Of course, there is no right way to trade all credit, but there are clearly advantages in trading credit in such a way that mitigates risk and increase opportunity.
Currently credit markets are experiencing considerable uncertainty but low volatility and therefore mitigating market impact, information leakage and maximising the immediate transfer of risk can allow a buy-side trading desk to most accurately reflect a portfolio manager’s objectives.
These may seem like qualities that all trades seek to achieve, but the protocol used to achieve them in these markets would be quite different to one in which volumes were high, rates unchanging and fund inflows/outflows relatively balanced.
Firstly, the cost of liquidity, which had been dropping over the past twelve months, will stabilise as dealers are less certain of the risk picture and therefore widen bid-ask spreads in order to minimise their exposure to market risk.
Secondly, volumes may drop as primary market activity begins to decline, and investors try to sit on more cash. Although there is a huge amount of refinancing due in 2025 for corporate debt, with interest rates predicted to fall, issuers may try to refinance at the lower rate later in the year. Investor appetite for risk can be seen in Berkshire Hathaway’s outsized cash pile, a clear marker for expectations of buying opportunities caused by an expected drop in markets in the near term.
In this environment, trading a large position through multiple smaller trades, or child orders, over a longer period of time, may elevate the risk of adverse price movement, or even only achieving a partial fill, through implementation shortfall as the overall order is more observable to the street.
Execution can potentially be better achieved via a limited exposure of an order to the market, showing it to fewer counterparties and thereby reducing the risks they take on with the position.
Giving the dealer a better ability to hedge its position without being spotted by predatory rivals will ultimately allow them to show a better price to the buy-side client.
Understanding the relationship between the implied cost and explicit cost of the trade are key to protocol selection as are the size, available liquidity, potential information leakage and dealer risk exposure that a trade might create.
If we contrast all-to-all trading with portfolio trading, we can see that the former, when engaged in competition 9in-comp) creates access to a far wider set of counterparties than the other, generating more competition which ought to drive down explicit trading costs for a smaller trade, and widen them for a large position. It could also be used non-comp if a counterparty not on a broker list was known to have natural liquidity for the order.
Portfolio trading would typically reach a far fewer counterparties, limiting the competition to drive down explicit trading costs for a small trade, but allowing a larger list trade to be priced in such a way that the dealer could balance out the implicit costs for a larger trade, and limit the upside explicit costs somewhat, making it an overall cheaper alternative.
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