A recent article on the challenges for banks in making a profitable business trading emerging markets (EM) credit has highlighted the complexity of the market.
Firstly, to get the terminology correct, credit does not only refer to corporate debt when trading EM. Any bonds that carry credit risk are considered ‘credit’.
Government bonds – with the exception of frequent defaulters – are considered free of credit risk when issued in local currency, as the government can always raise taxes or print money to pay off/de-value the debt outstanding.
If a government issues debt in dollars/hard currency, it is possible for it to default on those debts and so they are also ‘credit’.
“Local currency market issuance is huge,” says Kerim Acanal, global head of emerging market (EM) rates and CEEMEA cross products at Tradeweb. “It’s a huge market when you include that India is going to come into the open market, hopefully, very soon.”
As a consequence, market makers, whether local, regional or global, are covering both local and hard currency bonds with government and corporate issuers. That creates a broad range of risk factors to manage on the sell-side.
If the buy-side firm is trading from outside of the market that creates another set of challenges. The first of these is the period in which liquidity is available.
“Because liquidity pools are within the local markets, it doesn’t matter where the trader is, it matters in which time zone he’s sitting,” says Acanal.
That can also make a big difference when opportunities arise to buy or sell as a result of sudden change to the economic climate.
“During periods of market stress or volatile geopolitical events/election risk, local dealers are specialists in their native currency, their views and ability to recycle risk can provide key liquidity to the market,” he says. “One of our goals here at Tradeweb is to build out that local liquidity pool so our clients can access a diverse mix of liquidity when trading electronically.”
At present the electronification of the local currency market in institutional trading is around 5-10% he estimates. The second issue is a behavioural one.
“Most local dealers don’t necessarily have a mandate to cover the fund manager from another country, so it’s not necessarily a priority to provide them with liquidity at any point; their mandate is to deal with local corporates and local clients,” he observes, “If anybody comes from abroad they only trade if they want to. There are of course some exceptions with some local dealers having global ambitions.”
To overcome these potential barriers to accessing liquidity, traders need to use their most effective routes to building relationships with dealers and trading with them in the most efficient manner possible.
Firstly, despite the low proportion of electronic trading today, high levels of issuance in the EM space mean that the 5-10% represents a net growth in notional traded.
“We need to consider that EM is a growing market,” Acanal notes. “Developed markets are trying to reduce their debt to GDP, while emerging markets are building new airports, new bridges, so even if e-trading stays at 5-10%, the pot could increase.”
In addition, platforms are increasing access to local liquidity pools via local dealers, and that is increasing the capacity to trade not only cash products but derivatives, which brings access to better engagement and returns for local dealers.
There are also developments around trading protocols which could deliver increasingly efficient access to liquidity by limiting information leakage.
“We have been very successful in our request for market (RFM) protocol in interest rates where the RFM is trading multiple volumes compared to RFQ, protecting the clients but also the winning dealers,” Acanal notes.
©Markets Media Europe 2023
