There's a lot of buzz about alternative trading systems in the U.S. fixed income space, where the corporate bond market could be on the verge of an overhaul. As Wall Street firms grapple with new regulations and capital charges, the buy side is seeking alternative ways to find liquidity for corporate bonds, which are less dependent on the dealers.
Facing more expensive capital charges under Basel III for holding risk-weighted assets, dealers have slashed their inventories of corporate bonds to facilitate institutional trades by roughly 80 percent, from a high of $230 billion in late 2007 to approximately $56 billion at the end of March, according to the Wall Street Journal (registration required). Big money managers have raised concerns about dealers reducing their previously huge inventories of high-grade corporate bonds, which could result in a shortage of liquidity for bonds, especially if interest rates rise. Also, banks have reported fixed income losses of $8 billion on an aggregate basis since early 2008, according to Tabb Group in a report last December.
"The ability for dealers to continue to warehouse bonds on their balance sheets and take risk for customers will definitely diminish," comments Kevin McPherson, head of U.S. sales for MarketAxess, which operates the largest electronic fixed income market place for high-grade corporate and high yield bonds. The problem is that while sell-side balance sheets are capital constrained and more reluctant to house corporate bonds, investors are hungry for liquidity. "On the investor side, the demand for global wealth and investment management is swelling and the need for liquidity is growing," says McPherson.
While the existing structure corporate bond market revolves around dealers making markets with two-sided bids and offers -- with dealers in the middle of each trade -- some believe that the regulatory and cost pressures are setting the stage for a major shift in the evolution of the fixed income market structure toward electronic trading platforms.
[For more on how fixed income trading is moving to electronic methods, read: E-Trading Finally Takes Over Fixed Income.]
In a fourth-quarter 2012 report on U.S. fixed income trading, Greenwich Associates predicted that the regulatory changes which have already produced a pullback from the dealers could have a negative effect on liquidity "to the point that electronic trading venues typical in equity markets become viable alternatives for investors." Greenwich lays out a case for electronic trading to transform U.S. fixed income from its "dealer-based, principal-trading, over-the-counter (OTC) structure to a new, equity like model featuring agency trading, crossing networks and increased electronic execution."
Consultants expect electronic trading of corporate bonds to more than double over the next few years. "As dealer inventories continue to decrease, buy-side crossing solutions are being introduced to the market and established trading platforms are seeing more activity," Booz & Co. wrote in its capital markets outlook. Less than 20 percent of the corporate bond market traded on electronic platforms, but in two to five years Booz predicted that could jump to 35 to 45 percent, led by the most liquid, investment grade issues.
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