Capital regulations restrict banks’ bond holdings

A shake-up beckons for corporate bond trading in the US, led by two pronounced trends that have investors, banks and technology vendors scrambling to implement solutions.

Tougher capital regulations have compelled banks to lower their inventory holdings of bonds sharply, reducing liquidity in the secondary market for bond investors and money managers, known collectively as the buyside.

This comes as computerised trading is steadily growing across fixed income and has many in the market wondering if machines and new firms providing two-way prices for bonds and derivatives can help offset the recent drop in support from Wall Street banks.

While some university studies suggest the use of electronic trading can be the most cost-effective way to buy and sell bonds, a long journey of acceptance looms for an industry that has preferred the telephone and personal relationships with dealers for conducting business.

“We are on a journey, this won’t happen overnight,” says Richard Prager, head of global trading at BlackRock. “Nobody likes change, but the market will evolve.”

Improving liquidity

Nearly a year has elapsed since a group of leading bond investors sat down with dealers at State Street’s headquarters in Boston to discuss ways to improve trading liquidity. Not much has changed apart from the wide recognition that the market has a problem.

“There is a broad recognition that the liquidity model is broken for corporate bonds, as seen by the sharp drop in dealer inventories in recent years,” says Rick McVey, chief executive of MarketAxess, a leading electronic trading platform for corporate bonds. “It is alarming for investors to see the shift in dealer inventories.”

The amount of bonds currently held by banks is less than a quarter of the $235 billion peak reached in 2007, according to Federal Reserve data. It means banks have fewer bonds in reserve to help facilitate a smooth market for large investors seeking to either buy or sell debt.

Working against the greater adoption of electronic trading is the fragmented and less liquid nature of corporate bonds, where each security has its own unique number, known as a Cusip. Unlike equities, where an individual stock is common to all investors, each bond issued by a company is distinct, with different coupons and prices. The lack of a generic bond works against a liquid market developing in this sector.

To date, electronic trading has mainly focused on small lots of bonds and niche areas of the market.

Ashish Shah, head of global credit at AllianceBernstein, says the expansion of corporate-bond electronic trading will evolve in the future. “Most buyside investors use electronic trading to manage small transactions, but that threshold will grow over time,” he says.

MarketAxess has a market share of approximately 20 per cent for bond trades that are smaller than $5 million in size. That figure drops to about 5 per cent for trades of more than $5 million. This has many in the industry pushing for standardising of debt issues and creating a directory of Cusips that can facilitate electronic trading.

But much depends on companies and their corporate treasurers embracing such a change. Selling debt via standardised funding notes would sharply reduce the number of individual securities that characterise the current bond-trading environment.

Electronic initiatives

Dealers such as Goldman Sachs, Morgan Stanley and UBS have launched electronic initiatives in order to boost secondary liquidity. Meanwhile, BlackRock’s alternative trading system, known as Aladdin, has also attracted attention as a venue for transacting bonds.

Working against single dealer platforms is the reluctance of large bond investors to reveal too much information.

“Investors want a meaningful amount of anonymity when they trade on electronic systems,” says Shah.

A US-based money manager who attended last year’s Boston meeting says electronic trading is not the silver bullet, just part of the solution.

He says information leakage is the area of most concern for bond funds trying to buy or sell large amounts of bonds across electronic platforms.

“The most important thing is anonymity,” he explains. “We are agnostic about the platform, you just don’t want the system being used against you.”

Prager envisions a market where investors provide bonds prices for central limit order book electronic trading platforms and also rely on sending specific requests to other players for quotes.

“I’m optimistic that the major buyside firms will move faster than some people think,” he adds.

— Financial Times