Better liquidity hoped for from electronic venues

Creators of electronic trading venues for fixed-income securities are hoping that, by matching buyers and sellers, more choices in trading will result in more liquidity in the secondary market.

Investment Technology Group Inc. and Liquidnet Inc. announced in the past month they will introduce fixed-income automated trading systems in late 2014 or early 2015 that will anonymously pair trading partners.

ITG also will provide recommended trading prices and execution services; Liquidnet will match participants and leave them to execute the trades themselves. They join other electronic trading operators like Electronifie Inc. and Bondcube Ltd., which plan to start operations later this year.

Those firms — as with other established ATS like Tradeweb Markets LLC, MarketAxess Holdings Inc., Bloomberg LP and MTS Bonds.com — aren't expected to replace the traditional method of calling dealers. Instead, they will serve as an alternative that, ATS providers say, will create more avenues for liquidity in a fragmented market of more than 60,000 different corporate issues.

“Liquidity affects us,” said Wayne Kozun, senior vice president, fixed-income and alternative investments at the C$140.8 billion (US$125.8 billion) Ontario Teachers' Pension Plan, Toronto, which holds more than C$18.5 billion in corporate debt. “The inventory dealers hold 75% less” than before the 2008-'09 financial crisis, he said. “It can be hard to find bonds and it's harder to block-trade than before. That's where electronic trading can be useful.”

ITG's new venue is part of a general move to electronic market-making in fixed income, said Frank DiMarco, director of fixed-income electronic brokerage at ITG, New York. “Everything we do is evolutionary, not revolutionary. We're providing an extension of liquidity. We're not replacing anything. Money managers want liquidity and price improvement. We try to provide both.”

“We're not replacing the (request-for-quotes) process,” said George O'Krepkie, president of MTS Bonds.com, New York. “That still has a purpose in bond trading. ATS provides an alternative.” Mr. O'Krepkie was CEO and president of Bonds.com Group Inc., which was acquired by London Stock Exchange subsidiary MTS Markets International Inc. in May.

Mr. O'Krepkie said 80% of fixed-income trades now are done by phone, 15% through RFQsand 5% anonymously through limited-order books such as what MTS Bonds.com offers. “Five years into the future, there'll still be 70% to 80% of trades made by phone,” he said.

Added Constantinos Antoniades, global head of fixed income at Liquidnet in New York: “We can't make buyers out of thin air. What we can do is bring together hundreds of participants in a way that won't tip off the market. Institutional investors have asked for this. The fear of a sell-off is one driving force behind it, because of the rise in risk premiums. The other driving force is market-making. There's a mismatch of availability in the market and the demands of clients.”

Liquidity already has shrunk as a result of regulatory and economic conditions that have led fixed-income market makers — particularly investment banks — to have less inventory on their balance sheets. Conversely, high volumes of corporate issues since the 2008-"09 financial crisis have put as many as 60,000 different bonds on the market, snapped up by fixed-income money managers running portfolios for asset owners. Many in the industry are asking what happens if interest rates increase and those asset owners and managers head for the exits, or what will be the impact of potential outflows from fixed-income funds managed by Pacific Investment Management Co. following the departure of co-founder William H. Gross to Janus Capital Group Inc.

“All of that is related to the liquidity challenge,” Brandon Swenson, senior portfolio manager and co-head of U.S. fixed income at RBC Global Asset Management (U.S.), Minneapolis. “We may or may not see redemptions, but the bond market is worried about that anyway.” RBC Global managed $36.9 billion in U.S. fixed income as of June 30.

Gregory Davis, principal and global head of fixed income at Vanguard Group, Valley Forge, Pa., is all for electronic trading as long as it's cost-effective. “We're very cost-conscious,” Mr. Davis said. “We'd love to use electronic platforms, but those that offer a very fair price. ATS may charge higher trading costs than we'd pay picking up a phone.

“For any of the electronic models, the challenge is finding buyers for fragmented markets — not only the number of issues, but the number of venues,” Mr. Davis said. “I'd also like to see consolidation in the number of venues. There's a limited amount of time in a day to pick a security. Managers don't have the luxury to check all ATS to get best execution. At the end of the day, you want to execute at the best price, then move on to another execution.” Vanguard managed $112 billion in U.S. indexed fixed income and $19.5 billion in active fixed income as of Dec. 31.

Mr. Davis' call echoes one made in a white paper last month by BlackRock Inc., New York, which recommended standardization of newly issued corporate bonds as well as adoption of multiple electronic trading protocols.

RBC Global's Mr. Swenson sees the appeal of BlackRock's suggestions, but also concurred with the firm's assessment in the white paper that such changes would be difficult to implement. “BlackRock's proposal is a direct response to the current environment for investment banks,” Mr. Swenson said. “The market structure has already changed, but on the asset management side, nothing has changed.”

That points to the inherent problems of providing liquidity in fixed income no matter what market conditions are, said Kevin McPartland, principal and head of market structure research at Greenwich Associates, Darien, Conn. “Liquidity is not an easy problem to solve. If it were, it would have been solved years ago,” Mr. McPartland said.

Anthony J. Perrotta Jr., principal and head of fixed-income research, TABB Group Inc., New York, said electronic trading can help by increasing the number of “providers of immediacy to service assets that might be for sale in the market ... The unknown is whether connecting end-users directly creates more liquidity. I would argue it does, as long as we have the proper technology infrastructure in place ... A multifaceted trading ecosystem would open up the market in the universe. Broker-dealers would coalesce around a part of the market they could serve, and the ATS providers can do the same. For money managers, that would mean more choice, lower transaction costs with ultimate improvement in alpha.” n