbated by the lagging implementation of European regulations; MiFID II is unlikely to come into force until 2016, two years behind the Dodd-Frank regulations in the US. As such, if a European participant wishes to trade with a so-called “US Person”, then this trade must be executed on a SEF and in accordance with the Dodd-Frank rules. This has resulted in a 30% drop in notional terms of Euro denominated interest rate swaps traded on SEFs since the start of mandatory trading back in February. Also, a clear split has emerged with separate pools of liquidity forming for “US Persons” and “Non-US Persons”.

The challenge going forward will be how best to access this fragmented liquidity and the key will be the ability for banks to easily integrate with all of these venues, whether it be a SEF, MTF or Exchange, offering an economically equivalent swap future product, in a standardised, low-cost manner. What the market agrees on at this stage is that a collaborative approach to solving the fragmentation issue makes sense. The good news is that the vast majority of the SEFs have adopted the FIX Protocol, which means more efficient and cost-effective connectivity for all concerned.

A Low Inventory Environment

The feeling in the market place seems to be that fixed income may well take a similar path to the equity markets. The huge block trades that were once the norm in the credit markets will be replaced by smaller and smaller average order sizes over a period of time as the fragmentation of liquidity continues.

The Basel III capital requirements have forced banks to drastically reduce the amount of inventory they can keep on their books. This has led to the buyside stockpiling the vast majority of corporate bond inventory without an efficient and practical way to trade in and out of these large positions.

Will the role of the buyside morph into one of a price maker as well as a price taker, as the traditional dealer’s model of committing capital gradually disappears? For the less liquid issues, this is a possibility. The financial market participants are frantically looking for a solution with dozens of existing or proposed initiatives out there aiming to solve the liquidity problem. But how will the buyside connect to each of these platforms? The use of standardised connectivity solutions based on FIX is likely to be a critical factor in ensuring a successful transition to the new market structure.