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Policy shifts won’t stop bond market evolution

Experts say electronic venues to flourish even if Dodd-Frank is gutted

Anthony Perrotta Jr.
Anthony Perrotta Jr. expects the SEC to require best execution for fixed income.

Efforts to deregulate financial services won't halt changes in fixed-income market structure — particularly the increased use of electronic trading venues, sources said.

Such changes, spurred by both market and regulatory factors, have become the norm in the industry, and any efforts by the Trump administration to remove rules that came from the Dodd-Frank Wall Street Reform and Recovery Act, including the Volcker rule, will have less of an impact on fixed-income trading than in other financial services.

“I think the horse has already left the barn on this,” said Anthony Perrotta Jr., CEO of TABB Group, New York.

Added Michael C. Buchanan, deputy chief investment officer and head of global credit at Western Asset Management Co., Pasadena, Calif.: “Our view is that the evolution of electronic trading sped up because of regulations, but it's happening either way.”

Regulations like Dodd-Frank, along with Basel III requirements for banks, forced dealers to have capital backing for fixed-income securities in inventory, causing many to drastically reduce or eliminate their fixed-income trading desks. That was a factor, sources said, in the move toward electronic venues like Tradeweb and MarketAxess for fixed-income trading, particularly with odd-lot, or small block, trades.

But fixed-income trading hasn't turned into a zero-sum game, in which electronic venues win while banks lose. Many banks adapted by restructuring their trading desks, focusing more on non-risk business while moving to a role of agency broker from their pre-crisis role as market maker, said Daniel Lomelino, director, head of North American fixed-income manager research, Willis Towers Watson PLC, Chicago.

“Banking regulations are important, but we've already seen the sell side cleaning house,” Mr. Lomelino said. “Income from fixed-income sales and trading have gone pretty well in the last couple quarters.”

That's evidenced by data from industry analytics firm Coalition Development Ltd., London, which showed bond trading revenue at the world's top banks rose 9% in 2016, the first increase since 2012. That rise was in contrast to a 13% decline in equity trading revenue for the year, the largest decline since 2008.

“Banks kind of like the idea of just crossing bonds,” Mr. Lomelino said. “I don't think we'll ever see the rate of inventory held by banks as you saw before.”

“The sell side has shifted from a capital-and-people game to a more intellectual, technology-driven, efficient use of capital and return on resources,” said Thomas Thees, head of fixed income at investment bank CastleOak Securities LP, New York. “If we roll back all the regulations, you won't see a switch back by banks to their former position anywhere near the level they were pre-crisis.”

“Today, banks are in the moving business more than the storage business,” Mr. Thees said. “Pre-crisis, the tendency would be more on the storage side. There's an unbelievable reduction in that behavior now. On the flip side, all investors have gone into the moving business. And that's been enhanced by the use of technology.”

Real driver

Western Asset's Mr. Buchanan said although electronic trading did benefit from regulations that affected banks' traditional market-making business, the real driver has been the volume of fixed-income securities on the market.

The shift to more electronic trading “was necessary just by sheer growth, particularly in global credit,” Mr. Buchanan said. “Dodd-Frank constrained dealer capital and thus the traditional model of dealer-driven trading. With corporate credit, that was the traditional model. But look at high yield, investment-grade credit, global credit. Par value has doubled from $6 trillion in 2007 to $12 trillion today, yet the mechanism for trading has been reduced, and Dodd-Frank played a big part in that. Something needed to fill that void. I think electronic trading was one of those things that became necessary. Deregulation doesn't change that evolution.”

He said while already 90% of odd-lot corporate bond trading is done electronically, larger round-lot electronic trading of more than 100 shares at a time — currently only 3% to 5% of the corporate bond market — “will continue to grow.”

“Any time we've had deregulation, there's been an increase in trading volumes and leverage, though not like we saw in 2005, '06, '07,” Mr. Buchanan said. “Again, electronic trading will be part of this growth.”

Yet another driver to electronic trading, sources said, was increased focus among institutional investors and asset owners on best execution, which has meant in many cases going beyond the traditional three requests for quotes from banks in favor of the transparency and data available through electronic trading.

“The primary driver toward electronification has been from an increased need for efficiencies from a transaction-cost perspective, said TABB's Mr. Perrotta. “There are two elements to this. First, with the level of rates being so low and tight credit spreads, a 10th of a basis point or less now counts for your investors. Just look at the massive movement to passive. It costs more for active but the returns are not high, so investors pay more for less return. So costs do matter now. Second, there's the fiduciary responsibility that managers are now held to in fixed income. ... The common denominator is, if you're trading electronically, you have a wider data set to draw from” to measure execution, “away from the three price quotes.”

Mr. Perrotta said he expects the Securities and Exchange Commission to impose a best-execution requirement for fixed income. “It's impossible for those regulators to ignore the size of the marketplace,” he said. “As for asset owners, since there's no mandate for best execution, there's no true compliance driver yet. But down the road, it's inevitable. Look at the Department of Labor and the changes and scope in fiduciary responsibility. That has put a tougher burden on financial representatives and increased the scope of the fiduciary. My guess is that the best-execution mandate will fall with the SEC, but it could be in conjunction with the DOL.”

Existing trends

Colm Murtagh, managing director, head of U.S. institutional rates at Tradeweb Markets LLC, New York, said regulation “has served as an accelerator of existing trends toward greater efficiency and transparency through electronic trading.”

However, he added: “Even if reform were to be rolled back in some ways, we don't anticipate market participants would sacrifice the technology investment and operational improvements they've made to their trading workflows, especially considering the performance benefits and scale they achieve through e-trading. It would be counterintuitive.”

But even if Dodd-Frank were rescinded, banks are still bound by risk-restrictive regulations, said Jake Rath, fixed-income portfolio manager at RBC Global Asset Management (U.S.) Inc., Minneapolis, and the firm's lead analyst on financials.

He cited the supplemental leverage ratio, imposed by the Federal Reserve, Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency in August 2014 following on Basel III capital requirements for banks. The rule will require that, as of Jan. 1, 2018, banks hold a minimum percentage of assets in Tier 1 equity, with a higher percentage for those banks determined to be systematically important.

“That's not a part of Dodd-Frank,” Mr. Rath said. “So if you rip up Dodd-Frank, you still have the leverage ratio.”

This article originally appeared in the March 6, 2017 print issue as, "Policy shifts won't stop bond market evolution".