We are concerned about the new equities-like transparency rules for non-equity products that are being introduced under Mifid2. These rules means that for some instruments, prices will need to be made public as well as the details of the executed deal. Other securities that previously traded over-the-counter will be forced to onto organised venues. We are concerned that too much transparency will harm our ability to trade effectively in illiquid items, potentially bringing a further element of strain on liquidity in these markets. We understand that finding that right balance in transparency obligations capable of supporting the price formation process and at the same time encouraging the provision of liquidity is a difficult equation to achieve. However, we feel that the unintended consequence of setting wrong transparency obligations might be significant, especially in an market crisis event. 

All-to-all:

Buy-side to buy-side: One of the main problems of B2B trading network is determining the price for a bilateral exchange between two buy-side participants in the absence of a multilateral market price which could be considered ‘fair’ to both sides and agreed as fair by the regulator. In the equity world, this problem is solved by the use of the mid between the best bid and offer (BBO) across all the marketplaces in which that equity trades – the European Best Bid and Offer (EBBO). But this is not available for bonds. Blackrock, which launched a B2B platform in 2012, announced a year after that it was discontinuing its attempt to offer such a service.

Liquidity aggregator: Neptune

Call Market: this is also the way in which most European stock markets including the LSE set opening and closing prices. It simply consists of a “periodic market auction”. Periodic auctions, rather than continuous auctions, aggregate the buy-side’s demand for liquidity over a period of time into a short trading session. In this model, it is thus much more likely that a match can be found for bonds which trade relatively infrequently. In addition, often if there is no match, the provider of the ‘sessions’ platform, may be willing to commit capital and take the other side.

Hybrid system: these are system that use both electronic trading and voice assistance. It operates in a similar way to a limit order book in many regards. It requires two parties to agree a price at which they will trade, but GFI then advertises the trade to the market for a brief period. More often than not, other participants join in and the trade goes through in larger size than the amount agreed between the two original parties. This system brings in people who are neither traditional takers or makers but a third group which is opportunistic: people who want to see a trade happening first and will then go along. Order book trading can also be supplemented by periodic auctions when there is insufficient liquidity in the continuous trading order book.

We are probably at a stage in the electronic market development where new trading platforms will continue to be launched at regular intervals. But we will also see a Darwinian process whereby many of them will fail to gather sufficient business and will disappear.

For liquid bonds, exchange type trading may become more common. Where that liquidity is not there, a continuos market with pre-trade transparency will not work and perhaps even periodioc auctions may not solve the problem. Thus brokers/dealers capital facilitation might be needed at an higher cost. Institutional LIS crossing network will succeed and buy-side will probably shift toward a more active role in price making rather than just participating as a price taker.

Can the buy-side make prices?

Corporate bond dealers in the US are said to have reduced their corporate bond inventories from a level of around $250billion in 2007 to only around $50billion in 2012. With so little inventory and the cost of holding that inventory so much higher in terms of capital, the new environment is one in which balance sheet facilitation of client trades is less attractive to brokers relative to agency broking than in the past.

If we add that in excess of 90% of bonds inventory (some say even 99%) is held by institutional bond investors, it is easy to understand that we, the asset management industry, are holding the key to address the liquidity conundrum. Those large dormant inventories held by asset managers, pension funds and other institutional investors are a natural source of liquidity that can be used as an alternative to the now greatly reduced capacity of broker/dealers to use balance sheets to facilitate clients’ trades.

How can that be achieved? By shifting from a pure price takers role to a price makers one, a role that large asset managers like us have to start considering. What would be the risk and the opportunities connected to such a model change? The reward would be to take out the spread instead of paying the spread. A price maker in fact buy at the bid and sell at the offer, therefore  the net result will be a significant improvements in terms of pricing and eventually performance for the end client.

Making prices does, of course, present a risk of losing money by getting the price wrong or having unwanted positions. However, asset managers are much better equipped from to manage inventories for a number of reasons:

-          Brokers/dealers have their trading books highly mismatched from a maturity perspective’ since they finance long-term bonds with overnight repo. In contrast to broker/ dealers, asset managers do not have to re-finance their long maturity inventory every day in the overnight repo market and therefore do not have to bear the risk of not being able to roll-over repo during a liquidity crunch.

-          Fund managers do not need to be concerned with collateral or haircuts

-          Asset managers are not subject to the Basel III Liquidity Ratios which also raise the cost of broker/ dealer market-making. Their portfolios are already funded by their fund investors so they are better placed to provide liquidity to each other than are highly leveraged intermediaries.

We believe that if the buy-side offered liquidity services successfully, it would have private and public benefits. The private benefit would be to create another source of alpha for clients. The public benefit would be a shift of liquidity provision from highly leveraged firms to unleveraged funds which would  likely reduce systemic risk.

And this is not only true in the secondary market, but would bring huge benefits to the functioning of the primary market as well, which, as we know, is one of the main source of alpha for asset managers over the past few years.

Over the last few years primary markets went through significant change in terms of how the underwriting system works. Traditionally, in primary deals, lead managers buy the whole issue from the corporate before it had been sold to investors, thus taking on price risk prior to distribution. When this happens, broker/ dealers (investment banks) commit substantial funds, hence regulatory capital, to the distribution process, which under the new Basel regulatory framework would become much more costly. Today the majority of the deals eomply the so-called ‘pot’ system, where only when sufficient orders have been collected to cover the whole amount of the issue (the book), the deal is finally priced. Only at this point, when there is virtually no risk of loss, the new issue is finally launched. Bonds are then allocated to clients of all underwriters by the ‘book-running/lead manager. In other words deals are no longer launched until they are already placed i.e. effectively bought by investors. So the underwriting risk has largely been taken away from the dealers. On the other hand, buy-side asset managers find increasingly herder to understand how to play a more meaningful role in this market as the rules of engagement of the process of allocation are not always completely clear and transparent. An alternative would be for the buy-side to work with the sell-side by joining distribution syndicates and acquiring their positions directly from an issuer. In such case, the investment bank would undertake only pricing and issue management rather than also providing capital commitment. As in direct buy-side participation in the secondary market, this would allow institutional investors to buy at the syndicate buying price (bid) rather than at the syndicate selling price (offer). It would, of course, mean taking on a different role and taking on additional risk but in a similar way to institutional equity investors participate as new issue sub-underwriters. For those that would undertake these activities successfully, it would be another way of successfully generating alpha.

The move to a more active role of asset managers in the market making space is less far than we think.  In fact, while in dealer markets only dealers can provide quotes, on an order-book markets any trader accepted on the system can enter limit orders and can thus potentially offer liquidity to other traders (by being a price maker). As a result, in an electronic order-book driven market, dealers and buy-side are, in terms of the types of order they may enter, no different from each other. On an all-to-all platform both can enter limit orders (make price) as well as market orders (take prices).

Will institutional bond investors enter the market as ‘dealers’? we don’t know but certainly tis is an opportunity for asset managers. Certainly the skills required to price securities are very different from those of the traditional institutional buy-side trader, whether in equities or bonds. It requires skills, competence and platform. It require a move to a multi-asset trading desk and a global integrated trading IT infrastructure that is capable of supporting the complexity, and related risks, of such activity.

Given the above, the dominant electronic multi-dealer platforms, such as Marketaxess, Bloomberg, Tradeweb are all trying to discover new way of connecting people.

What follows is a non-exhaustive list of initiative that are gathering attention from market players:

All-to-all:

Buy-side to buy-side: One of the main problems of B2B trading network is determining the price for a bilateral exchange between two buy-side participants in the absence of a multilateral market price which could be considered ‘fair’ to both sides and agreed as fair by the regulator. In the equity world, this problem is solved by the use of the mid between the best bid and offer (BBO) across all the marketplaces in which that equity trades – the European Best Bid and Offer (EBBO). But this is not available for bonds. Blackrock, which launched a B2B platform in 2012, announced a year after that it was discontinuing its attempt to offer such a service.

Liquidity aggregator: Neptune

Call Market: this is also the way in which most European stock markets including the LSE set opening and closing prices. It simply consists of a “periodic market auction”. Periodic auctions, rather than continuous auctions, aggregate the buy-side’s demand for liquidity over a period of time into a short trading session. In this model, it is thus much more likely that a match can be found for bonds which trade relatively infrequently. In addition, often if there is no match, the provider of the ‘sessions’ platform, may be willing to commit capital and take the other side.

Hybrid system: these are system that use both electronic trading and voice assistance. It operates in a similar way to a limit order book in many regards. It requires two parties to agree a price at which they will trade, but GFI then advertises the trade to the market for a brief period. More often than not, other participants join in and the trade goes through in larger size than the amount agreed between the two original parties. This system brings in people who are neither traditional takers or makers but a third group which is opportunistic: people who want to see a trade happening first and will then go along. Order book trading can also be supplemented by periodic auctions when there is insufficient liquidity in the continuous trading order book.

We are probably at a stage in the electronic market development where new trading platforms will continue to be launched at regular intervals. But we will also see a Darwinian process whereby many of them will fail to gather sufficient business and will disappear.

For liquid bonds, exchange type trading may become more common. Where that liquidity is not there, a continuos market with pre-trade transparency will not work and perhaps even periodioc auctions may not solve the problem. Thus brokers/dealers capital facilitation might be needed at an higher cost. Institutional LIS crossing network will succeed and buy-side will probably shift toward a more active role in price making rather than just participating as a price taker.

About technology

If you look at how the trading environment has changed over the last ten years, it’s exciting. Ten years ago most trades were done over the phone. Today, we’re talking about microseconds, HFT firms that employ military technology to maximise their trading speed; that’s how much the market has changed. Millions of trades happening every second. Once you accept that the trading environment has changed so dramatically, technology has to be part of your life. With the worsening liquidity situation in the market and the fragmentation due to the stricter regulation environment, technology has to play a major part in our investment strategy. Over the last three years, at Pioneer, we have made a significant investment in technology, and last year we completed the deployment of our global order management system, Aladdin, which is an global Order management System (OMS) with an integrated execution management system, with all the relevant connectivity.

Today, we are connected, via FIX, to all major electronic platforms; Tradeweb, Market Access, Bloomberg, TSOX, BondVision. With the volumes and sizes we trade, we need to leverage on as many sources of liquidity as possible and in this type of environment, only technology is capable of giving you that possibility. The fragmentation of liquidity that has been generated by legislation, regulation and the change of market structure, has now made it impossible for people sitting on a desk, to go and look at every single venue. You need to have your order management system, your connectivity to exchanges, your smart order routing, an optimiser that allows you analyse the quality of execution that you have in every single venue, and so on.

In 2015, we have also completed the implementation of the Global Trading Desk, which is one of the reasons we were given the ‘Best Multi-Asset Trading Desk of the Year’ award. It’s basically, a global integrated order book, on which all assets can be traded, leveraging local market expertise. So, if a portfolio manager in Europe wants to execute a US security, we can leverage on our Boston trading desk. Every order can be executed in the place where you have the best capability and in the local time zone, leveraging on the full market day. We feel that that will give us an edge vis-à-vis our competition, because it will allow us to enhance the quality of execution, reduce dramatically the cost of trading and minimise the market impact over all, eventually adding value to the investment process.

I believe the choice an investment firm makes about its trading technology strategy can significantly  impact alpha generation. Having the right technology  infrastructure in today’s market place is a must to become a best-in-class asset managers and generate investment performance, beause the right systems will allow fund managers to focus on what they are paid for, without the distraction of having to spend time in navigating through cumbersome booking processes or downstream manual tasks. In today’s highly pressurized trading environment, you cannot ask to traders to execute a large amount of orders with the right quality, market timing and speed if they have also have to worry about filling the gap of poorly integrated systems, which eventually will translate in trade errors, opportunity costs and compliance breaches. The technology infrastructure that a financial firm adopts can have resounding repercussions both for the firm and potentially for its clients.

As an investment organizations that consistently pursue new asset classes, new strategies and new jurisdictions, in Pioneer senior management is greatly aware of the importance of having the right IT infrastructure in place to support growth and scale. 

Today in the bond markets, the traditional broker/ dealers have also become much less willing to hold large positions on their balance sheet. This results in large part from Basel III capital and liquidity rules even though these are not yet fully in place. The new capital rules require much more capital, perhaps four times as much as before, to be posted against trading book positions and the new liquidity rules disadvantage overnight repo financing which makes inventory holding more costly. In the US we also have Dodd-Frank and the Volcker Rule and in the EU, MiFID II, MiFIR and the FTT (which we consider in the final section) which give rise to further issues for market making

Agency trading aggregate liquidity, it does not add to it. You still need principal makers and those with the ability to warehouse risk in order to work your large positions while minimizing market impact

The intention of regulators is incentivising a transparent price formation process. This is good as long as transparency does not become an objective itself rather than a mean to achieve a better and fair execution for our clients. We are in favour of a greater transparency, of course. However, there are some orders that are just too big to be worked through an order book. These orders are subject to abuse by HFT and need either to be broken up in child orders or be allowed to rest in a dark pool. I think there is a lot more engagement from the industry this time to ensure that policy-makers get it right. In 2007 the industry was not ready and the unintended consequence of Mifid I have been quite dramatic in terms of fragmentation of liquidity

Liquidity is always the parameter to determine the success of a venue as well as the proper mix of participants. We expect each of the new proposed platform to prove whether they are really worth and can generate value for our trading processes.