The creeping equitisation of credit trading

Dutch market-maker Flow Traders has just published a report that examines the evolution of European fixed income trading. It’s one of Alphaville’s fave subjects (yes, we’re a hoot at dinner parties), so we dug in.

The overall direction is clear: Europe is also seeing a huge shift away from phone lines and Bloomberg messages and towards algorithmic trading on various electronic platforms.

The rapid shift in corporate bond trading is particularly interesting. Flow Traders reckons that algos made up about half of all executed volumes in European credit over the past 2-3 years. The Dutch market-maker had some interesting additional detail on these new algorithmic trading protocols:

Flow Traders estimates that there are over 15 sell-side algos active in Euro credit today, with varying degrees of sophistication. Some of the more advanced algos can automatically price the full range of Euro IG (around 5K) ISINs as well as the larger sizes for the more liquid parts of the universe.

In Q4 of 2022 the top five average quoting times on Tradeweb for all sizes Euro Corporate bonds was under six seconds. This proves the dominating position of algorithmic trading strategies in the current credit markets. In Europe, bond pricing sources are extremely fragmented and as there is no pricing consensus coming from a CT, bond traders face the challenge of the need to consolidate various pricing information sources in a quick and efficient manner. The use of algos allows them to collect, aggregate and interpret pricing determinants and translate them to a competitive pricing in a matter of seconds. ETF market makers are the main drivers of this development, they have been utilizing algorithmic strategies for ETF liquidity and have been adjusting these mechanisms to achieve the same efficiencies in the underlying bond markets.

As you’d expect, it is particularly dominant in small tickets worth less than €1mn (big trades still often need a human touch). These accounted for 87 per cent of all European investment grade corporate bond trades in 2022, up from 83 per cent in 2021. Every other slice is declining.

Credit mavens have often predicted that corporate bond trading would evolve very differently to equities (if it evolved at all). But much faster, much smaller and much more voluminous trades doesn’t sound that dissimilar?

Flow Traders is big in ETFs market-making, so naturally they big up the role that they have played in these developments.

Fixed income ETFs continue to gain popularity amongst institutional investors who aim to gain exposure to the bond markets. ETF trading is characterised by easy liquidity access, immediacy and certainty of execution as well as tight tracking to the underlying bond markets. Central banks globally are tightening monetary policies resulting in positive interest rates for the first time in eight years. In this new interest rate regime investors are again looking to increase the fixed income allocation in their portfolio mix and ETFs prove to be an excellent vehicle to gain diversified and cost effective exposure.

Next to their return generation benefits, ETFs are also widely used by investors to manage risks in their bond portfolios. Single-name credit default swaps (CDS) used to play that role before the implementation of the European market infrastructure regulation (EMIR) and the adverse change of their liquidity has impacted the fixed income markets negatively, as also confirmed by the ICMA study presented in the previous chapter. Fixed income ETFs prove to be reliable instruments for hedging credit risk.

All of these factors drive the growth of fixed income ETFs and we expect that this trend will persist in the coming period, due to this additional layer of liquidity and price transparency they add to the credit markets. This nurtures the natural growth of the underlying credit markets with ETF APs and market makers playing the catalyst role in this symbiosis.

But as Alphaville has written before, the growth of fixed income ETFs really does seem to be leading to some pretty radical changes in the bond market structure. It’ll be interesting to see what things look like in a few years.