Gone are the days…. It used to be that you could pick up the phone to your friendly neighborhood broker and ask for an offer on 50 million bonds. After a small amount of (mostly) good natured haranguing you could be done, booked, billed and off to your next trade.
In today’s brave new world that friendly neighborhood broker is not in your neighborhood, they’re at a big desk in another city. You are not on the phone with them, you are instant messaging. And your desire to invest one piece of 50 million is met with a chuckle (if you are lucky) followed by an offer to sell you five million and a request to work the balance.
The lavish amount of balance sheet that your broker used to devote to carrying broad and deep inventory to meet customer’s anticipated demand is long gone. Electronic trading coupled with spread narrowing has taken the value proposition out of devoting those kinds of resources to provide that type of liquidity to the buy side.
Where are we today?
Without the ability to source significant liquidity from the broker community and at risk of creating information leakage through significant trade print in TRACE reporting, many firms are choosing to get their liquidity through the ETF market. Much has been said about this new and improved (and dare I say it, cool) way of getting exposure to fixed income by buying an ETF on an exchange. Could it be any easier? Probably not, but what we’re seeing now is unintended consequences.
What we are seeing is what happens when a new product becomes mainstream and popular in an environment of constrained liquidity, increased electronic trading and smaller trading spreads –extreme volatility going on in the names held in ETFs. In some instances, the ETF is trading at a discount to the underlying holdings. Volatility of the bond ETF pricing versus the positions held has exceeded everyone’s models predictions.
What we are seeing is a cottage industry of investors that have sprung up who are trading bonds versus the value of the various ETFs. This is feeding on itself as average trade size has plummeted and a whole new group of this type of trader/investor has added a new layer of volatility and noise to the market.
What lies on the road ahead? Trending higher rates should bring back investors who have been sidelined due to lack of attractive yields available in the market. Will this anticipated demand prove great enough for Wall Street to start expanding the balance sheet devoted toward fixed income trading? Or will the once bitten, twice shy brokers continue to seek more attractive means to deploy capital? That remains to be seen. Some of the arbitrage players though might be contributing less noise going forward.
There have been talks of large HFT firms looking to merge due to falling profitability and several ETFs are looking to merge or close due to lack of volume/interest in some of the more off-the-run strategies. The increased cost of doing business in today’s uncertain regulatory environment has dramatically increased costs for the smaller players. The disappearance or consolidation of some of the firms living off miniscule spreads will hopefully open the door for traditional asset managers and bond buyers to step back into the market.
Electronic trading is here to stay. ETFs are here to stay. Let’s hope that better liquidity is around the bend.