Experts fear rise in trading costs will follow onset of Volcker rule

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.”

While sources couldn't say exactly how much costs have increased as a direct result of the regulatory changes, Mr. Perrotta said factors that are driving the increase are the regulations that increase the cost for banks to build their inventory because they need to back that inventory with capital; and the reduced inventory that will make it more labor-intensive to sells bonds.

The ban on proprietary trading is particularly troublesome for block trading, said Kevin McPartland, principal and head of market structure research at Greenwich Associates, Darien, Conn. “If you can't proprietary trade for corporate bonds, that makes things particularly difficult ... You're less likely to do a large block trade. Ten years ago, you'd call your top dealer and say you had $10 million to sell, and the dealer would have the inventory. Today, a big block will end up in smaller chunks. Whether that's trading by phone or through an electronic venue, you have to do that to find liquidity.”

Sources said the liquidity concerns have increased the use of electronic fixed-income trading venues. Electronic venues don't provide liquidity directly, but match buyers and sellers.

“It's challenging today,” said Richard Schiffman, product manager, head of open trading at MarketAxess Holdings Inc., New York. “In the old days, firms had numerous counterparties on the Street that could access large blocks of inventory when they wanted to buy. But there are fewer of those counterparties with a lot less inventory ... It's so different now. (In an electronic venue) it's common that bids can go out to 1,000 counterparties at once. That can open up a meaningful amount of new liquidity that previously was untapped.

“With markets pretty benign, liquidity's not all that bad today,” Mr. Schiffman said. “But no one knows when it will change.”

While electronic venues can help in finding liquidity, there's a risk their use will result in information leakage, a similar issue with equity dark pools in which trades of large blocks — or pieces of them — can tip the hand of the buy side, said Steven Glass, president and CEO, Zeno Consulting Group LLC, a Washington-based consultant to asset owners on trading issues.

Rather than seek inventory from banks, “what do managers do instead? To some degree, this is where electronic venues can help,” said Mr. Glass. “But that's a double-edged sword, in a sense. Electronic trading can be useful for some managers, but on the other hand, it's too risky to send out multiple RFQs (requests for quotes) without tipping off the market.”

The block-trading concerns have forced money managers to take liquidity into account not just immediately before trades are executed but far in advance, RBC's Mr. Swensen said

“Liquidity concerns have to be incorporated into decision-making, valuation, all the factors you would normally need to know before you decide to make a trade,” he said. “You have to know where the liquidity is before you act. More than ever, you need to think about the exit before you enter the trade ... You have to make a decision on an exit when you decide you want to buy: Are you selling a security that trades every day or just a couple times a month? If it's illiquid, you give up opportunity costs in case of a sell-off or redemption requests. You don't want to be caught offsides when the market changes. So overall, our decisions have to be more nuanced. We talk about liquidity every day.”

The difficulty in making block trades is an unintended consequence of the regulations, which are intended to reduce risk in the financial system, Mr. Glass said.

“It all goes back to maintaining the security of the financial system,” said Mr. Glass. “You don't want big banks to fail, and if one does, you don't want to have a big ripple effect elsewhere. But the restraints on inventory make it more challenging for big institutional investors who trade in blocks to get in and out of fixed-income positions. So the question becomes: How do you intelligently source liquidity?”

Mr. Schiffman of MarketAxess said he thinks the fixed-income market is going back to the days of Glass-Steagall, the 1932 law that prohibited commercial banks from doing investment banking business that was repealed in 1999. “Back then, banks weren't in the bond market, and there were just a few big companies that were brokers. They didn't take enormous risk or carry vast amounts of inventory. “n