February 4, 2015
TABB Fixed Income Conference: tackling reduced trading liquidity in corporate bonds and OTC
Following January 2014's TABB Fixed Income conference: "BREAKING RATES", the Thursday January 29th TABB conference "PERFECT STORM NAVIGATING THE CONFLUENCE" held promise of answering the question of whether the market has dealt with the marked withdrawal of dealer market making capacity from the cash and derivatives markets in response to Basel III constraints.
Following January 2014's TABB Fixed Income conference: "BREAKING RATES" (see my write up here), the Thursday January 29th TABB conference "PERFECT STORM NAVIGATING THE CONFLUENCE" (agenda: here, with speakers/sponsors: here) held promise of answering the question of whether the market has dealt with the marked withdrawal of dealer market making capacity from the cash and derivatives markets in response to Basel III constraints.
The conference consensus seems to be "yes" for more liquid securities – like equities, US governments, agency MBS – whose liquidity enable market makers to minimize securities held on balance sheet but "not yet" for OTC derivatives – even with SEF trading – and for less liquid securities – like corporates, private label ABS/MBS, CMBS etc. Here finding a basis-risk free hedge or offloading the position resulting from the client trade take longer and push Basel III ratios down towards mandated minimum levels while the unhedged position is held.
The conference featured a noteworthy trashing of CFTC's SEF rules by recently appointed CFTC Commisioner Giancarlo in his keynote speech which explained why the rules are worsening rather than improving liquidity. The panel sessions explored various aspects of the markets work in progress to counteract the drain of market maker liquidity largely focusing on corporate bonds. What was not discussed (perhaps to painful?) is that there are further regulatory constraints on market makers to come.
OTC derivatives – have SEF regulations helped liquidity? Quite the opposite, says commissioner Giancarlo.
The SEF trading mandate along with considerable technology implementation is now here but still less only 50% of US OTC trading is on SEF (up from 10%). As with corporate bonds covered below, dealers are trying to move towards risk-less principal or agency trading models piggybacking on the SEFs. Even the 50% flatters to deceive as this includes voice-enabled trades reported through the SEF platform.
In his conference keynote speech, CFTC commissioner J. Christopher Giancarlo did not mince words in calling for a revamp of the CFTC SEF rules which he believes miss the legislative intent of congress in Dodd-Frank and crimp liquidity by restricting trading methods and fragmenting liquidity pools and cross-border trading. An executive summary and full white paper are on the TABB website here and there is a risk article on the speech here (subs. required).
- It will be interesting to see whether Chairman Massad takes up Commissioner Giancarlo's suggestions.
Corporate bond trading liquidity – a work in progress
A big focus of the conference sessions and sponsors was corporate bonds. QE and the resulting investor search for yield has led to a glut of corporate issuance at the same time as market-maker bank balance sheet withdrawal due to Basel III pressure – heightening focus on corporate bonds liquidity in the secondary market.
1. So how dramatic is the banks withdrawal from corporates market making? Market maker liquidity is become scarcer, but secondary corporates trading won't die.
The consensus seems to be that dealer withdrawal may have been a little exaggerated as the balance sheet reduction figures partly reflect an unusual balance sheet run up before the crisis as well as the banks response to Basel III. Banks are being more selective or efficient about using balance sheet to facilitate client trades – whether by withdrawing market making from some corporate sub-sectors or by only sourcing bonds in response to an order to minimize time on the banks inventory. It seems that larger buy side firms are adjusting to longer holding periods but can get dealer liquidity where they need it (see quote from Amy Koch in the attached risk article (subs)). The unspoken hint is that smaller buy-side firms are probably struggling more for liquidity. The biggest voiced concern is that selling a corporate bond during a crisis is less likely than before.
2. Is there a technology silver bullet for corporates? No. The question is whether the new developments become prevalent or remain a small fraction of trading.
Nearly 20 e-trading platforms exist or are emerging for different parts of the high-yield or high-grade credit spectrum targeting according to a Greenwich research report here (subs. required). The big hope is that all-to-all trading (e.g. Liquidnet Fixed Income platform) will allow buy side firms to trade with each other directly and can avoid altogether the need for dealer market maker involvement. Buy-side firms are definitely interested in direct trades with other buy side firms but likely do not want to dispense with market makers altogether as they recognize that buy side liquidity alone is not enough. An alternative to the all-to-all platforms is dealers who try to use their distribution network to internalize flow on an agency basis supported by technology (e.g. UBS's NEO).
- Smaller buy side firms may struggle in corporate bond trading especially in high-yield unless on a buy and hold strategy.
- Now is the time for all-to-all and dealer agency trading to establish market share but they are not panaceas, not all institutions will use them and not all bonds will be liquid enough.
- Perhaps some bonds drop out of secondary trading and become "buy-at-issue-hold-to-maturity"?
Regulatory Context: you might be hoping that market-making regulatory impacts are over with? Afraid not.
1. Basel III risk-based and leverage ratios – are live but the risk-based capital ratios ratchet up through 2018 from 8% to 10.5% due to the "conservation buffer" and there could be further surcharges for largest banks.
2. Basel III liquidity coverage ratio (LCR) (daily from July 2015) – banks can't easily term fund transient market making inventory in less liquid securities / corporates beyond 30 days so they'll incur LCR denominator usage.
3. Volcker rule (July 2015) – in theory dealers are allowed to hold positions commensurate with client demand. In practice this can only further constrain market making inventory.
4. OTC bilateral margin mandate (Dec 2015) – mandates IM and associated funding costs and leverage ratio impact on buy side trades and the associated dealer hedges.
5. OTC client clearing (US live, EU 2016) – this may lead to a capital strain on banks FCMs / clearing brokers as the quantum of aggregate client risk and the client default fund subsidy by FCMs increases.
6. U.S. Intermediate Holding Company (IHC) (2016) – grosses up capital costs by region for EU and Japanese banks.
- For corporates, beyond Basel III capital, the main effects are Basel III LCR, Volcker and US IHC.
- All of the above affect OTC derivatives. Beyond electronic trading, netting and compression vendors may help free up capital usage. Trade compression was the story of 2014 with TriReduce's ramp up and LCH and CME starting trade compression services. LCH was represented on a panel at the conference. Looking forward startups like LMRKTS and NetOTC (see risk article) may have a part to play in reducing risk / RWAs / funding costs rather than just notional / leverage ratio exposure.
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