Liquidity in fixed income markets

Over the past few years, much has been written about bond market liquidity. In this brief presentation, we will go through some of the main set of data that have been cited by several reports as being the main causes of liquidity reduction. 

-          The decline in broker-dealer inventories

-          The decline in turnover by comparing the amounts of bonds outstanding to bond trading volumes

-          The increase in corporate bond issuance

-          The growth of the asset management industry

Notwithstanding the above, we feel that the above data ignore several other factors and constraints that might drive the decisional process of market participants in different directions, in particular:

1)      Liquidity is not free.

Inherent in the price of fixed income assets is the concept that liquidity has a cost. The cost of liquidity can increase when immediacy is needed and even more so if immediacy is demanded when liquidity is scarce. An increased cost of liquidity might mean losses for some investors but, at the some times, it might mean an investment opportunity for some other market players, who can see a market sell-off as a buying opportunity. This circumstance, introduce the next element often forgotten in liquidity analysis:

2)      Many asset owners have unrelated investment objectives and constraints that drive their behaviour in disparate ways

During the spike in volatility that occurred on the high yield market in December 2015, mutual funds redeemed almost $10bil of assets from high yields funds. However, the HY market did not register a net negative net flows, for the simple reasons that while mutual funds were selling, other institutional investors decided to increase their HY allocation, viewing the sell-off as an attractive buying opportunity. Hence, while increased liquidity cost might reduce investment returns and generate losses for some, it might generate profit for someone else. The fact that there are winners and losers in the market clearly shows that we are facing market risk not systemic risk.

3)      Diversity of asset owners

While the asset management industry has grown in size, the majority of fixed income assets are owned by long-term low turnover investors, such as fund managers, pension funds and insurers. These firms have all different objectives related to return, risk, investment horizon, liability structure, tax regime and liquidity needs. It is therefore unlikely to assume that they will all react in the same way when facing a market event.

4)      Bond  turnover data often omits the growth of ETF market as a source of liquidity

We think that these data reflect a structural change to market liquidity that is encouraging market participants to evolve and adapt their processes and systems.

What to do:

1)      Enhance trading capabilities

In Pioneer, over the last few years, we have made a significant investment in technology to enhance our trading capabilities through the deployment of a global integrated order management system, an embedded execution management system, the deployment of the Global Trading Desk, the enhancement of our connectivity platform and the development of a comprehensive set of trading tools aimed at improving our execution capabilities.

2)      Adapt the investment process

We are not alone in the firm. Portfolio managers have also adapted their investment process to account for reduced market liquidity and our risk management function has also built new tools to enhance its monitoring of liquidity risk in our portfolios. The inability, or worse, the unwillingness to adapt to the change in market structure and liquidity through stronger trading capabilities, thoughtful investment process and more robust risk management tools can lead to significant issues.

3)      Recognise and accept liquidity as a cost and represent market risk, not systemic

4)      Modernise fixed income market structure

Market participants have increasingly looked at new ways to become more efficient at aggregating fragmented sources of liquidity and to find smarter solutions to execute trades. This has resulted in the development of electronic platforms. All dominant electronic multi-dealer platforms, such as Marketaxess, Bloomberg, Tradeweb are all trying to discover new way of connecting people.

Besides, new initiatives have been launched aimed at offering new trading protocols and innovative solution to find liquidity by directly connecting buyer and sellers with a much lower level of intermediation.  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 the platform provider also 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 continuous market with pre-trade transparency will not work and perhaps even periodic 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.

5)      From price takers to price makers

If we consider that in excess of 90% of bonds inventory (some say even 99%) is held by institutional bond investors, it is easy to understand that the asset management industry is 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.