The implementation of the Volcker rule last month is expected to accelerate the trend among institutional money managers to break up their block trades in fixed income, causing concern that the potential for information leakage and execution delays could increase, driving up trading costs.
The Volcker rule, a provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act that went into effect July 21, bans proprietary trading by banks and also makes holding inventory more expensive, including inventory in fixed income that institutional investors can buy. That rule, along with other regulations under Dodd-Frank and European banking rules under Basel III, led banks' trading desks to cut back on fixed-income inventory, a traditional source of liquidity in the fixed-income market.
As a result, managers — especially those looking to trade more than $5 million in bonds at once — are spending more time and money finding buyers and splitting up their block trades to do so. And the potential for rising interest rates could make that search for liquidity even more expensive.
Aiming to get ahead of the new rule, banks have already started breaking up blocks. According to data on block trades from the Financial Industry Regulatory Authority's TRACE reporting site cited by the U.S. Treasury Department, 73% of all corporate bond trading activity by volume was in blocks of more than $5 million in 2013, compared with 85% in 2008. The average block size of $15 million in 2013 is down from an average of $21 million in 2008. (FINRA TRACE discloses block trade data 18 months after trades are done.)
Those declines are expected to continue as the search for liquidity intensifies, making it that much harder to trade large positions.
“It's more difficult to trade blocks today vs. a year ago and certainly vs. five years ago,” said Brandon Swensen, vice president, senior portfolio manager and co-head of U.S. fixed income at RBC Global Asset Management (U.S.), Minneapolis.
“No doubt, institutional investors are breaking up trades, but unlike equities, which have deep markets, fixed-income markets aren't deep,” added Anthony J. Perrotta Jr., principal and head of fixed-income research at TABB Group Inc., New York. “For institutional investors, it takes longer to execute a trade, sometimes much longer, from minutes to hours or days, maybe weeks. Also, the cost of liquidity increases.”