Corporate Bonds:Investors Need Dealers, Dealers Need Incentives

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CONTENTS AUTHOR

© 2015 Greenwich Associates, LLC. Javelin Strategy & Research is a division of Greenwich Associates. All rights reserved. No portion of these materials may be copied, reproduced, distributed or transmitted, electronically or otherwise, to external parties or publicly without the permission of Greenwich Associates, LLC. Greenwich Associates®, Competitive Challenges®, Greenwich Quality Index®, Greenwich ACCESS™, Greenwich AIM™ and Greenwich Reports® are registered marks of Greenwich Associates, LLC. Greenwich Associates may also have rights in certain other marks used in these materials.

RESEARCH GOALS AND METHODOLOGY

In May of 2015, Greenwich Associates interviewed 13 of the 20 largest corporate bond dealers in the U.S., according to Greenwich Associates Quality Share Leaders data. Also interviewed during the same time period were 112 U.S.-based corporate bond investors. Interview topics included trading platform usage, incentives for trading on particulars venues, and opportunities for and threats to corporate bond-dealing businesses.

Kevin McPartland is the Head of Research for Market Structure and Technology at Greenwich Associates. He helps the Firm’s clients navigate market structure changes driven by regulation, technology and behavior shifts.

Cover Photo ©istockphoto.com/teeeejay

Dealer E-Trading Adoption 3

First Decisions, But Not Final Decisions 4

Trading Technology 4

If You Want Liquidity, Pay for It 5

More Clients, Please 6

Customize My Stream 6

Methodology 7

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Institutional investors need access to liquidity to meet their investment objectives. Corporate bond investors

receive an outsized portion of this liquidity from the sell side and will continue to do so going forward. Electronic trading has created pathways to new sources of liquidity, and dealer balance sheet limitations have reduced the liquidity dealers can provide. However, investors continue to recognize the important role dealers play in the bond market. As such, e-trading shouldn’t aim to replace dealers, but instead, incentivize them to increase their participation in the market.

Investors—especially the big ones—undoubtedly influence dealer behavior. The commitment of a major client to trade on a particular platform or to use a particular product can be enough to ensure the involvement of their sell-side counterparts. Nevertheless, bond dealers must still see long-term opportunity in such a decision regardless of the client ask. They are not in the business of providing liquidity as a public service after all, and have a responsibility to their shareholders to make sound business decisions.

We spoke with roughly two-thirds of the top 20 dealers of investment-grade bonds in the U.S. To put this sample in perspective, the top 10 dealers handle roughly 90% of client trading. Slightly greater than half of the dealers we spoke with saw opportunity in current and proposed electronic trading platforms. As would be expected, the top five dealers by market share saw the current e-trading evolution as more of a threat than an opportunity, with smaller dealers more apt to see the benefits new e-trading initiatives can bring to their franchise. Multidealer electronic trading systems can provide distribution capabilities to emerging bond dealers that would be much harder to acquire in a voice world.

But in order to truly understand dealer perceptions, we need to dig a bit deeper. One bulge-bracket dealer pointed out that increased liquidity on electronic platforms could provide an outlet for flow trades that aren’t terribly profitable and, as such, further automation could prove beneficial. Conversely, a more regionally focused dealer emphasized that it is their direct client relationships that keep them relevant, and a move to more anonymous trading would hurt their boutique-like approach.

Just as the buy side is a very diverse group, no single approach to interacting with clients will work for every dealer or every trade. Greenwich Associates does not believe the market can support dozens of corporate bond trading platforms, but we do believe that the availability of execution protocol flexibility and customizable client-interaction parameters—with limited transaction fees—are key to the long-term success of electronic trading.

Dealer E-Trading AdoptionMarketAxess continues to handle the lion’s share of both investment-grade and high-yield e-trading between dealers and clients in the U.S. (see Greenwich Report from Q3 2014, Changes in U.S. Corporate Bond Market: Evolution, not Revolution). Bloomberg’s ALLQ is the second most used platform, albeit with much lower market share but considerable desktop penetration. These platforms are both used by everyone in the top 20, and we do not expect that to change.

Note: Based on 13 respondents in 2015.Source: Greenwich Associates 2015 U.S. Corporate Bonds Study

New Corporate Bond E-Trade Offerings:Opportunity or Threat?

Opportunity54%

Threat46%

New Corporate Bond E-Trading Offerings Currently Deployed

Note: Based on 13 respondents in 2015 and platform-provided data.Source: Greenwich Associates 2015 U.S. Corporate Bonds Study

MarketAxess Open Trading

Number of users 121

CodeStreet

Tradeweb Credit

MTS Bonds.com

TMC

Tradeweb Direct

TruMid

Bloomberg BOLT

Electronifie

KCG BondPoint

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Self-reported dealer engagement with new offerings paints a more opaque picture. Tradeweb’s credit platform was the most mentioned by the dealers we spoke with, which isn’t surprising given many of these same dealers are stakeholders in Tradeweb. The next three platforms on the list show that all-to-all trading does attract some dealers. The LSE’s MTS (which acquired Bonds.com) also has increasing penetration, breaking away from its retail roots. MarketAxess’ Open Trading is on the desk of every major dealer, given the penetration of their RFQ platform, and has posted the strongest volume growth in the past year. TruMid was the most mentioned startup, with emerging dealers taking the greatest interest.

More interesting than having a platform installed on the desktop is actual trading. Seventy percent said they’ve executed a trade via at least one of the new offerings, although usually by responding to traditional RFQs. More than half are also streaming executable, non-firm quotes, but very few said this has brought in any meaningful flow to date. An even smaller few—only 10%—said they’ve placed a limit order in an order-book-style market. In both cases, prices pushed out to the entire market tend to be higher than prices targeting a specific customer or customer type, as the ultimate recipient of price cannot be known. This dynamic has limited the number of trades done to date via these platforms.

First Decisions, But Not Final DecisionsThe aforementioned dealer-platform usage statistics represent initial decisions made regarding which platforms to engage with, but they are likely not the final decisions. When we asked which additional platforms they planned to engage with in the coming

months, the picture changed slightly. In fact, nearly two-thirds of dealers had plans to engage with one of the new entrants in the coming year.

TruMid and Electronifie are well-known in the dealer community and have many firms either “watching them closely” or in the process of onboarding. These ventures, although encouraging dealer involvement, are representative of the short-term threat some dealers see if the corporate bond-trading world moves toward anonymous interactions.

Algomi, BondCube, CodeStreet’s Dealer Pool (CDP), and Project Neptune are seeing varying degrees of early success as well, although each is very different from the other and from the platforms mentioned above. While BondCube and CDP help to actually match trades, Algomi and Project Neptune are more focused on streamlining the overall trading process. The range of platforms available supports our hypothesis: The market doesn’t need dozens of platforms, but it does need choices to meet the diverse trading styles and strategies dealers and investors present.

Trading TechnologyThe cost of system integration continues to prove a big barrier for dealers interested in working with new platform providers. The vast majority of dealers trade bonds electronically via their order management system, mostly responding to RFQ pop-ups brought into their platform via direct links to the source trading venue. Despite the growing use of industry standard protocols, such as FIX in the fixed-income market, this type of integration still requires weeks or months of planning, implementation and testing before being deemed ready

Planned Use of New Corporate Bond E-Trade Offerings

Note: Based on 13 respondents for plan to use offerings and 7 respondents making selections in 2015. Source: Greenwich Associates 2015 U.S. Corporate Bonds Study

TruMid62% of respondents plan to use newcorporate bond e-trade offeringsin the coming year

How many plan to use these offerings? 51

Electronifie

BondCube

Neptune

Tradeweb Credit

CodeStreet

Note: Excludes list-trading on MarketAxess and ALLQ on BBG. Based on 10 respondents in 2015.Source: Greenwich Associates 2015 U.S. Corporate Bonds Study

Use of New Corporate Bond E-Trade Offerings

Are youresponding

to RFQs?

Are yourestingorders?

Are youprovidingstreamingquotes?

NoYes

Have youexecuteda trade?

30%

70%

10%

90%

40%

90%

10%

60%

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for prime time. Although the integration approach differs for third-party and internally built platforms (which are used by most of the top 20 dealers), the ultimate cost and time commitments are equally steep. The incumbent platforms have a leg up, as they are already tightly integrated into the trading desk’s workflow.

Using the native interfaces provided by the liquidity venues can reduce this integration pain. Most of the new entrants have come to market with internet-deployed offerings built with HTML5 and similar technologies that make installation easy or unnecessary. Furthermore, both incumbent and startup providers have invested considerably in ensuring ease of use and offering features that are only accessible through their front end in an effort to keep the traders’ eyes on their screen.

Going with the native front end doesn’t make integration a no-brainer, however. Major dealers all have compliance, legal, technology, and operational due-diligence checks that need to be performed before the system can be installed. Trading via a web-deployed interface isn’t possible if the executed trades can’t clear and settle. So while technology integration today is more streamlined than it was during the last corporate bond platform explosion, there is still some way to go before trying out a new venue is as easy as installing an app from the app store.

If You Want Liquidity, Pay for ItGreenwich Associates research confirmed earlier this year what the buy side wants first and foremost: access to new liquidity providers and dealer-provided pricing (see the Greenwich Report from Q1 2015, U.S. Corporate Bond Trading: A Multitude of Platforms Give Investors Options). And for the buy side to get either or both of those things, the dealers need to be involved. Investors trading directly with one another will become more common over time, but the bulk of trading by dollar volume will continue to involve the sell side. So while investors’ needs and wants are critical to the devel-opment of new liquidity pools, dealers too must be economically incented to show up to the party. With dealer input, a new communication network being developed by DelphX offers such economic incentives.

Note: Numbers in parentheses represent respondents in 2015. Source: Greenwich Associates 2015 U.S. Corporate Bonds Study

Features of Interest in Electronic Dealer/Investor Communication Network

0% 25% 50% 75% 100%

Eliminating transaction fees and costs

Maximizing the number of investors sending you qualifying RFQs

Being continuously informed of the identity and contact informationof all dealer and investor participants

Viewing only RFQs and messages you deem to be of interest

Trading with non-customers without counterparty risk

(7)

(7)

(6)

(7)

(6)

100%

100%

100%

86%

83%

Pairing more riskless trades

Receiving ongoing subscription fees you specify from investorsseeking to access your Level 2 quotes

Maximizing the number of potential counterparties viewing your quotes

Electing to communicate on a lit, or temporarily or continuously dark basis for each quote (or inter-dealer RFQ)

Viewing the quotes of other dealers and directly or indirectlyresponding, as appropriate

(7)

(7)

(7)

(6)

(6)

71%

57%

43%

33%

33%

Note: Based on 7 respondents in 2015. Source: Greenwich Associates 2015 U.S. Corporate Bonds Study

14% who send quotes and receive RFQs

directly via theLIQUIDITY VENUE

FRONT END

vs.86%

of respondents send quotes and

receive RFQs through API VIA INTERNAL

APPLICATION

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Profit has two components—revenue and expenses. On the expense side, the most common complaint we hear from dealers is the high price of access and transaction fees. Not surprising of course, as who wouldn’t want something for nothing? But given the high cost of running a bond trading platform—technology, legal, operations, et al—and the value dealers place on seamlessly accessing clients and prospects, the idea of cutting fees to zero is a hard pill to swallow. Given that someone has to pay, the only other party in this equation is the buy side.

One idea floated is that smaller clients might be willing to pay for access to quotes that are today reserved for bigger clients. While this might seem far-fetched at first blush, it amounts to the buy side paying for liquidity, which some argue is the easiest solution to the current liquidity drought in corporate bonds. If you want liquidity, pay for it.

A variation of that mantra is “maker-taker” pricing. Common in equity markets, this model sees the maker of liquidity being paid when a posted price is executed against, the taker of that liquidity paying for it, and the trading venue capturing the difference. More than half the dealers we spoke with agreed incentivizing quote provision was intriguing, and we expect some flavor of these models to hit the market in the coming months.

More Clients, PleaseOn the revenue side, the sell side is also attracted to the idea of seeing more qualifying RFQs. This want is almost as obvious as the desire to not pay fees: If your platform can find me more customers, then I’m there. But the caveat here is “qualifying RFQs,” which means knowing who is on the other end. While the bulge bracket was more threatened by anonymous trading than the next tier of dealers, all of the banks we spoke with prefer to continue trading name give-up, particularly for larger trades.

Given that execution quality in the secondary market is the most important factor for investors when deter-mining whom to trade with, dealers understandably want recognition for great execution.

This takes us back to the idea that dealers need flexibility regarding how they interact with the market in general and their clients more specifically. For instance, bond issues trade differently based on their age. When a new bond is issued, trading that issue in an

order book is feasible and often desirable for a number of weeks. Buyers and sellers are plentiful and, therefore, pricing is transparent. Once the bond has been trading in the secondary market for about six months, streaming prices become a better model. Total market volumes have cooled off, but the price is still fairly transparent given the relative newness of the issue.

As the bond approaches its first birthday, buyers and sellers are less plentiful; a new issue from that same issuer could have hit the market, and pricing transparency has fallen. This is when trading by appointment—either RFQ or another auction variant—becomes the best model. Given most tradable corporate bonds fall into this category, it’s no surprise that RFQ has been the most successful model to date. This lifecycle demonstrates that plenty of room exists for multiple trading protocols.

Customize My StreamThis brings us to customizing client interactions. All major dealers tier their clients based on a number of metrics; this is no secret. Clients are offered liquidity, bid/ask spread, capital commitment, etc., based on their tier. This is no different than Walmart’s ability to buy TV’s at a lower cost per unit than I can as an individual; bigger clients get better prices. Therefore, giving dealers the ability to automatically dole out customized liquidity (whether as RFQ responses or real-time price streams) to different clients, based not only on their protocol preference but also their tier, would cut transaction costs and increase trade frequency. Keep an eye on those platforms that offer recipient-specific price streaming functionality, such as DelphX and Tradeweb.

The technology to implement these and similar ideas exists, with the biggest roadblock being the time it takes to change the mindset of the trading desk. Ultimately, such innovations hurt few and benefit most. Investors gain improved liquidity, the sell side can increase

Note: Based on 69 respondents in 2015.Source: Greenwich Associates 2015 U.S. Corporate Bonds Study

Volume Allocation Factors

Salesservice

New issuecapabilitiesand allocations

Execution insecondarymarkets

Researchservice

Back office/operations

9%

1%

49% 17%24%

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trading frequency by adding automation to their liquidity provision decisions, and the various trading platforms will see only the most appropriate flow sent their way, increasing the success rate of their customers.

Moving the market in this direction will not happen overnight, nor is it a complete slam dunk. Not everything in the mind of a trader can be imprinted on a computer chip, nor can relationships be replaced with mouse clicks. But by providing tools to enhance efficiency and liquidity, the bond market may find the boost it needs. n

MethodologyIn May of 2015, Greenwich Associates interviewed 13 of the 20 largest corporate bond dealers in the U.S., according to Greenwich Associates Quality Share Leaders data. Also inter-viewed during the same time period were 112 U.S.-based corporate bond investors. Interview topics included trading platform usage, incentives for trading on particulars venues, and opportunities for and threats to corporate bond-dealing businesses.

The data reported in this document reflect solely the views reported to Greenwich Associates by the research participants. Interviewees may be asked about their use of and demand for financial products and services and about investment practices in relevant financial markets. Greenwich Associates compiles the data received, conducts statistical analysis and reviews for presentation purposes in order to produce the final results. Unless otherwise indicated, any opinions or market observations made are strictly our own.

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