The market convulsions in mid-October, when equity markets sold off sharply and investors rushed into US treasury bonds, once again highlighted the fragility of bond market infrastructure that investors have been complaining about since 2012. Back then, BlackRock memorably described the liquidity trap in corporate bonds to Euromoney as akin to a lobster pot: easy to get into, but almost impossible to crawl out of.
Last month it was the shallow depth of market in supposedly liquid US government bonds that caught investors by surprise. More than six years after the collapse of Lehman Brothers prompted regulators to impose higher capital charges and curtail principal risk taking to make banks safer, bond markets have still not found a way to replace the traders’ role as shock-absorber.
The old request-for-quote model of asset managers asking banks to make prices to buy or sell blocks of bonds is in sharp and irreversible decline. No replacement has yet emerged. Trading desk heads at big asset managers describe the way the market works today as a kind of spurious agency model with a bit of balance sheet behind it and a lot of smoke and mirrors.
This month Euromoney reports on yet another new industry venture to address the problem. Project Neptune is interesting for two reasons. At first glance, it seems unambitious relative to more visionary attempts to shift OTC bond trading onto new exchange-like venues with new protocols. It is concerned only with agreeing a common FIX based messaging language and standardized flagging system for pre-trade exchange of bond orders. But it is well supported with 12 of the biggest 15 dealers in European corporate bonds on board and 15 or 16 big asset managers, after a sudden meeting of minds during the autumn conference season.
Time will tell if a critical mass of market participants sharing common pre-trade messaging makes it easier for different counterparties to find the other side of the trade in shrunken and fragmented secondary bond markets. It’s encouraging to see banks and investors working together in the common interest – and sharing the costs – to devise ways to improve bond market infrastructure, rather than just whining about the changes new regulations have wrought.
But there’s one big constituency still missing. That is bond issuers. Frequent corporate borrowers – with the banks themselves the most prominent examples – have traditionally sold bonds of varying terms into any pocket of demand, revelling in a dispersal of liability maturities. But this has led to many tens of thousands of individual bonds outstanding, the vast majority of which hardly ever trade. On these bonds, illiquidity now becomes self-reinforcing, with price gapping on thin turnover requiring higher VaR capital charges and so disincentivizing banks from taking on positions from customers.
In a September position paper that described the corporate bond market as broken, BlackRock points out that greater standardization of new issues would reduce the number of individual bonds, via steps such as issuing similar amounts and maturities at regular intervals and reopening benchmark issues to meet financing needs. Standardized terms would improve the ability to quote and trade bonds, and would create a liquid curve for individual issuers. Standardization has improved liquidity in other markets, such as interest rate futures and credit default swaps.
Issuers cannot much longer stand aloof from this debate.
In a speech in September, SEC commissioner Daniel Gallagher offered a stern reminder that the SEC is the lead regulator of non-government US bond markets in which retail investors are increasingly exposed. He called for more electronic and on-exchange dealing to improve liquidity and transparency and suggested that issuers could perhaps agree standard sets of terms for debt contracts akin to Isda swaps contracts.
Gallagher warned that, if bond market participants fail to find a way forward: “We risk a disastrous liquidity crunch and the attendant negative impacts on our economy. And it isn’t a stretch to think that Congress could respond to such a crisis by mandating that all corporate bonds be executed on-exchange platforms.”
The time has come time for borrowers to engage.
With volatility returning to bond markets, investors are fretting once more about illiquidity. Policymakers too worry that it might turn a bond market meltdown systemic. A new project for a shared messaging language to improve the flow of information connecting holders of inventory sounds unglamorous next to all-to-all trading platforms and central limit order books. But the rush of support from both buy-side and sell-side suggests Project Neptune could make a vital contribution.