Buy side’s new liquidity dynamics
Kevin McPartland, Head of Market Structure and Technology Research at Greenwich Associates, discusses the market’s new liquidity dynamics and explores how the changes are impacting the buy side
The market has become obsessed with liquidity. Some believe liquidity has declined marketwide. Others believe that liquidity was simply mispriced for years, and we’ve now transitioned into a more sustainable state. And still others are sure that declining market liquidity that led to major market events such as negative interest rates in Japan and oil’s collapse in late 2015/early 2016 drives up volatility in ways that previously would have been damped by dealer balance sheets.
A debate also continues regarding the cause(s) of these changes. A reduction in dealer balance sheet allocated to making markets is the key culprit cited. A combination of high capital costs and forced risk reduction has caused banks to pull back their role as principal market makers. It can also be argued the unusually high market correlations, the continued growth of index funds and ETFs, and low interest rates are driving much of the investing community to act in the same ways at the same time, removing the natural other side to many trades.
And while individual asset classes and the products within them have their own idiosyncrasies and nuanced market structures, this liquidity debate appears to be asset class and product-agnostic. Conversations span corporate bonds, US Treasuries, interest rate swaps, credit default swaps, FX – need I go on?
While 2016 will be filled with as many conferences about liquidity as were conducted in 2015, one thing everyone can agree on is that something has changed. In fact, Greenwich research has confirmed liquidity as the top concern of European institutional fixed income investors (see Exhibit 1). And if the provision of liquidity has changed, so too must the buy side’s consumption of that liquidity and its understanding of liquidity risk.
Relationships continue to dominate fixed income trading. Greenwich research finds that quality sales coverage attracts nearly as much buy side flow as quality execution – often over one third. However, as dealers cut back on both people and balance sheet, investors have been forced to try new outlets for their order flow.
“Individual asset classes and the products within them have their own idiosyncrasies, but this liquidity debate appears to be asset-class and product-agnostic”
Electronic trading platforms have proven to be huge recipients of this trend. Throw in swaps trading mandates from Dodd-Frank and eventually MiFID II, and fixed income electronic trading is taking off in places where it had failed many times before.
The 17% of investment firms trading some of their swaps volume electronically in 2010 has jumped to nearly two-thirds of firms today, according to the results of Greenwich Associates’ 2015 US Interest Rate Derivatives Study. Looking at asset managers specifically, the increase is even greater, with nearly three in four now trading online. To further the story, 60% of client trading by notional swaps volume is done electronically today – up from 9% in 2010 and 20% just last year. See Exhibit 2.
Corporate bonds tell a similar albeit less dramatic story, with electronic trading of investment-grade bonds in the US jumping 25% in the last year alone – all without regulatory mandate. Potentially more interesting is the traction seen by some all-to-all trading platforms. Rather than allowing clients to request prices from and then trade with dealers, these platforms allow all market participants to throw their buy and sell orders into the pot in search of a match regardless of firm type. This results in asset managers trading with asset managers, dealers with dealers and almost any other combination you can think of. All that matters is that one wants to buy what the other is selling at a mutually agreeable price.
The jury is still out regarding how much of the market all-to-all trading will ultimately comprise. In theory, the more standardized the market the easier it is to find natural buyers and sellers in an anonymous market. This idea points to more all-to-all trading in government bond, index CDS and interest rate swap markets. However, the importance of the bilateral relationship in these and other fixed income markets is critically important, as we pointed out earlier. As such the idea of circumventing dealers and/or trading anonymously isn’t as appealing to many as it might seem to be.
“While hedging interest rate and credit risk is certainly not a new science, taking into account liquidity risk requires a whole new way of thinking”
In fact the market that has seen the most new all-to-all trading in the past few years is the corporate bond market. While relationships are as critical here as they are in the other fixed income markets, liquidity concerns are more acute, driving investors to try new outlets in search of quality execution.
Which raises the next needed change – the ability to quantify quality executions. While nearly every equity investor now uses Total Cost Analysis (TCA) as a part of their investment process, only half of fixed income investors utilize the technology. And while half seems low by comparison, it actually shows huge growth in TCA adoption with only 19% of investors using fixed income TCA in 2012. See Exhibit 3.
But despite this move in the right direction, fixed income TCA across all included products – corporate bonds, government bonds, swaps etc. – is still in its early stages and defined by different people in very different ways.
TCA for fixed income remains largely focused on post-trade analysis, examining data collected after the fact to understand the cost of the trade and to aid in determining if the right execution choices were made. It also plays a part in internal reporting and compliance reviews. Utilizing TCA pre-trade and in-trade, however, remains mostly aspirational. For instance, taking into account the liquidity profile of a given instrument to help the trader execute that trade in the most effective way is still a workflow in its infancy.
Better understanding your risks and the associated costs ultimately should lead to better hedging tools. While hedging interest rate and credit risk is certainly not a new science, taking into account liquidity risk in addition to once unthinkable situations like negative interest rates requires a whole new way of thinking.
“Greenwich research has confirmed liquidity as the top concern of European institutional fixed income investors”
Furthermore, the mix of products available to hedge has expanded considerably. Futures gave way to swaps, which gave way to swap futures. And within each of those categories, several variations have come to be as a result of both demand and the desire of their providers to create demand.
While the optionality is good for investors, the complexity of choice leaves many wishing for simpler times. Furthermore, the cost of trading, clearing and holding positions in those various instruments has changed dramatically since the financial crisis, impacting long-held beliefs regarding the most efficient ways of doing things.
Investors need to ensure they have the best and the brightest on the desk, of course. But not simply those that know the market – those that also understand market structure, regulations and the ability of technology to improve performance. Greenwich Associates research has found that the buy side is spending increasingly more to find and keep this talent – $10.8 billion in 2015. They must also be provided with tools that provide access to liquidity – wherever it may reside – deep, data-driven analytics and the technology to take action when and where it is needed. It is only through the right mix of the two that investors can continue to succeed despite the market’s constant evolution.