Dark pool for bonds might depend on equity success

The recent launch by eight large U.S. money managers of an equity dark pool has some wondering if something similar could be built by the buy side for fixed-income trading.

The concerns that helped form U.S.-based Luminex Analytics & Trading LLC along with another manager-owned venue, Europe-based Plato Partnership Ltd. — best execution in block trades and transparency for its participants — are also crucial issues in fixed-income trading, analysts said, which makes it logical that a buy-side fixed-income trading venue could serve those needs.

Jamie Selway, New York-based managing director and head of electronic brokerage at Investment Technology Group Inc., said he thinks it could be done. “I don't see why not. ... Look at Project Plato; that deals with multiassets. The managers who've gotten together on Luminex have indicated that they could do other things besides equities.

“The buy side is comfortable acting like a liquidity provider with equities but not in bonds,” Mr. Selway said. “They rely on the traditional sell side for that. But the buy side is joining with others who say it's time to change and become a price maker, so they need to map into the trading process. They're saying more and more, "Why do I need to go to a Goldman Sachs or Morgan Stanley to get anything done?'”

Managers involved in the creation of Luminex — Fidelity Investments, Bank of New York Mellon Corp., BlackRock Inc., The Capital Group Cos. Inc., Invesco Ltd., J.P. Morgan Asset Management, MFS Investment Management, State Street Global Advisors and T. Rowe Price Group Inc. — have talked about a fixed-income venue.

“We'll need to see if we get the equity parts of Luminex right,” said Kevin Cronin, managing director, global head of trading, at Invesco Ltd., Atlanta. “If we do, then we might do fixed income. Discussions are going on as fixed-income market structure changes. Something conducive to block trading is always going to be looked at.

“We're open-minded about this,” Mr. Cronin added, “but our primary focus is on getting U.S. equities right. If we do and are ready to expand, I think we'd consider fixed income. We don't want to be exchange operators, but if Luminex exerts pressure on other market operators to act responsibly, that's a good thing.”

The devil, said Mr. Selway, is in the details.

“It certainly won't be as easy as with equities,” he said. “Look, equity crossing is hard, but boy oh boy, fixed-income crossing is much, much harder. All sorts of companies are trying to come up with ways to do it: us at ITG, Liquidnet, Tradeweb, MarketAxess, OpenBondX. If bond crossing can be proven out and the new entrants can change the way bond trading works, then something like a Luminex could work.”

“It's a long shot,” said Anthony J. Perrotta Jr., principal and head of fixed-income research at TABB Group Inc., New York. “Theoretically, there's nothing prohibiting the buy side from putting together a network to efficiently transfer risk given that they're the predominant asset managers. But in practical terms, it'd be almost impossible to do.”

Henry Yegerman, director of trading analytics and research at financial data provider Markit Group Ltd., New York, agreed that in theory, a manager-operated fixed-income trading venue could be created. “But you could also theoretically land a person on Mars. There are a lot of obstacles that you'd need to overcome to do that. A dark pool for fixed income would have the same issues.”

Specifically, issues to be dealt with concern price discovery, access to liquidity in times of a sell-off and ultimately, the nature of fixed-income trading, Mr. Yegerman said.

“In an equity dark pool, I know I'm getting a fair price because the equities are also trading in lit markets. That's not the case in fixed income,” Mr. Yegerman said. “Also, the nature of equity trading is that you do it to make money. In fixed income, you're looking to trade bonds to get cash flow to meet your liabilities. The overwhelming number of people in the market are the MetLifes, the Allstates, trading to match cash flows.”

The issue of finding buyers in a limited-size market in case of a sell-off also would be unique to fixed-income money managers. “Among (fixed-income) money managers, everyone's on the same side of the trade,” Mr. Yegerman added. “They're either all buyers or all sellers. The portfolios they manage are investment mandates; how different are they really? If there would be a market issue, all would be sellers; who would buy?”

Mr. Perrotta of TABB Group said how money managers look at debt would also make it problematic to trade in a Luminex-type venue. “With equities, that's a limited universe of instruments that you're working with,” he said. “Even the most similar asset managers have extraordinary views of those instruments based on all the elements they factor into their strategies. In fixed income, while in certain aspects more complex than equities, asset managers look at debt because it sits higher in the capital structure and is seen as having less risk. Those asset managers are very protective of the assets they own.”

Luminex's limited membership on the equity side also would be a concern if mapped to fixed income. While the number of fixed-income securities outstanding greatly outnumbers those in equities, a small percentage of fixed income actually trades actively, “so the more participants in a venue, the better the chance to get inventory and match buyers and sellers,” said Diana Bhaktul, marketing and communications manager, MarketAxess Holdings Inc., New York. MarketAxess joined forces with BlackRock to create Open Trading, an all-to-all trading platform with money managers, broker-dealers, exchange-traded funds, hedge funds and market makers as participants.

“If you set up a platform with a small number of participants, they'll have even fewer bonds available to trade,” Ms. Bhaktul said. “The more participants in a fixed-income market, the higher the liquidity.”

At dark-pool operator Liquidnet Inc., New York, Constantinos Antoniades, head of fixed income, said the likelihood of a fixed-income version of Luminex is small because “we're already doing for them what money managers are asking for.”

Mr. Antoniades added that Liquidnet already has more than 100 money management clients trading through the Vega-Chi fixed-income platform it acquired in March 2014.

He said Liquidnet will introduce a fixed-income dark pool this summer that “will provide for the exchange of liquidity at a very low cost, with the confidence of having a credible venue operator operating the dark pool.” n