Bond markets: It’s time for open order books

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Talk to big dealers and investors in the secondary corporate and government bond markets and it is clear that radical changes are coming. An exchange-like model with a central order book for bonds has been talked about for years. The time for action is at hand. The old over-the-counter market-making system is withering.

Liquidity has always been poor in corporate bonds because borrowers have churned out so many securities, each with its individual terms. Some issuers, with just one equity trading on world stock markets, have thousands of bonds.

The quality of secondary markets has become much worse because of the regulatory response that followed the financial crisis. That has taken one big buffer out of the market in the shape of bank proprietary dealing desks and radically reduced balance-sheet appetite for making markets. Dealer inventory is running at only 25% of levels prevailing before the financial crisis while ultra-low interest rates have caused bond market outstandings to double. That had driven managers to reduce fund volumes in relative-value strategies, so taking a third buffer out of the market.

Illiquidity today is no longer solely a function of the profusion of individual credit securities. It is increasingly evident in the supposedly liquid government bond markets.

Low rates, as well as supporting a vibrant primary market that has obscured the shrunken secondary beneath, have also inflated a bond bubble and the market is gripped with fear as to how the turn will play out when all the longs scramble for the exit as rates lurch up. We had a brief taste of what’s to come in June.

Investors have been complaining loudly about the withdrawal of dealer liquidity for 18 months or more. That’s not going to change. If anything it will get worse, even in government bonds, as new leverage ratio rules reduce repo books through which dealers fund low-risk inventory.

Investors have to do this for themselves. Several platforms have been set up that operate variants of all-to-all trading and allow investors the choice of displaying indications of interest to deal or firm orders at specified prices that other fund managers, seeking to put on an opposing view, can hit.

It’s important to distinguish investors displaying offers to deal at a firm price in a set size from market-making. No one is suggesting that investors should use their inventory to quote two-way prices and offer to make markets to competitors. These new platforms offer investors a better chance to find willing liquidity, the mythical investor taking the other side that dealers used to seek while warehousing customer position and basis risk. Investors have to give some liquidity in order to get it from their peers.

The reasons why such ventures will fail have been rehearsed many times over the years. Investors always want to go the same way at the same time and will always need intermediaries until the other side appears. They won’t deal with their competitors directly or disclose their intentions to them.

Here’s why it will be different this time. The entire thrust of regulation is towards centrally cleared markets with full audit trails and transparent price data on actual trades rather than mere displayed quotes with no underlying activity that rogue traders might manipulate. Fund managers are facing growing requirements to deal at best price, as this cost is ultimately passed on to moms and pops and pensioners that put cash into their funds.

All-to-all trading offers the ultimate prize of dealing at or near the centre of the spread. Vega-Chi, for example, charges a commission of up to 6.25 cents a trade but can save each side 20 to 30 cents a trade. If dealing on new platforms is almost always at better prices than in the OTC markets, investors will be obliged to put more business through those platforms, ultimately providing the critical mass order books need to match investors taking opposing views.

There’s still a role for dealers, who might act as prime banks or sponsors for investors to protect their anonymity. At the very least, banks might handle all the associated payments infrastructure for fund managers.

The smart dealers see this. They’ll back new trading protocols on centralized order book markets. This particular battle of ideas is already almost over.

Could big borrowers one day tap out for themselves, rather than use bank arrangers, new offerings or re-openings of securities to be traded on de facto exchanges? That might severely curtail the fees banks earn in the primary market. It might help investors by further promoting liquidity in more standardized bond issues. This is the battle that lies ahead.