Institutional investors struggle to execute large block trades without moving the market against themselves. They know that banks do not have the balance sheet to take down their clients’ positions at a small discount, assume the principal risk and work them down over time. And so even asking dealers for quotes risks an indiscreet flurry of requests for off-setting trades that tips a customer’s hand before it has bought or sold a single bond.
The buy side has started to do the job for themselves. The good news is that it appears to be working.
In July, Liquidnet, the member-owned trading network on which 850 of the world’s largest asset managers execute large equity and bond trades anonymously, minimizing market impact, surveyed buy-side traders at 52 of the world’s largest mutual, pension and hedge funds. The survey covered the impact of Mifid II (very big in Europe, pretty substantial in the rest of the world), the rise of electronic trading (it’s going to continue) and capacity to execute large trades.
It comes as no surprise that access to liquidity remains the number one focus of both US and European traders when selecting a trading venue. More intriguing is that a majority of respondents indicated that bond liquidity conditions were better than a year ago. What might be behind that? Half of those surveyed reported an increase in fixed income electronic trading in the last year, with 54% indicating that peer-to-peer platforms are now complementing their existing workflows.
Liquidnet’s most basic crossing service allows institutions to rest block-size orders anonymously and passively on the network in the hope that another asset manager will supply an indication that it has the opposite side of the trade. But match rates are low – much lower in bonds than in equities – because of the large number of different bond securities. So Liquidnet established a new protocol of targeted indications that allows an investor seeking to sell a block of bonds, for example, to send indications that it is looking to sell only to so-called ‘contras’ – investors who have been buyers in the last few days.
It is just one indication among many of how new marketplaces are slowly devising trading protocols and technology to reveal new liquidity for investors; connecting them to participants that might take the other side of their trades, without revealing their intentions.
MarketAxess first established open trading protocols in 2013 to enable all-to-all trading, linking investors directly to other buy-side firms without going through broker dealers. It began to report a seismic shift in buy-side behaviour last year, with big increases in investors making prices to each other – not continuously like market makers, but sufficiently frequently and in such size that by the third quarter of last year approximately 50% of all liquidity being provided via open trading was coming from other buy-side clients.
This improvement is a welcome sign of the market fixing itself, if not before time. It became obvious to investors five years ago that post-crisis regulation had so reduced the capacity of dealers to intermediate the bond market as principals that the asset managers would have to find a way to do this for themselves.
That’s hard enough. But there is another structural issue at play here. Transparency has become central to regulators’ efforts to ensure that end investors are not being ripped off by the asset managers who deploy their money and by the banks that service the asset managers.
Mifid II requires data capture and audit trails to prove best execution.
But transparency is something buy-side traders looking to execute large strategic orders without moving prices against themselves are desperate to avoid. Indeed, the journey from anonymously resting a passive order in the hope a match will appear, towards targeted dissemination of indications of interest is a path across all the dark pools in which investors only reluctantly, as their desperation to execute increases, enter lit markets where they know transacting is bound to have damaging market impact.
Capturing reliable and timely price data from dark-pool execution in order to benchmark transaction cost and best execution analysis will be the focus for trading venues, buy- and sell-side market participants and regulators for years to come.
Figuring out that investors had to make prices and supply liquidity to each other was the easy part.