Corporate Bond Market Needs Price Discovery Overhaul —Report

As buy side firms scramble for liquidity in corporate bonds, a new report Tabb Group lays out the need for a new price discovery mechanism with new tools and pricing sources to replace traditional phone-based quoting.

Dealers are finding ways to provide liquidity in corporate bonds without deploying principal-based capital, according to a new report by Tabb Group, which details the need for market structure changes and more real-time pricing.

In the new Tabb Group report, “Real Time Corporate Bond Prices: Panacea, or Pipedream,” the authors call for new price discovery mechanisms that will enable dealers to provide liquidity on a riskless- principal basis.

The 12-page report is based on in-depth conversations with key participants in the corporate bond market, including brokers, dealers, exchanges, ATSs, hedge funds, asset managers, connectivity providers and data providers.

The report was released this morning just as the SEC is hosting an all-day roundtable to improve the transparency and efficiency of fixed income markets.

In the move to agency-based trading, dealers need to develop new structures to efficiently price a bond trade without a salesperson negotiating over the phone, note the report authors Will Rhode, a Tabb principal and director of fixed income research and Henry Chien, an analyst who covers fixed income and derivatives.

The structure of the secondary corporate bond market must evolve so that buy side liquidity concerns are addressed, insist the report’s authors. “More efficient mechanisms of price discovery for a bond at a particular size are required to replace the traditional process of phone-based quoting,” write the study’s authors.

The report examines the major electronic trading initiatives in the secondary corporate bond market, such as the rise of new single-dealer platforms with auction-market sessions and RFQ (request for quote) models, in which dealers can algorithmically generate bids and offers. It also looks at the emergence of buy-side crossing networks in corporate bonds such as BlackRock’s Alladin Network. But each of these methods has it limitations.

“There’s no silver bullet for the looming liquidity crisis in the secondary corporate bond market,” comments Will Rhode, a TABB principal and director of fixed income research in the report’s executive summary. “A collaborative industry approach may well be the answer to the corporate bond market’s future.”

Whereas large trades can reward dealers with higher spreads that can compensate them for high-touch price discovery with a salesperson on the phone, small trades have been moved to a low-touch automated, electronic price discovery process to maintain margins. This has led to the creation of three different trading environments: Micro (under 100k in value), odd-lot (100k to 1mm), round-lot (1mm to 5mm) and block (5mm and over markets).

Here are some of the highlights of the report:

• Retail ECNs such as Tradeweb Retail and Knight Bondpoint, are used by dealers to price multiple bonds, and these retail ECNs that aggregate quotes are important distribution mechanisms for dealers to price multiple bonds,

• Firm prices generated by quote algorithms are increasingly common tools for dealers to compete for flow.

• Retail ATSs facilitate an estimated 75 percent of micro par volume. In the institutional odd-lot market, a similar transformation has occurred with the adoption of electronic multi-dealer RFQ platform such as Bloomberg and MarketAxess, which account for an estimated 60 percent of odd-lot volumes.

• As a result of dealers pricing bonds via electronic networks and increases in automated executions, odd-lot par volumes have grown 5 percent in 2008 to 13 percent in 2012, according to the report.

• Price discovery is problematic in the round-lot marketplace, and at the low end of the block market, where spreads are not high enough to compensate the cost of high-touch price discovery. Sales traders may ignore trades that are less than US $5 million in size to the detriment of smaller funds.

• In the round lot and low-end of the block market, dealers can no longer provide price discovery profitability over the phone. New technologies and electronic structures to price and trade bonds are required.

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

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