BlackRock has pressed for changes in secondary corporate bond trading, citing a "broken market" where reforms are needed on many fronts.
In a market structure research paper posted this week on its website, the asset manager said the problem is being masked by low interest rates, low volatility, and the Federal Reserve's QE policy. "When any of these factors change, the extent to which today's fixed income markets are not 'fit for purpose' will be exposed."
BlackRock suggests more all-to-all markets, where investors can trade with anyone; more trading protocols for electronic trading; more standardization of newly issued corporate bonds to aggregate liquidity on electronic platforms; and encouraging behavioral changes by market participants.
As the world's largest money manger, BlackRock has been the most vocal about pushing for reforms in the corporate bond market. It holds $1.3 trillion in bonds, according to The New York Times.
The firm is concerned about deteriorating liquidity in the corporate bond markets and how technology developments can be used to cure fragmentation. Though corporate bond issuance has skyrocketed, liquidity has shrunk. Regulations such as Basel III and Dodd-Frank have imposed higher capital and liquidity requirements and have led dealers to reduce their inventories of corporate bonds.
"Liquidity as a whole has dropped off," Michael Chuang, founder and president of iTB Holdings, a developer of trading platforms that connect to electronic venues, told us. Low volatility and near-zero interest rates have created calmer markets while limiting trading volume, and sell-side revenues are terrible.
"It's creating an artificially low volatile market for both stocks and bonds, and it's tricking people to think that electronic trading doesn't matter so much," said Chuang, a former bond trader. "When the Fed starts to raise rates, they're going to wish they had paid attention to electronic trading. Liquidity is painful when you need it the most."
When the Federal Reserve decides to raise interest rates, as it is expected to do when it stops its stimulus program, BlackRock and others anticipate problems. If the Fed decides to raise interest rates by even a tiny amount, a mutual fund or pension fund that decides to sell 10% of its bonds can cause an enormous wave of selling. If BlackRock hypothetically had to redeem 10% of its $1 trillion in bonds, that could mean liquidating $100 billion in bonds, Chuang said.
BlackRock said in its report: "A less-friendly market environment will expose the underlying structure as broken, with the potential for even lower liquidity and sharp, discontinuous price deterioration."
Despite their diminished balance sheets, dealers sit in the middle of fixed income trading, the report said. Most electronic trading models are based on bilateral transactions where bond trading occurs between a dealer and a customer, or between two dealers.
Many observers, including BlackRock, say the sell-side business model needs to change, too. "With the confluence of these factors, the traditional principal based, OTC model for fixed income trading is 'outdated' and in need of modernization," the report said.
BlackRock recommends the development and acceptance of all-to-all trading venues where multiple parties from both the buy side and the sell side would come together to communicate and "latent liquidity" could be discovered. "While broader e-trading is certainly an important component, without a concurrent change in the underlying trading protocols, this will likely result simply in a transfer of RFQ voice activity into the electronic execution environment -- rather than truly broaden liquidity in a meaningful manner."
In suggesting more trading protocols, BlackRock mentioned MarketAxess, an ECN that has been a thought leader in defining new protocols that offer both open trading and list-based all-to-all RFQ protocols.
"What's new is that it [Open Trading] allows the buy side to respond to an RFQ, which is something historically that a dealer did," Chuang said.
In the paper, BlackRock said it's necessary for investors to become liquidity providers, not just price takers. Chuang agrees that insititutions need to be connected to electronic markets prior to any change in interest rates.
Interacting with electronic venues
On Sept. 2, iTB released an upgraded interface for institutional customers of its iTBconnect to make it easier for buy-side customers to post their bids and offers en masse on electronic trading venues. This lets their orders be routed to venues for execution.
"We recognized there needs to be additional orders into the market, and that the buy side may have additional orders they want to expose to the marketplace," Chuang said.
The new iTB trading interface helps traders post bid/offers easily to the fixed income marketplaces while monitoring market data feeds from the venues.
Retooling the buy side is related to changing the market structure, too, he said, "because they're providing quotes back into the market, which creates new liquidity, and by definition, new liquidity is evolving market structure."
iTB has designed the interface to meet high-volume institutional workflows, so participants can display their bids, offers, and inventory to fixed income trading venues and contribute to liquidity.
For more advanced users, iTB is offering an Excel API to allow the buy side to pump pricing into Excel spreadsheets to make model-based trading easier. The Excel interface lets traders bring in the venue data, so they don't have to look on the screen and write it down. Lots of traders use Excel to model different bonds and keep track of trading positions, he said. Users can consume thousands of lines of data from the electronic trading venues on Excel. It's impossible to monitor where 1,000 bonds trade, since there is so much market data out there from the electronic venues.
"If the Federal Reserve increases rates, a fund that is worth $100 a share one day could be worth $70 the next day," Chuang said. "Buy-side firms should know how to move risk. They should be thinking about whom to call, whether it's Goldman, Morgan Stanley, Market Axess -- they should have choices."
To illustrate the point, he shared a story. After he recently demoed his system to a buy-side firm, the head trader agreed to sign up, even though he said he didn't have any problems with trading bonds. Chuang asked why he signed up. "I know I don't have a problem today, but when I have a problem, when the Fed moves, I need to have your platform, so it's my fire extinguisher, so I'm not scrambling, so I can be a good fiduciary," the trader said. That trader has become a very active trading client, Chuang said.
Sell-side firms will need to change their behavior, too. "The business of being the middle man in fixed income is not sustainable," he said. "If it were, they would be making a ton of money." Many sell-side firms are shifting from a principal-based model toward an agency-trading one.
"There will be sell-side firms that innovate how they make money in this environment, whether it's becoming an agency broker, using technology, or providing research," Chuang said. "They will figure it out, and then everything else will follow."Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio