LONDON, Sept 2 (IFR) - Corporate bond investors are being converted to new trading technology in greater numbers, but they are still struggling to move paper in size at a time when central bank buying is making a structural liquidity drought more acute.
There are several strands to their shifting behaviour, all stemming from increasing use of electronic as opposed to voice trading. Algorithmic trading of smaller positions is beginning to be utilised. E-trading is even opening the door to trading protocols that side-step investment bank dealers and encourage investors to make markets.
"They are being asked by banks to make a price for a bond, rather than the other way round.""The interesting thing we are seeing now through e-trading is buyside firms becoming price makers," said Russell Dinnage, lead consultant at GreySpark Partners.
For several years since the financial crisis, investors have struggled to come to terms with the market's structural liquidity problem. They now hold most bonds, with investment banks no longer willing or able to maintain vast warehouses of paper given new regulations and higher capital requirements.
Investors used to buy and sell corporate bonds by simply picking up a phone to a dealer. Now over 80% of US-based accounts trade investment-grade corporates electronically - a figure up 10% since 2015 and having more than doubled in the last decade, according to research from Greenwich Associates.
According to GreySpark's Dinnage, the split between voice and e-trading is now moving closer to 60-40, having been around 70-30 for the last three or so years.
Goldman Sachs now offers clients small trades using an algorithm, which calculates executable prices on otherwise illiquid lots. The hope is that as the technology improves, it can be used for larger tickets.
But for now it is the growth of all-to-all, equity exchange-style trading that could be the most promising development. Over 50% of transactions on MarketAxess's all-to-all Open Trading platform are now buyside to buyside. Furthermore, over 600 investor firms responded to requests for prices through the platform in Q2 2016, up from 375 in the same period last year.
But this does not indicate that the traditional liquidity providers investors used to rely on have been replaced. Nor does it yet herald the death of the request-for-quote model as dealers are still integral to corporate trading, electronic or not.
Inertia?
"The e-trading sector is a very new endeavour - it's a big retraining exercise," says Evan Moskovit, head of corporate fixed income at Symetra.
Moskovit questions the practicality of asking one of his traders to learn and utilize various software applications, all of which are different and require training.
"Right now, it's impossible to pick the right one."
Numerous platforms have failed. There were around 30 e-trading venues competing for corporate business in early 2015, but there are now only around a dozen with genuine market share, according to one market specialist.
The industry has also not yet solved two of the biggest post-crisis problems: the difficulty of transacting in size and the inability to easily trade when prices are volatile.
The Bank for International Settlements estimates that some 85% of electronic corporate bond trades are for less than US$1m.
Greenwich puts the small drop this year - from 20% to 19% - in high grade volumes traded electronically partly down to bouts of volatility, such as in the wake of the UK's Brexit vote.
"The value of the person is not to be underestimated, as they are a big part of the solution to the liquidity problem in corporate bonds going forward," said Stu Taylor, chief executive at Algomi, a trading software provider.
"When volatility spikes, the uncertainty leads to an immediate reduction in screen-based trading, and that's when you pick up the phone to improve your information."
Despite the numerous hurdles, Greenwich expects the percentage of investment-grade corporates traded electronically to increase to a "medium-term peak" of 30%-35% of total volumes.
"If and when buyside access to liquidity diminishes further at the hand of a market shock, rate rise or increase in the cost of capital for dealers," writes Greenwich's head of market structure and technology research, Kevin McPartland, "the resulting new pain for institutional investors will act as the catalyst needed for a dive head first into new ways of trading."
Central Bank Catalyst
The European Central Bank has hoovered up 17.8bn of corporates since June 8, and the Bank of England diving into the UK market will further restrict the universe of easily tradable paper.
The pain of competing with central banks for paper may push more investors to try out e-trading.
Analysts at Bank of America Merrill Lynch recorded large spikes in bid-offer spreads - the favoured liquidity indicator of many market participants - after the ECB's corporate purchase programme was announced on March 10, then after it began on June 8, and then again after a list of purchased bonds' ISINs was released on June 23.
The analysts note that amid a drift higher in bid-offers since the ECB started buying, liquidity seems to have deteriorated further for eligible and purchased names after the ISINs were published.
Notwithstanding technological developments, for now it looks like market participants will continue to contend with greater pricing volatility, increased expense, slower execution and ultimately greater levels of frustration.
"Former liquidity providers have to find a better way to operate and optimise their operations and capital," said Moskovit.
"Regardless of the business, if rules change, smart players work out better ways to operate. But who knows how long that will take?" (Reporting by Tom Porter, editing by Alex Chambers, Julian Baker)