COMING TO TERMS WITH THE NEXT PHASE OF MARKET TRANSFORMATION.

By Mike du Plessis, Managing Director, UBS Global Head of FX, Rates & Credit Execution Services.

The need for an answer will take on increasing urgency in the months ahead, as monetary policy and market structure changes move into a new phase. Based on current market practices and regulation, markets are perhaps only a third of the way through their post-crisis transformation. Successfully navigating the next wave of change will require the market to think hard and in detail about the sustainability of myriad business models under a fully implemented post Basel III regime.

As we countdown to the exit from a period of volatility-quenching central bank action, there is a pressing requirement for participants to ratify their business models in the context of the likely final shape of the re-worked marketplace. The efficacy of the emerging order will determine the ongoing viability of many strategies for both the buy side and sell side.

The first step is to acknowledge the extent to which markets remain sheltered by this highly accommodative monetary policy stance. These policies have been critical in allowing for the reduction of dealer balance sheet without an associated explosion in volatility. However, central banks seek to return to a more normal stance. As improving market and economic conditions give them opportunities to implement those plans, it will be the extent to which the dealer network has been made more open that will determine the capacity of the system to deal with large flows – particularly at turning points in trend.

As the headlines remind the market almost daily, the liquidity equation is far different from what it was pre-crisis. The traditional arrangements in which institutions relied on comparatively few bilateral relationships will no longer suffice.

One lesson of the credit crisis is that those arrangements were inadequate to deal with the pronounced asymmetry between the buy side’s massive holdings and dealers’ balance sheets. In retrospect, market participants may not have appreciated how dependent they had become on the cushioning role of dealers in turbulent markets, or the true costs of liquidity, particularly in stressed situations.

That asymmetry continued to grow in 2015. The decline in dealers’ fixed-income holdings and their reduced market-making capacity has received the most attention, reflecting new capital requirements and other regulatory initiatives. Holdings of corporate bonds by primary dealers continued to decline, ending 2015 at about half the level at which they started the year. Nonetheless, new issuance continued at a healthy pace, with US investment grade and high yield corporate debt outstanding up another 4% in 2015 to a new high of $8.2 trillion¹.

At the same time, a proliferation of new trading platforms and products, fostered by the post-crisis regulatory environment, has sprung up as alternative means to map liquidity opportunities. One consulting firm recently counted 99 of these platforms, offering trading in one or more of corporate credit, interest rate and credit default swaps, and government bonds². Adding to the already challenging execution environment are the new generation of Swap Execution Facility, a proliferation of new exchange-traded products aiming to replicate the returns of more complex products and funds, and new platforms for foreign exchange.

Much of this change is positive. Banks are taking significantly less risk than before the credit crisis. Though many of the new trading platforms have yet to develop substantial liquidity, the buy side finds itself in a world of many choices and more transparency.

But along with the benefits of change come the strategic challenges. The cost of connectivity in a world of highly dispersed liquidity is a major issue. Managing electronic access across multiple platforms represents another layer of costs, both direct (such as connectivity and onboarding) and indirect (such as integration into the TCA layer). Further complicating the picture is the challenge of efficiently managing collateral and margin utilisation given clearing brokers face substantial capital charges in respect of client and CCP exposures.

A telling feature of this complexity is the wide range of trading protocols found on platforms. A recent SIFMA study of 19 bond trading platforms³ identified seven different categories of trading protocols. They range from real-time matching, request-for-quote, and lit order books to matching sessions, dark pools, hidden order books and Dutch auctions. Within each of these categories are multiple variations depending on the platform.

Given the many new venues now operating, investors face a number of critical questions, including:

• What type of liquidity are they interacting with on specific platforms?
• How do they best balance certainty of execution with information release?
• Which of these platforms are likely to survive the inevitable consolidation?

Globally, investors are adjusting to this complex landscape of multiple venues at different paces. Some have observed signs of a change in practices, particularly a willingness to engage with other market participants as “makers” of prices in addition to being “takers” of prices. A recent Greenwich Associates’ study of 60 global investors found that 29% either currently make prices in the corporate bond market or plan to do so in the next 12 months⁴.

Amid these trends, several realities must be highlighted:

• Institutional investors are unlikely to become market makers in a traditional sense. Their clients typically do not look to them to use their investment capital to make two-sided markets. Importantly, segments of the institutional markets differ widely on their investment horizons, regulatory situation and fiscal requirements, which in turn influence how they engage with counterparties in this evolving market environment.
• Some investment strategies at this stage of market developments may be too large relative to the available liquidity. Certain credit strategies may need to be scaled back, and momentum strategies may encounter difficulties capitalising on trends.
• Investment banks will continue to play a large role in the evolving market structures. They will still offer principal trading, providing liquidity for a wide range of transactions. Strategically, they bring substantial market knowledge and electronic trading skills to the table, plus expertise in cross-platform and cross-asset trading that is of significant value in the new liquidity landscape.

UBS Investment Bank made an early decision to orientate its role towards helping clients reduce the complexity in dealing with these changes. Critically we are able to deliver an enormous and anonymised network of bond liquidity directly to our clients through our Bond Port platform as well as facilitating direct access to aggregated pricing in Interest Rate Swaps that was formerly the sole preserve of Dealers – empowering our clients to assume a greater level of control in the execution process.

Through our connections with a broad range of participants, established and emerging trading venues, as well as our leadership in electronic trading, we provide a simpler, more cost-efficient path to access liquidity on a global basis across major asset classes. We will shortly be adding government bonds to our electronic offering alongside FX. We believe this approach will prove indispensable as the post-crisis transformation of global markets enters its next phase.

The above should not construed as a solicitation or an offer to buy or sell any financial instrument. The Bond Port platform is not available in all jurisdictions.

Footnotes:

1. Federal Reserve Bank of New York data, accessed April 2016.
2. “Fixed Income Investors Have 99 Ways to Trade and One Big Problem”, Bloomberg, 14 April 2016.
3. SIFMA data, accessed April 2016.
4. “The Difference Between Price Makers and Market Makers”, Greenwich Associates, 1 April 2016.
   

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