By Constantinos Antoniades, Global Head of Fixed Income at Liquidnet
Since early 2015 we have seen a steady acceleration in the migration towards electronic trading in the corporate bond market. Today, electronic trading of investment grade bonds in the US is estimated to be 20% of the total investment grade trading volume, representing a 150% increase from 20131. All signs point to this trend continuing, driven by three key factors: 1) the development of more trading protocols that put the buy side in the driver’s seat, 2) increased market penetration by a small number of credible and well-funded electronic platform operators, and 3) regulation such as MiFID II which has already and will continue to steer more trading onto electronic platforms. Nevertheless, some commentators continue to believe that electronic trading is solely here to improve the client-to-dealer interaction or assist with the execution of smaller trades. Such arguments ignore the reality that today institutional investors are increasingly using electronic platforms in order to access new liquidity from their peers and execute larger trades without information leakage.
At Liquidnet we launched our Fixed Income dark pool at the end of September 2015. With us now having a full year of operation behind us, we are able to shed light on the current state of play in electronic trading of corporate bonds. There are five important lessons that our industry should embrace as we move forward in building a more efficient way for institutions to source corporate bond liquidity.
Lesson 1: The buy side is perfectly capable and willing to proactively seek and create liquidity
Many market observers believed that asset managers would be either unwilling or incapable to proactively seek liquidity in buy-side focused platforms. Similar scepticism was echoed before Liquidnet launched the first institutional all-to-all dark pool for corporate bonds.
Such scepticism was misplaced and driven by the misunderstanding of the changing market structure and the problems faced by asset managers following the financial crisis.
During our first full year, the average daily liquidity in the Liquidnet Fixed Income platform regularly exceeded $6 billion, an amount estimated to be around one-seventh of the daily combined total trading volume in the corporate bond market in the US and Europe2. More than 99% of our average daily liquidity originated from our 500+ active buy-side users, proving that the buy side is perfectly capable and willing to proactively seek and create passive liquidity when provided with the right trading protocols, information protection, and a trusted place to trade.
Lesson 2: Price formation is not an issue
Another so-called obstacle frequently mentioned by sceptics is the inability of buy-side firms to execute a trade where they face each other, absent any voice intermediary. This rationale contends that an intermediary is needed to help reconcile the price of the trade, because only the intermediary has access to the most current market pricing information. Additionally, each trading party would be willing to reveal some price parameters to the broker/dealer, but never to each other directly. The Liquidnet Fixed Income dark pool, as well as other platforms which enable buy-side to buy-side trading, has crushed such scepticism. Almost half of all negotiations in Liquidnet Fixed Income, where both sides submit a price, result in a trade3.
Buy-side firms have a plethora of price data sets at their disposal, ranging from dealer runs, TRACE (US only), and evaluated pricing feeds operated by firms such as Interactive Data Corporation, Markit and Bloomberg. Such data sets enable the buy side to comfortably observe the market context, enter into a price negotiation, and trade inside the traditional bid/offer spread. This results in reducing transaction costs and achieving best execution along the way. The availability of fixed income data will only improve post-MiFID II as the pre and post‑trade reporting requirements will create more data points.
Buy-side traders possess all the skills needed to identify liquidity opportunities and negotiate to execute a trade. Years of experience trading in the over-the-counter market (which can often be as laborious as an archeological dig) has armed buy-side traders with everything they need to anonymously negotiate with each other when the opportunity arises. After all, responding to an interest to buy or sell a bond is what buy-side traders have been doing thousands of times daily in the OTC market – seeking liquidity and negotiating electronically is no different.
Lesson 3: Use of order management systems (OMSs) is becoming a differentiator
In a world where almost all trading is voice-based, OMSs are primarily a tool to reduce operational risks, book trades, and provide portfolio analytics. However, in the new world where dark and latent liquidity resides in electronic trading platforms, the OMS takes the role of a GPS in helping find additional liquidity, and generate additional alpha.
The best use of an OMS involves the staging of orders into the OMS blotter, and using the connectivity between the OMS and trading venues to uncover dark and latent liquidity without any action or effort by the trader. This process can seamlessly locate liquidity and reduce the amount of time a trader spends looking for it, allowing them to instead focus on negotiating and executing trades. Liquidnet Fixed Income Members take advantage of OMS blotter synchronisation (aka “a full blotter scrape”), and typically see an improvement of three times the number of matches and trades, versus a non-OMS Member4. Blotter synchronisation demonstrates an effective way to maximise liquidity and trading opportunities, with very little effort.
Lesson 4: Dark pools execute larger and more difficult trades
Historically, electronic trading platforms utilised a request-for-quote (RFQ) protocol to make the client-to-dealer interaction more efficient. RFQ is an important part of the corporate bond market structure and is here to stay; nevertheless, it does little to solve the bigger problem of sourcing liquidity in the post-financial crisis environment.
The new generation of trading platforms and trading protocols aim to address the issues created since the financial crisis. Specifically, they work to access larger size liquidity outside the most liquid securities and reduce the need for capital commitment from traditional intermediaries. Dark pools efficiently connect buyers and sellers electronically and anonymously, facilitating larger size crossing against natural liquidity. For example, the average indication size and the average trade size in the Liquidnet Fixed Income dark pool in 2016 were $4.3m and $2.2m respectively.5 The average trade size on RFQ platforms is much smaller at around $500k.6
In addition, dark pools tend to naturally generate better liquidity distribution across the liquidity spectrum. FINRA TRACE data show that around 36% of total US investment grade trading volume is concentrated in the top 500 most actively traded bonds, with the bottom 78% of bonds in terms of trading volume accounting for only 29% of total volume. Looking at the liquidity distribution in the Liquidnet dark pool over the same period, those same top 500 most actively traded bonds accounted for only 15% of the total liquidity, and the bottom 78% of bonds accounted for 58% of total liquidity.7
This is also why dark pool trading is expected to become a much larger part of the market. A recent report by TABB Group estimates that dark pools will account for 5-10% of market volume within 2-4 years.
Lesson 5: Dark pool trading generates significant transaction cost savings
Even though dark pools cannot find liquidity for every single trade, there is typically a significant direct transaction cost advantage when executing a trade against natural liquidity in a dark pool with full anonymity.
Based on our internal evaluation of trades executed in our Fixed Income dark pool in 2016, transaction cost savings were estimated to be around 65%, when compared to the expected inside bid/offer price or spread. Such transaction cost savings enable the traders to become a source of direct alpha to the fund and a performance advantage for their firm.
The corporate bond electronic trading landscape is constantly evolving with a small number of platform leaders emerging. Providing critical mass, OMS connectivity, financial strength, and a proven track-record are the basic essentials for a successful platform and adoption by the buy side. Looking ahead, the asset managers who maximise the full potential of the platforms that leverage smart technology and consistently deliver innovation, and the OMS, are the ones who will gain an advantage. The year ahead is likely to prove a milestone year for the industry as electronic trading is reaching critical adoption levels. Firms that combine access to the deepest electronic liquidity pools together with the liquidity sourced by traditional broker-dealers will probably have access to a more diversified liquidity ecosystem, better trading opportunities, and greater alpha generation.
- Greenwich Associates, “The Continuing Corporate Bond Evolution”, Q4 2015
- US data: www.sifma.org/research/statistics.aspx. EMEA data: TRAX, Q4, 2015
- Jan 5 – Dec 20, 2016
- Data June 1 – Aug 31, 2016
- As of Dec 31, 2016
- US Dept of the Treasury, July 2016: www.treasury.gov/connect/blog/Pages/Examining-Corporate-Bond-Liquidity-and-Market-Structure.aspx
- Data Jan 4-Nov 30, 2016