E-Trading Disruptors Seek Untapped Liquidity in Corporate Bonds

Challenge: Rewiring the market structure for corporate bonds requires a change in investor behavior.  Buy side firms will have the opportunity to post bids and offers through anonymous all-to-all markets. Will they step up to the plate?

Why is this important: Dealers have slashed inventories of corporate bonds by as much as three quarters since 2008 due to regulations like Basel III and the Volcker Rule. The market fears that a rapid change in Fed policy, such as tightening of credit or raising interest rates, could drive retail investors to exit bonds. Blackrock, the world’s largest money manager, wrote in a market structure report that the secondary corporate bond market is broken. “Fixed Income is a disaster. Corporate-bond issuance is up five times. Dealer capital is down 75%,” said Seth Merrin, CEO of Liquidnet, at the Baruch College Market Structure Conference in November. With record issuance of corporate bonds, $1 trillion has gone into fixed-income funds in the past 10 years, says Merrin.“This is a cliff that everyone is walking toward because everyone is walking the same way." In September, SEC Commissioner Dan Gallagher publically spoke out about fixed-income reforms, urging the SEC to push for price transparency, electronic trading, and standardization of terms for debt issues.

Wall Street & Technology's Capital Markets Outlook 2015
Here are 10 topics that will be a focus for financial institutions in 2015 and beyond:

• Technology Innovation Returns to Financial Services
• Global Banks Need to Demonstrate RDA Progress in 2015
• Where Should You Spend Your IT Budget in 2015?
• Financial Firms to Struggle With Growing Social Infrastructure in 2015
• As Market Matures, Fintech Startup Winners Will Emerge in 2015
• Universities Increasing Programs for Data Scientists
• Next Year, Aim for Communication & Clarity of Cloud Apps
• E-Trading Disruptors Seek Untapped Liquidity in Corporate Bonds
• Swap Markets Debate Anonymous Trading in SEFs
• The Clock For Market Structure Change Is Ticking
• Increasing Cyberthreats Pose Massive Challenge for Financial Firms

Where the industry is now: Currently, most bonds (more than 80 percent) are traded over the phone with investors calling up dealers. Dealers are matching buyers and sellers with the same quantities, and taking less risk as they shift toward what’s known as an agency or risk-principle model. Up until recently, the main trading protocol has been request for quote (RFQ), offered by Market Axess, which has garnered 85% of the electronic market for corporate bond trading. 

In response to liquidity constraints on the dealers, MarketAxess introduced Open Trading to allow the buy side to send IOIs out to 1,000 subscribers, which allows for anonymous  trading. Though Wall Street has long resisted electronic trading, experts say the industry has reached an inflection point. In an October commentary, Tabb Group’s principal, Anthony Perotta, director of fixed-income research, wrote: “After almost two years of gathering the ingredients, the market may be on the verge of finally concocting the stew,” wrote Perrotta.   

Focus in 2015: The bond market is focusing on new trading protocols and technology innovations that are intended to facilitate investor-to-investor trading, without relying on dealers to commit capital. “We’re seeing a change in behavior. Traders are open to trading electronically and not using the phone. They’re open to adopting something new,”says Amar Kuchinad, CEO, Electronifie Inc., a new ATS. “Ninety-nine percent of the outstanding bonds are at asset managers, pension funds and insurance companies. They are the ones committing capital, through mostly institutional holdings,”he says.

Nicole Olson, Chief Strategy Officer, Electronifie

New entrants like Electronifie, BondCube, and TruMid are attacking the problems with new technology. Institutional marketplace builder Liquidnet acquired Vega-Chi to launch Liquidnet Fixed Income, an “all-to-all” anonymous institutional electronic crossing network for corporate bonds. In addition, it offers a block trading facility for firm orders above $5 million. E-trading pioneer ITG is beta testing POSIT Fixed Income, a dark pool providing point-in-time matching and continuous crossing, initially aimed at the buy side. "This is the opening salvo in probably a multi-year war, so to speak," says Jamie Selway, ITG managing director and head of electronic brokerage at a briefing in November. The firm sees new liquidity providers, including relative value funds, credit funds, and ETF market-markers, standing in for brokers.

In addition, Tradeweb launched a new U.S. corporate bond-trading platform backed by 60 investors and 30 dealers. A new ingredient in Tradeweb’s platform is access to live, streaming prices from liquidity providers for round lot trades under $1 million, notes Perrotta.

In 2015, new platforms will focus on onboarding clients. Customers will try out a few of these platforms and see which ones get critical mass, says Kuchinad. Electronifie is focusing on institutional trades above $1 million. “Obviously, for any of these platforms to work, they need to have the network effect,” says Kuchinad, a former Goldman Sachs trader who is a former SEC policy advisor.

“It seems that 2015 is going to be the pivotal year for fixed income where the market defined by Blackrock as broken takes a big step toward fixing itself. It’s going to come from the market, new platforms and the buy side taking a look at those platforms and fixing their own liquidity crisis.” -- Nicole Olson, Electronifie

Obstacles: The major problem has been that some corporate issuers have thousands of bonds and most of them are not traded. “With 50,000 CUSIPs in the market -- IBM alone has 4,000 bonds -- it’s a technological problem,” says Kuchinad. If Spotify gets a two million song-library down to a 50-song playlist, he says, “technology can boil a very large amount of data down to something that is digestible by humans.” Similarly, Amazon suggests other products to buy; when someone looks at the IBM 2023 bond, it’s possible that they could buy the 2022. After studying FINRA’s TRACE data, Kuchinad found that 52 percent of dealer-to-customer trades are crossable, meaning the client was buying the same bond from a dealer, the same day another client was selling a bond to a dealer. If technology could help them find each other, they would cross. "I don’t think there’ s a problem with liquidity. It’s that you can’t find it,” says Paul Reynolds, CEO of BondCube, a new ATS/dark matching venue that’s focusing on illiquid bonds using algorithms. “It’s the 96% of the market that never trades."

Market forecast: Tabb Group forecasts that 37% of the bond market is expected to be traded electronically by 2016, an increase of more than 50% from today's levels. The biggest growth is expected to occur in the untapped large trade segment.

Technology providers: New platforms include BondCube, Electronifie and TrueMid, Liquidnet Fixed Income, ITG’s POSIT Fixed Income. Established players are MarketAxess, Bloomberg, Tradeweb, KCG BondPoint, and MTS/Bonds.com (owned by the London Stock Exchange).