ICMA IC ICMA and bond market evolution ICMAs European corporate - - PowerPoint PPT Presentation

ICMA

International Capital Market Association

IC ICMA and bond market evolution

• ICMA’s European corporate bond liquidity study
• Electronification of bond markets in Europe

Liz Callaghan ICMA

ICMA’s European corporate bond liquidity study

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• November 2014 - ICMA released the first study on corporate bonds: The current state and

future evolution of the European investment grade corporate bond secondary market: perspectives from the market.

– Semi-structured interviews, allowing participants to focus on issues or topics of most relevance to them. The market participants interviewed (investors, issuers, banks and broker- dealers, intermediaries and e-trading platform providers) considered the liquidity impairment largely attributed to the unintended consequences of banking regulation and extraordinary monetary policy. – The study discussed and acknowledged the increasing concern that European credit bonds had become critically impaired and were not functioning effectively or efficiently. – The causes were complex, but the major impact was the reduction in the capacity, or willingness, of broker-dealers to fulfil a market-making role. At the time, many respondents expressed concern about how this could play-out under more stressed market conditions, and the potential broader economic implications. Frozen capital markets? Risks to economic growth? Prospect of another financial crisis?

ICMA 2016 corporate bond market study

In 2014, ICMA was asked by the buy-side to investigate the state of play in corporate bond markets and the possible cause or causes of the liquidity challenges.

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• July 2016 – ICMA released the 2nd study into the state and evolution of the European

investment grade corporate bond secondary market: Remaking the corporate bond market

ꟷ Scope & Methodology: Unlike the previous report, which was largely based on a series of in- depth interviews with market participants (investors, issuers, banks and broker-dealers, intermediaries and e-trading platform providers), the 2016 report relies on both qualitative and quantitative input (interviews, market data, a survey of buy-side members from these market participants. ꟷ Cause: Market participants report that in the current environment it continues to be more challenging both to provide and source liquidity. The cause is primarily the result of interaction of various regulatory initiatives and extraordinary current and future monetary policy, and the undermining of the market-making liquidity model, largely due to greater capital constraints on banks and broker-dealers. ꟷ Impact: Increasingly difficult to trade in large sizes, to execute orders quickly, or to establish reliable prices. ꟷ Result: Market participants are more resolved to adapt to the new norm, and are evolving their business models accordingly. While sell-side firms continue to reshape their models around balance sheet efficiency, acting more as principal brokers than market-makers, the buy-side is taking more initiative in terms of locating and creating liquidity. Technology is playing an increasingly important role in the market.

ICMA 2016 corporate bond market study

In 2016, ICMA was asked to investigate how the market has evolved since the previous study.

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What do we mean by liquidity?

ICMA 2016 corporate bond market study

• “The ability to get a price in the size you require, when you need it”
• “The ability to trade without major market impact”
• Sometimes there are more questions than answers:
• What are the appropriate determinants?
• Bid-ask spread? Market depth? Expected time to execute? Market impact? Historical volume

and prints? Characteristics of instrument? Distribution of holders?

• Can liquidity be measured?
• MiFID II/R liquidity measures
• ICE Data Services liquidity scores
• Bloomberg’s LQA
• Should liquidity measures be based on trade data, or on what failed to trade?
• Is liquidity dynamic, and should we expect different measures depending on market cycles

as well as the life cycle of the underlying security?

• If liquidity can be accurately measured, can it be commoditized?

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ICMA Buy-side Liquidity Survey

ICMA 2016 corporate bond market study

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Improve Remain more or less the same Deteriorate Deteriorate significantly

Liquidity: next 12 months (EUR)

0% 10% 20% 30% 40% 50% 60% 70% 80% Improve Remain more or less the same Deteriorate Deteriorate significantly

Liquidity: next 12 months (GBP) 5

ICMA Buy-side Liquidity Survey

ICMA 2016 corporate bond market study

0% 10% 20% 30% 40% 50% 60% 70% 80%

Initiatives to improve liquidity (EUR)

Decrease Little or no impact Improve Significantly improve

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Main conclusion of the ICMA study

ICMA 2016 corporate bond market study

• The general perception is that market liquidity is declining – but it is more nuanced than

simply things are getting worse

• Over all, liquidity is becoming more challenging to provide and source
• It highlights several reasons for discrepancies between official sector and market studies
• Causes for this are attributed to the confluence of monetary policy and regulation
• Market participants are responding the challenge, including sell-side, buy-side,

intermediaries, and infrastructure providers: changing business models and behaviour

• More interest in new trading protocols and e-solutions, as well as alternative products
• Looking ahead, major risks seen as the ECB’s CSPP, MiFID II/R pre-trade transparency, and

CSDR mandatory buy-ins [pre-Brexit]

• Corporate issuers more focused than ever: concerned about a growing disconnect

between secondary market liquidity and primary market efficiency

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Recommendations from the ICMA 2016 study

ICMA 2016 corporate bond market study

• Provide capital relief for market-making
• Including related hedging and funding activity
• Revitalize the single-name CDS market
• Including central clearing and capital relief for CDS market-makers
• Review and re-assess certain aspect of regulation
• In particular MiFID II pre-trade transparency and CSDR mandatory buy-ins
• Bring all market stakeholders together to review the market structure

“Only through a greater understanding and appreciation of different stakeholder needs and perspectives can the market community achieve consensus and develop private and public initiatives to maintain and grow a healthy and vibrant pan-European corporate bond market.”

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Ele lectronif ification of bond markets in in Europe

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Evolutionary “triggers”:

• Regulatory pressures (including MiFID II and Basel III) are transforming trading practices

and today are one of the leading contributors to the altering state of the market.

• Technology is speeding up the change in fixed income trading and represents the other

leading contributor to the changing shape of bond market trading.

• Technology is starting to create a more efficient, rationalised model of trading, and some say

‘smarter’.

• The key driver for the technology development is the liquidity challenges experienced within

the buy-side trading community.

Electronification of bond markets

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• Fixed Income vs. Equities:
• The key element to point out is that equities is more about electronic trading - speed e.g.
• HFT. Whereas, fixed income is more about the ‘automation’ or ‘optimisation’ of trading e.g.

sourcing, aggregating and datamining.

• Regulatory pressures such as MiFID II is a major catalyst for change:
• MiFID II concerns the framework of trading venues and structure in which instruments are
• traded. MiFIR on the other hand, concentrates on regulating trading venues and structuring

its operations. So, ‘who’ the market structures are, ‘what’ they trade and ‘how’ they are traded.

• Fixed Income trading must adapt and innovate.
• This will involve all facets of trading including people, technology and a re-direction of

business strategy. The bond trading eco-system will see new possibly disruptive entrants, innovative incumbents and adaptive trading protocols and venues.

Key facets of electronic trading evolution:

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• Equities:
• Equity Instruments – 6,810 shares

admitted to trading on regulated markets in the EU, on average trade 400 times per day.

• Commission based.
• Order driven with Straight Through

Processing (STP), using FIX protocol enabling full end-to-end trading with audit trail.

• DMA

to exchanges using bank’s pipes and plumbing.

• Heavy use of algorithmic trading for

electronic statistical and rules based trading in an agency environment.

Key facets of electronic trading evolution: Fixed Income vs. Equities

• Bonds:
• Over 150,000 debt securities (contained

in Trax’s Computer Updated International Database [CUPID]), on average trade 1.5 times per day.

• Quote driven relying on RFQs.
• Different characteristics – each bond can

have a different maturity, coupon and rating.

• Heavy use of OTC Markets with market

making and balance sheet usage.

• Heavy use of IDBs.

( Biais and Declercq - Academic Study, 2007 and ICMA published article 2009)

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• Key trading objectives of MiFID II:
• Move OTC trading onto trading venues, such as OTFs, through a trading obligation for

fixed income instruments. Systematic Internalisers will also become more relevant for bond trading.

• Increase transparency and create a price discovery mechanism, by expanding pre- and

post-trade transparency requirements to fixed income instruments.

• Preserve liquidity in already challenged markets through:
• pre-trade waivers and post-trade deferrals; and
• tailored approach to calibration of transparency requirements for different types of trading

systems.

Key facets of electronic trading evolution: MiFID II, the catalyst for change

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• The protocols and platforms that are being used by buy-side traders are dependent
• n the characteristics or the “conditions” of the trade.
• Time sensitive – illiquid: requires strategies or protocols that involve some form of bilateral

negotiation such as voice OTC, OTC market making or RFQs.

• Time sensitive – liquid: requires multilateral low-touch protocols such as all-to all (fixed

time, ad hoc or continuous) auctions with no concern about market impact as information leakage is not important.

• Non-time sensitive – illiquid: requires protocols that are a combination of multilateral and

bilateral, with an anonymous twist. The order can sit and wait for the other side or at the very least the best price. The order interacts anonymously with other participants but there is an electronic negotiation phase before execution. There is no market impact as there is zero chance of information leakage.

• Non-time sensitive – liquid: requires trading multilateral protocols that are low-touch, such

as Central Limit Order Book (CLOB) or Smart Order Routing (SOR) technology to multiple

• CLOBs. These strategies will have more in common with equity instruments than most

fixed income

• Key facets of electronic trading evolution:
• The Buy-side adapting and driving protocol and platform market structure development

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“Electronic trading technology development is the best proof yet that a liquidity problem exists.”

• There is a link between liquidity and technology. Often it is heard from regulators that

there is no evidence that liquidity has deteriorated. Whereas, market structure technology development says “all evidence to the contrary”.

• Why spend all the time, money and effort to develop solutions to problems that do not

exist?

• The buy side, which is facing the lion’s share of liquidity challenges today, is actively

shaping protocols and working with trading venues and IT firms to tailor-make functionality.

• Electronic trading technology innovation can assist in accessing liquidity with sourcing,

aggregating, crossing, routing or optimising whatever little liquidity there is out there.

Linking liquidity and technology

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Electronic trading technology innovation:

• “Fuzzy matching”: Software which can identify a bond that matches closely the

characteristics of the bond which the buy side or sell side is trying to source. This technology is the best proof yet that there is a liquidity problem. Buy-side traders and portfolio managers are giving up on accessing certain bonds and trying for ones that nearly match the wanted criteria.

• Information Networks (INs): sourcing and aggregating liquidity: IN firms provide an

aggregation layer, offering the trader two key sets of functionality: (i) a global view of liquidity and (ii) a choice of trading protocols and execution mechanisms from which to

• select. The trader uses this layer to obtain an accurate, timely view of available liquidity

across markets. INs use a high degree of technology embedded in the buy side and sell side’s internal systems.

• Liquidity scorecards: The buy side is already working with this to an extent today. In the

future, it will become more commonplace and standardised. The likelihood is that rating agencies might take this up in order to truly standardise liquidity ratings. However today, this functionality is built in to some trading venues and data providers.

Linking liquidity and technology

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• All-to-all: This is the true definition of “multilateral trading” (connecting dealers, investors

and other market participants on a centralised all-to all platform). All-to-all brings together pre- and post-trade information from a number of market data sources and electronic platforms and routes transactions through one all-to-all platform, creating a buy-side/sell-side firm liquid marketplace.

• Central Limit Order Books (CLOBs): CLOBs are an example of all-to-all but with built-in

electronic limits. CLOBs are popular in small sizes and liquid trades.

• Buy sides and sell sides don’t want to leave a large/illiquid price available to be traded

against.

• Anonymous trading platforms (multilateral): Anonymity is attractive to market

participants who want to complete large transactions without drawing attention to their trades, since such attention could impact market prices.

• Anonymous and/or semi-lit platforms can be buy-side to buy-side or buy-side to sell-side.

Price formation is in the dark (non-transparent) as the anonymity protects participants. The challenge is accurate price formation, although tools are starting to emerge to create a reference price.

Linking liquidity and technology

Electronic trading technology innovation:

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• Multi-asset trading: As banks and buy sides review their bottom lines more, it has

become obvious that some IT and skill-sets can be shared.

• Separate trading infrastructures are expensive.
• Cross product liquidity strategies and knowledge sharing is seen as a bottom line benefit.
• Multi-asset desks can provide high touch and low touch trading based on the needs of the trade,

regardless of instrument.

• Internal fund crossing portal: A workflow efficiency tool enabling the buy side to execute

internal fund crosses at an independently determined mid-price, creating “internalised liquidity”.

• Buy-side price-makers: Buy side placing firm prices on Central Limit Order Books (CLOBs)

and other agency-only trading venues.

• Buy-sides not placing firm prices in large sizes. Hedge funds may step in (providing it suits

their trading strategies) and provide larger sized bond pricing, bolstering available liquidity. This remains to be seen. However, highly unlikely the market will ever see traditional asset managers or indeed hedge funds stepping in as market makers with two-way pricing.

Linking liquidity and technology

Electronic trading technology innovation:

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• “Super trading desks” or “outsourced trading”: Large regional buy sides are creating

centralised super-desks offering efficiency and lower operational risks. These out-sourced trading desks can access more easily sell-side market making capabilities (balance sheet e.g. liquidity) and global reach.

• An outsourced trading provider will be able to evidence best execution to regulators and

trade report to the public for its clients in a scalable manner. The ability to measure best execution and broker performance as well as buy-side trader performance will be offered through transaction cost analysis (TCA). Further benefits are regulatory process control through management of transparency thresholds under MiFID II and “reg-tech” costs.

Linking liquidity and technology

Electronic trading technology innovation:

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Conclusion

• No one knows exactly what will happen in the coming years but there is a high probability

Darwin and ‘natural selection’ will play a part. There will be successes and failures of platforms and protocols as well as bank and buy-side business practices. What is clear is that an agile, flexible and scalable model is emerging .

• A successful landscape will be an adaptive landscape.

Electronification of bond markets

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