Steven Zamsky is a former head of global credit trading at Morgan Stanley and is now a senior adviser to Oliver Wyman and a financial services consultant.
After decades of inertia, corporate bond trading has evolved by leaps and bounds in the last several years. Frankly, it’s pretty remarkable how far it’s come.
The long-fitful growth in the portion of trading volumes conducted on electronic venues has surged since the pandemic, and now stands at around 40 per cent in the US. As one trader puts it, “it’s as if everyone working at home suddenly decided to trade credit electronically”. And it stuck, even if WFH is fading.
Outsiders have always been befuddled by the weird world of credit trading. There were too many instruments (consider Ford Motor’s one equity share class available on the NYSE relative to its 23 public bonds, and scores of private debt securities), with too many different terms (maturity, currency, callability, covenants etc), too little price transparency, and big chunks locked up in buy-and-hold accounts.
Trading was dominated by a small number of mammoth institutions with similar investment strategies, facing off in hand-to-hand combat with market-making bond dealers who priced risk and warehoused bonds. Equity and macro traders looked at credit as an archaic marketplace and retail investors found it fraught with peril; it was largely impenetrable other than to the professionals dedicated to the space.
The early 2000s saw the first attempts at real change. Electronic trading venues started to pop up, trading desks (buy- and sellside) began to experiment with quantitative approaches, the first ETFs were launched, and innovators saw the credit default swap as a way to make a corporate’s credit risk more homogeneous and “tradeable” (via the standard five-year CDS contract). Gone were the days of once-per-day bond pricing runs distributed via fax machine.
But things moved glacially from there. Some trading venues made headway, but primarily in odd-lots. Many faltered. New trading protocols came and went, fighting unsuccessfully for mind share and screen space. The CDS experiment got steamrollered by the post-GFC hangover of counterparty risk, regulation, and the market’s phobia of acronyms and leverage-fuelled credit strategies.
Bond ETFs enjoyed some growth but were surprisingly slow to catch on with retail investors, and were deemed competitors by many institutional investors. Wall Street couldn’t figure out algorithmic trading, suffering from a lack of data, illiquidity, and bad performance in down markets.
For sure, some innovation was happening that would lay the groundwork for the future, and the market share of electronic trading slowly climbed into the low-teens. And — very importantly — Finra’s bond trading transparency rules vastly increased the quality and quantity of available data.
But vested interests among both dealers and investors contributed to the sluggish, halting pace of change. For most credit traders, the base case was that the market structure five years forward would be basically the same as it had been for decades.
Then 2020 happened.
Enabled by innovation on both buyside and sellside, we suddenly reached a tipping point. Electronic investment grade corporate bond trading volumes have now doubled in five years (and high-yield volumes have almost trebled over the same period) as the fabric of market structure shifted radically. Credit trading now has more players, is increasingly driven by technology, and sees lots more but smaller trades.
Years of data capture and analysis — itself enabled by cheaper, faster technology and spurred on by a younger generation of traders (often at new entrants like Jane Street for example) — has born fruit in the form of pricing engines that power ETF arbitrage, systematic trading strategies, algorithmic trading books, and portfolio trading.
Price transparency has improved due to regulatory change, data availability, and Bloomberg’s acquisition of the most widely tracked fixed income indices, which make prices visible on its ubiquitous Terminal (for a fee of course). Price squabbles that were long the sand in the gears of innovation have given way, at least in part, to a more standardised language.
New tools have meant new participants, including ETF arbitrageurs, systematic strategies, and a proliferation of “algo” or “electronic” books supplementing traditional “voice” businesses at major dealers. The market model is changing from “few-to-few” to “many-to-many”, an evolution that addresses one of its most fundamental challenges.
Look, the shifting landscape is not without its growing pains and risks, nor does it address the illiquidity of the asset class for many investors. Electronic trading can’t magically make credit as freely tradable as equities.
For a lot of bond vets it’s a tough time. Traditional fixed income sales and trading skills — relationships and an innate feel for managing idiosyncratic risk — are out of vogue (bad news for New York and London restaurants living off expense account spending). Data scientists and the ability to manage fat bundles of risk are in strong demand.
There are also obvious dangers potentially brewing. What some people euphemistically call “interdependencies” are building up, with pricing models taking inputs from other markets and referencing one another. That means this new market structure may be particularly exposed in big nasty surprises. And importantly, while new trading venues and market participants mean there are more on- and off-ramps to the corporate bond superhighway, there are still not enough parking lots to position risk in spicy markets.
But the still-ongoing electronic evolution is already yielding real benefits for investors and will continue to do so. It’s quicker and easier to optimise a bond portfolio, and decreasing friction on smaller bond trades will make life easier for quantitative and index strategies. Institutional investors are increasingly connecting directly to big dealers, a trend which will probably continue and allow for more streaming markets, “click to trade” or “click to engage” execution, tiered pricing, and new advances in portfolio implementation.
And then there is the holy grail — the potential for new platforms to retool corporate bond market access for retail investors and wealth managers who have historically suffered from opacity and high trading costs. It’s taken a quarter of a century, but it is finally happening.
Read the full article here