Debt trading: the future
Electronic trading offers serious challenges and opportunities to the debt world. Opportunities always occur when there is change but the question that most dealers are asking is whether new market trends and regulations are necessarily good for liquidity.
“The challenge from e-commerce is really hitting the cash business. The issues there are an overwhelming amount of price transparency which is asymmetrically skewed to the client base. The liquidity that they get in that space is mispriced. It is not a surprise to me that people are finding increasingly the cash part of the business is tough both in the US and in Europe and are increasingly diverting resources towards the derivatives business,” says Simon Morris, head of European credit trading at Goldman Sachs.
Dealers are aware that they can quickly find themselves badly caught out by sharp operators that will execute with various counterparties at the same time. This type of practice results in dealers being less willing to extend liquidity. But in some circumstances the bond issuers enforce a certain level of liquidity in their securities. This is certainly the case in the sovereign world where bond mandates are only given to those institutions willing to provide liquidity electronically.
So pressures are coming to bear on dealers from various directions. And although not much can be done about natural competitive pressures, market participants are not so sanguine when it comes to regulatory-driven change.
The EU’s Markets in Financial Instruments Directive (Mifid) could provide a further blow to liquidity if its requirements on best execution are not very carefully implemented, bankers argue. Transparency is a great thing in principle but debt markets are not like equity markets. There is a widespread fear that the regulators might not recognize that debt markets are not traded on an agency basis – with dealers simply matching buyers and sellers. Debt traders put their firms’ capital at risk and that means that too much transparency can be a bad thing.
Some of the major problems bankers have with Mifid appear to be linked to best execution. Market participants fear that best execution will require a level of post transparency that will result inevitably result in a withdrawal of liquidity comparable to that in the US following the introduction of the Trade Reporting and Compliance Engine system. The NASD introduced Trace in July 2002 in an effort to increase price transparency in the corporate debt market. Unfortunately liquidity has dried up as a result.
“I do think that regulators are coming around to understand the difference between agency and principal markets,” says a head of trading. “I do think they’ll incorporate that into their thoughts. If you look at how the market functions in Europe – it is pretty well functioning. Look at the NASD Trace system; you can see that these types of regulations can hurt liquidity in markets that are not agency-led.”
Those implementing Mifid need to decide if there has been a market failure and compare and contrast with the US. Not only is there not a significant European retail market in comparison with the US (just 6% versus 30%) but also the wholesale market is functioning fine.
If the issue is about retail and the appropriate selling of product, the markets’ dealers suggest that it is best to tackle that rather than addressing pre- and post-trade transparency and best-execution measures.