JP MORGAN: The parametric approach to credit trading

Andreas Koukorinis, global head of credit eTrading at J.P. Morgan.

Broadening the range and number of instruments traded in a single order is opening up liquidity.

The DESK spoke with Andreas Koukorinis, global head of credit eTrading at J.P. Morgan, to understand how new trading dynamics are increasing liquidity access and price formation for buy-side desks.

Why do we need to rethink the way liquidity and risk are managed at the moment?

The use of electronic trading has significantly increased over the last five to 10 years, helping to redefine liquidity. While liquidity has traditionally referred to the ability to convert securities into cash and back at a reasonable cost and in a timely manner, the use of electronic trading has allowed for a more precise quantification of liquidity. Real-time data on the supply and demand of securities can be used to develop specific metrics for assessing liquidity, which can provide any market participant with more accurate and timely information on when and how the conditions change.

Electronic trading has led to greater transparency and to some extent reduces transaction costs, but it has also led to increased market fragmentation and volatility. Trading activity can be spread across multiple platforms and venues making it harder to assess overall market liquidity. Additionally, the speed and frequency of large trades can lead to wider bid-offers at certain times, and increase volatility for the underlying securities, which ultimately can reduce liquidity and make it harder for someone in the market to manage risk.

How is the ability to recycle risk impacting liquidity in the bond markets?

If you’re able to recycle risk it can help increase liquidity in the market, because it creates more opportunities, and increases the number of buyers and sellers. When it is efficient for market participants to transfer risk easily, their ability to express views in the market is easier, which makes the price discovery process simpler and leads to a more liquid market and a more accurate way of discovering prices. When they’re not able to recycle risk effectively, investors become more hesitant to transact and that inevitably leads to a decrease in liquidity.

We’ve seen that in periods of stress such as Covid, and the invasion of Ukraine, and last year was a prevalent period for that effect. We’ve seen the recycling speeds increase through the use of exchange-traded funds (ETFs) and portfolio trading (PT), moving away from using traditional routes for trading in order to accesses immediate liquidity. That evolution helped by enabling investors to hedge or translate exposure, without having to trade single bonds ISIN by ISIN. That makes the market more efficient because it allows people to offload risk more easily.

What are the challenges around fungibility of risk?

The fungibility of risk is really the ability to exchange one type of risk for another, while keeping the same risk profile. If you’re changing one bond for another bond, or one portfolio for another, or bonds for derivatives, this concept is highly relevant. Factors affecting it are liquidity, which impacts the ease with which risk can be exchanged or substituted; a more liquid product will be more fungible than less liquid products.

Similarly, the size of the position can affect fungibility, as large positions may be more difficult to trade, or may impact the market price if traded in large volumes. Electronification has led to a barbell distribution of trade sizes, with either very large transactions or very small transactions, and fewer medium-sized transactions. With the rise of electronification in financial markets, instruments have become far more fungible. This has contributed to the growth of portfolio trading and ETFs in credit, as well as other asset classes. As a result, investors now have greater flexibility in managing their exposure to different types of risk, and can more easily trade and exchange assets within a portfolio.

How would you characterise the role that the ETF ecosystem is play in the risk recycling process?

ETF’s are designed to track the performance of an underlying asset or index or a portfolio of instruments, offering investors exposure to a diversified portfolio of assets. One of the key features is this ability to facilitate the exchange or substitution of risk. You can accomplish that with a primary process, where authorised participants like J.P. Morgan can create/redeem single ETFs using baskets of securities. Investors gain exposure to a diversified pool of assets and help mitigate specific risks in the portfolio, so they can use it as an investment product or a hedging product, reducing exposure or increasing exposure.

ETFs offer a high degree of liquidity, which makes them a popular choice for investors who want to buy or sell assets quickly and their adoption has fuelled the growth of portfolio trading. Market makers help to ensure that there’s always a buyer and seller for these shares. J.P. Morgan relies on that fact and on the ability to create and redeem shares, even in periods of stress which is when we tend to use them more as an instrument for managing risk.

Are you seeing a shift from the historical approach to trading instrument by instrument?

Historically, high-touch market participants were really focused on trading individual securities, and that is still a large part of the market. However the trend of trading more baskets of instruments, rather than individual securities is growing and the use of electronic platforms has helped that. The availability of data analytics tools enables investors to analyse and trade baskets of securities more efficiently and faster. Sophisticated algorithms can help build custom baskets of securities that meet their criteria. Investors will use PT and ETFs to get exposure and then substitute that into something more bespoke, rather than just trading an individual security on its own.

Price discovery is driving progress, because as dealers trade these baskets and have to liquidate them, they figure out the transaction point for bonds. As tools become more sophisticated, investors are able to analyse the composition of the baskets, better interaction points with platforms, use more API connectivity. However, as you go down the credit spectrum, exposure to single ISIN instruments will remain.

How could parametric trading of bonds potentially increase the capacity to access liquidity and price information?

Parametric trading has emerged in the highly fragmented US municipal bond markets as a way to access liquidity and support price formation efficiently and in real-time. In this trading protocol sets predefined parameters such as issuer, credit rating, maturity, and yield, which could work just as well in credit markets. This approach allows investors to access liquidity at a broader level and supports price formation by creating a transparent mechanism.

Algorithmic products can be built using objective criteria such as credit rating, maturity, yield, sector, and exposure, thereby increasing liquidity and making it more attractive for investors to participate in the market without having to deal with the complications of buying and selling individual bonds.

How are you supporting clients in this process?

We support our clients through education and resources around the risks and the benefits of different trading protocols and the different platforms. We are proponents of streaming pricing as a more efficient price discovery protocol, for example, for single bonds. We also provide research reports, whitepapers, and webinars that explain how market structure and fixed income trading is evolving and how it can be used to achieve specific investment objectives. Tools such as J.P. Morgan Direct are the platforms that enable clients to execute trades using all of the approved protocols.

Ultimately, we will meet our clients to the venue of their choice, highlight efficient routes and meet their needs with new products. For example, in the US we have launched the Liquidity Network, which is gaining more traction, as is the direct connectivity channel. We’re moving into algorithmic trading protocols in Treasuries that allow clients to specify predefined parameters for executing trades and providing access to certain liquidity pools. We can probably go a step further by supporting more parametric trading and IOI-based trading for single ISINs. We work closely with our clients to design solutions that are fit for them. 

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