Subject: File No. 4-660
From: Will Rhode
Affiliation: Principal Director Fixed Income Research, TABB Group

April 15, 2013

In Search of Liquidity: The Transformation of the Corporate Bond Market

On Tuesday, the Securities and Exchange Commission (SEC) is gathering the great and the good for a roundtable discussion on ways to improve transparency and efficiency in the US fixed income markets. This is an unprecedented initiative. Clearly, there is a high degree of anxiety about the world in which we live, in particular in terms of the current extended period of zero-percent interest rates and the way that Quantitative Easing (QE) is distorting the fixed income market. How will the buy side access liquidity from capital-constrained dealers that are withdrawing from secondary market making? And what will be the fate of buy-side fixed income portfolio valuations once volatility returns?

Also on Tuesday, TABB Group releases its report, Real-Time Corporate Bond Prices: Panacea, or Pipedream?
in which we analyze many of the issues the SEC plans to discuss. In the report, we look at how the structure of the secondary corporate bond market needs to evolve so that buy-side liquidity concerns are addressed. We contend that the old way of principal-based dealer liquidity simply cannot economically support the needs of a diverse marketplace. Balance sheet pressures are turning banks into agents, even as margins compress. The net result of lower spreads and a higher cost of capital is fewer and smaller dealer-facilitated principal-based trades.

What is quickly becoming essential for traders, therefore, is a real-time indicative price that can act as a reference to the point of execution, or market price, of a bond at a particular size. Where dealers can no longer price a bond and source the liquidity directly, the buy-side trader will need the tools to enable him to take more control over the execution process. In short, more efficient mechanisms of price discovery are required to replace the traditional process of dealer phone-based quoting. This will help buy-side firms that want to start acting like liquidity providers, not just liquidity takers.

The challenge is that corporate bond market structure remains fragmented, tiered to the size of the transaction across the micro (under $100k), odd lot ($100k to $1mm), round lot ($1mm to $5mm) and block ($5mm and over) markets, and each comes with its own set of dynamics.

In the micro and odd-lot size marketplaces, electronic trading is now thriving, with a wide variety of displayed networks, automated prices, and riskless principal execution. We have forms of electronic price discovery that can lead to flow and volume without the intermediation of a salesperson. But liquidity needs to be aggregated in order to help the buy side build a consolidated view across marketplaces and networks.

Dealers are being driven to use quote algorithms to auto-price bonds more efficiently across electronic multi-dealer electronic request-for-quote (RFQ) venues for odd-lot trades. The use of firm prices from dealers is also a growing trend, as execution risk is reduced with the adoption of dynamic order types and auto-hedge technology. This makes market share the No. 1 priority for existing RFQ platforms. We expect the next evolution of the electronic multi-dealer RFQ marketplace to combine algorithmic prices with posted buy-side inventory in order to facilitate real-time price discovery for larger trades.

In the round market, where spreads are not commensurate with the cost of a high-touch price-discovery process, new protocols such as periodic trading are needed that allow the buy-side trader to selectively target a network, communicate interest on a bond, and negotiate the bid/offer for the trade, while still leveraging an intermediary to clear the transaction. The buy side also seeks order blotter scrapers that allow for natural liquidity in larger orders to form through mutual interest.

In the block marketplace, targeted dealer networks, salespeople, product specialists, and principal capital are still essential components needed to price and execute a corporate bond trade. Dealers are in the process of fine-tuning proprietary algorithms that combine reference price inputs and use matrix pricing to generate a real-time indicative price. Data across bonds on the issuer curve, comparable bonds, TRACE prints, dealer quotes, and prices on credit default swaps (CDS) or interest rate swaps must be carefully weighted to create an accurate real-time indicative level.

The challenge is to recreate the human nuance of making a price over the phone, in an automated fashion. For innovators looking to shape the market, it is important to understand the value of dealer prices. Somehow, traditional dealer ability to make a price on a bond by utilizing relationship networks, placing targeted calls, negotiating trades over the phone, and clearing trades using principal must all be translated into a new structure. At the same time, it must be remembered that a real-time indicative price may yet be irrelevant to the trade. The market price of a large block trade, for example, is primarily determined through client relationships, price negotiation, inventory sourcing, and principal facilitation. In short, to price a bond electronically in real time is easier said than done. Todays algorithmic prices are still relative-value prices and are largely restricted to small-size trades.

Ultimately, the challenge is finding a market structure that can both balance competitive drive for flow, and let traders generate real-time prices for bond trades. Liquidity is too fragmented for an order-driven exchange for most bonds. Electronic RFQ protocols do not replace the nuanced negotiation needed to make a price without natural liquidity. Single-dealer platforms struggle to thrive in an environment of fragmented liquidity and crowded buy-side desktop real estate. Meanwhile, the natural liquidity of buy-side crossing networks cannot function without dealer price discovery.

But the stakes have never been higher. Secondary market liquidity is at its lowest point in recent memory. It is so bad that some traders at small funds now use exchange-traded funds (ETFs) as vehicles to access exposure. Everyone knows the problem, but no one has a solution.

Dealer IP and liquidity support will be key to success of any effort to transform the bond market as the secondary market crisis looms. There needs to be an element of cooperation to facilitate a market structure that is beneficial as a whole. But while there may be obstacles and challenges to overcome, once breached, the process of transformation will happen faster than you imagine. Remember how quickly equity trading moved from the floor to all-electronic exchanges? The same will hold true in the world of fixed income, which finds itself propelled by a unique set of dislocations and disruptions to the status quo, and into a new world.