The corporate bond liquidity challenge:

rethinking the market

An ICMA and City Week partner event, May 11th 2016

Andy Hill

What do we mean by liquidity?

The corporate bond liquidity challenge

“The ability to get a price in the size you require, when you need it”?

The ability to trade without major market impact?

Can liquidity be measured?

MiFID II/R liquidity measures

Bloomberg’s LQA

Interactive Data’s Liquidity Indicators

What are the appropriate determinants?

Bid-ask spread? Market depth? Expected time to execute? Market impact? Historical volume and prints? Characteristics of instrument? Distribution of holders?

Should liquidity measures be based on trade data, or on what failed to trade?

Is liquidity dynamic?

Should liquidity have a cost?32

Factors affecting bond market efficiency and liquidity

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Regulation

Macro-economic conditions and monetary policy

Spread compression and the search for yield

Structural trends in the holders of bonds

The traditional fixed income liquidity model

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Market Maker

Client A

Client B

Client C

Client JClient

X

Client Y

Client Z

Provides for:

Ready two-way pricingImmediacy of execution

The principal dealer (or market-maker) model

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Essential ingredients for the model:

Availability of capital (balance sheet) to hold long and short-positions and warehouse risk

Availability of an efficient and liquid derivatives market (such as single-name CDS) to hedge dealer positions

Availability of an efficient and liquid repo market to fund dealer positions

Skills and experience of the trader

The principal dealer (or market-maker) model

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Undermining the model:

Availability of capital (balance sheet) to hold long and short-positions and warehouse risk

Increased cost of capital (Basel III & IV)

Volker Rule and restrictions on bank proprietary trading

Availability of an efficient and liquid derivatives market (such as single-name CDS) to hedge dealer positions

EMIR and other central-clearing or margining requirements for derivatives

Availability of an efficient and liquid repo market to fund dealer positions

Leverage Ratio, NSFR,....

QE: negative rates and excess reserves

Skills and experience of the trader

Ongoing attrition of experienced staff and ‘juniorization’ of trading desks

The evolving dealer model

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Principal trader

Principal broker

Agency broker

What we lose is:

Ready two-way pricingImmediacy of execution

Changes in dealer behaviour:

Smaller inventories and faster turnoverMore considered allocation of balance sheetDeeper client engagement and awareness of needsMore specialization and focus on competitive advantageMore streamlined trading and sales desks

Future potential challenges to bond market efficiency and liquidity

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MiFID II/R pre- and post-trade transparency requirements (for bonds and single name CDS)

MiFID II/R best-execution requirements

CSDR mandatory buy-ins

Even higher capital and funding costs (FRTB, NSFR)

Other miscellaneous regulatory challenges (e.g. MAR disclosure requirements)

ECB’s Corporate Sector Purchase Programme

Ongoing macro-economic and geopolitical risks

The ‘unknown unkowns’

How is the market responding?

The corporate bond liquidity challenge

Electronification: new initiatives, platforms, tools, and protocols

Changes in buy-side behaviour

Use of alternative products, such as bond ETFs and CDS indices

New, non-bank liquidity providers (‘principal trading firms’)

Discussions on changes in issuance practice (‘benchmarking’)

CMU Call for Evidence and the ‘better regulation’ initiative

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Electronification of the market

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Electronification has the potential to provide a wide range of efficiencies for trading:

Pre-trade

Price discovery and trade negotiation

Execution

Click to trade, smart order routing, algorithm based trading (potentially including the simultaneous execution of reference hedges)

Post-trade

Settlement and confirmation (‘straight through processing’)

Data capture and management

Regulatory reporting, transaction cost analysis (TCA), cost expectation, counterparty evaluation, risk management, price discovery

Ancillary services

Trade analytics, liquidity scoring, portfolio analysis

Evolution of electronifcation in the corporate bond market

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Two key threads:

Connectivity

The ability to access ever more diverse and disparate sources of liquidity

Data

The ability to identify where those sources of liquidity are and to find the other side of the trade

Evolution of bond market e-trading protocols

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Early initiatives:

Central limit order books (CLOBs) for inter-dealer market

Disclosed request for quote (RFQ) systems for dealer-to-client market

Streaming for dealer-to-client

More recently:

Opening up of RFQ to ‘all-to-all’, counter-pricing, and anonymous

Standardized auctions (‘liquidity windows’)

‘Sweeps’ for matching odd-lots

Anonymous matching for large blocks

But dealer-to-client RFQ still dominates

Today:

Matching systems (or ‘information networks’)

Identifying sources of liquidity, and more axe driven rather than quote driven (more ‘point-to-point’ than ‘all-to-all’)

Changes in buy-side behaviour

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More reliance on primary market and less on secondary

Longer-term views (‘buy-to-hold’)

Broadening as well as deepening dealer relationships

Greater use of data (axe lists, trade history, etc.) to identify liquidity sources

Utilizing other products, such as ETFs or CDS indices

Utilizing e-solutions which offer new counterparty networks and trading protocols

Greater use of internal ‘crossing’ between funds

Becoming ‘price deciders’ rather than ‘price takers’

“Working harder than ever before”

Conclusion: rethinking the market

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Do we have to accept that liquidity is a limited resource, that requires hard work to source, and comes at a cost?

Will we move away from a liquidity model that is dependent on market-makers, or will we always be reliant on broker-dealers to some extent?

Do we redesign the ‘shape’ of the corporate debt markets to fit the established liquidity models of other markets (the ‘equitization’ of the bond markets), or do we design new models and protocols that best fit the market?

Can the corporate bond markets ever become fully exchange or platform based, or will they always require a basis of human interaction and relationships between participants that are built on experience, trust, and mutual understanding?

Can the corporate bond markets continue to serve their economic function of bringing investors and capital raisers together, efficiently and effectively?

Bibliography

Addressing Market Liquidity: A Broader Perspective on Today’s Bond Markets, BlackRock, February 2016

Fixed income market liquidity, CGFS Papers, No 55, January 2016

Market liquidity – resilient or fleeting? Global Financial Stability Report: Vulnerabilities, legacies and policy challenges: risks rotating to emerging markets, Chapter 2, October 2015

Global financial markets liquidity study, PWC, August 2015

Liquidity wars: Who wins and loses in the race to the bottom? Citi Research, June 2015

The Liquidity Conundrum: Shifting risks, what it means, Wholesale and Investment Banking Outlook Blue Paper, Oliver Wyman and Morgan Stanley, March 2015

The current state and future evolution of the European investment grade corporate bond secondary market: perspectives from the market, ICMA, November 2014

Market-making and proprietary trading: industry trends, drivers and policy implications, CGFS Papers, No 52, November 2014

The liquidity challenge: exploring and exploiting (il)liquidity, BlackRock, June 2014

Economic Importance of Corporate Bond markets, ICMA, March 2013

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About the SMPC

The ICMA Secondary Market Practices Committee is an open forum for sell-side and buy-side member firms active in the European investment grade corporate bond secondary market. Through open dialogue and engagement, as well as through its subsidiary working groups and work-streams, it seeks to be the representative body of the European corporate bond secondary market: addressing practical issues directly relevant to market practitioners; standardizing market best practice; disseminating relevant market information; and promoting the best interests of an efficient and liquid market.

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About the author

Andy Hill is a Senior Director in ICMA’s Market Practice and Regulatory Policy group. For seventeen years he has been a repo and money-market trader, for ten years of which he was an Executive Director at Goldman Sachs. He has also worked as a consultant in the Aid and Development sector, primarily based in Cambodia, and previously served on the Board of the Cambodian NGO Education Partnership in Phnom Penh while under a Goldman Sachs Public Service Fellowship. He holds a BSc (Hons) in Business Studies from Cass Business School and an MSc in Poverty Reduction and Development Management from the University of Birmingham.

Email: andy.hill@icmagroup.org

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This paper is provided for information purposes only and should not be relied upon as legal, financial, or other professionaladvice. While the information contained herein is taken from sources believed to be reliable, ICMA does not represent or warrantthat it is accurate or complete and neither ICMA nor its employees shall have any liability arising from or relating to the use of this publication or its contents.

© International Capital Market Association (ICMA), Zurich, 2015. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means without permission from ICMA.

Contact: RegulatoryPolicy@icmagroup.org

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