* Interest rate cycle could turn sentiment
* Secondary market suffers from an inadequate model
* New trading platform initiatives will be tested
By Laura Benitez and Alex Chambers
LONDON, Aug 22 (IFR) - A return to interest rate normality and a central clearing engine could address the liquidity risks faced by corporate bond investors, after this month’s market volatility highlighted how passive dealers have become.
But does it even matter that a European corporate bond now trades on average once a day, according to RBS, compared with nearly five times a day just over a decade ago?
Yes, say those who point to increased European investment grade bond issuance. That supply year-to-date stands at 168.6bn, compared to 98bn in the same period in 2007, according to Thomson Reuters data.
“I think the market is temporarily stabilising, and should probably be OK for the next month. But Fed tapering will be completed in October, and there will be renewed focus on the first interest rate increase in the US, so I do expect another bout of money exiting credit, and another illiquidity period,” Derrick Herndon, head of long corporate credit business and portfolio manager at PVE Capital.
Obviously the interest rate cycle is at a different stage on either side of the Atlantic but where the US credit market leads, Europe tends to follow.
Investors complain vociferously that dealers are now no longer willing to stand as principals behind a trade. Instead of making markets and taking risk positions to facilitate liquidity for end clients, they are now merely acting as agency brokers.
Inadequate secondary market liquidity is one of the reasons behind the launch of buy-side focused e-trading solutions like BlackRock’s Aladdin and GSessions from Goldman Sachs, but none have proven a real success.
None of these addresses the fragmentation in the credit market. There is Bloomberg’s ALLQ, Tradeweb, part-owned by Thomson Reuters, and BondVision, while MarketAxess has taken over Aladdin.
Some in the industry are trying to consolidate liquidity, which is the concept behind Oasis, conceived by Deutsche Bank, an e-trading solution to pull all types of venues and investors together.
“Over the last year there have been various initiatives all based on different protocols. During 2014 a common theme has developed which is a convergence towards a form of matching engine protocol which honours the unique characteristics of the credit market,” said Dominic Holland, global head of e-credit sales at Deutsche Bank.
A matching engine, which puts together motivated buyers and sellers could be a lot more efficient than dealers shopping around until they find an axe.
“One of the challenges for investors is that when they are contemplating a trade, leakage of that information can potentially adversely affect the price of that security, and indeed the entire curve of that borrower,” Holland said.
The idea of a matching engine is similar to the concept behind a new platform, Bondcube, which is yet to launch. There, players will post actionable indications of interest in a security. There is no hard obligation to act, but the system will discretely look at what other interest is out there and try to match buyers with sellers. It also stores those indications for future reference.
Holland said Oasis should facilitate the trading of bonds that currently trade infrequently, or not at all. If this is the case, it could unearth significant volumes; according to the SEC, nearly 20% of all corporate bonds do not trade at all.
The problem facing Deutsche Bank, which has pushed this idea for a year, is that the industry has failed to back it. The big hurdle for any start up is the lack of critical mass. And to get funding for speculative I.T. build out is not easy in the current environment.
Furthermore, there are varied interests at work, so to get the project off the ground, an independent player like an exchange could prove key. There is already evidence that they are taking notice, earlier this year Deutsche Bourse announced its backing for Bondcube.
The exchanges are already used to the idea of semi-lit and dark pools of liquidity in equities. But unlike equity markets, fixed income trading prospers on reduced transparency.
And over the last month there’s been more noise that an exchange could step into the void within Oasis, with some action expected in the early part of next year.
Before then, the market may well face a test of liquidity in the Autumn, a period when volatility is commonplace as bigger investment strategies are put in place after players return from their summer breaks.
One banker says we could see some “big bets being put on”.
Despite potential changes and dangers ahead, market players are dismissing the recent media frenzy over a potential mass sell-off in the corporate market. Many say there is relatively little to suggest that everyone is on the point of rushing for the exits just now.
“It’s a bit like being in a crowded theatre in which the Fed has suddenly shouted, ‘Fire! Please leave in an orderly fashion.’ Your best guess is that the exit will be orderly - especially when they’re only whispering, and we had a fire practice last year,” Matt King, global head of credit products strategy at Citigroup said.
“There’s a constant risk of it becoming disorderly, and that doesn’t just depend on how loud the Fed shouts, but on a complex interaction between the individuals in the theatre.” (Reporting by Laura Benitez, Alex Chambers; editing by Julian Baker)