The corporate bond liquidity challenge:
rethinking the market
An ICMA and City Week partner event, May 11th 2016
Andy Hill
The corporate bond liquidity challenge
What do we mean by liquidity?
 “The ability to get a price in the size you require, when you need it”?
 The ability to trade without major market impact?
 Can liquidity be measured?
MiFID II/R liquidity measures
Bloomberg’s LQA
 Interactive Data’s Liquidity Indicators
 What are the appropriate determinants?
 Bid-ask spread? Market depth? Expected time to execute? Market impact? Historical volume
and prints? Characteristics of instrument? Distribution of holders?
 Should liquidity measures be based on trade data, or on what failed to trade?
 Is liquidity dynamic?
 Should liquidity have a cost?
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The corporate bond liquidity challenge
Factors affecting bond market efficiency and liquidity
 Regulation
 Macro-economic conditions and monetary policy
 Spread compression and the search for yield
 Structural trends in the holders of bonds
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The corporate bond liquidity challenge
The traditional fixed income liquidity model
Provides for:
Ready two-way pricing
Immediacy of execution
Client
C
Client J
Client
B
Client
A
Client
X
Client
Y
Market
Maker
Client
Z
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The corporate bond liquidity challenge
The principal dealer (or market-maker) model
Essential ingredients for the model:
Availability of capital (balance sheet) to hold long and short-positions and warehouse risk
Availability of an efficient and liquid derivatives market (such as single-name CDS) to
hedge dealer positions
Availability of an efficient and liquid repo market to fund dealer positions
Skills and experience of the trader
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The corporate bond liquidity challenge
The principal dealer (or market-maker) model
Undermining the model:
 Availability of capital (balance sheet) to hold long and short-positions and warehouse risk
 Increased cost of capital (Basel III & IV)
 Volker Rule and restrictions on bank proprietary trading
 Availability of an efficient and liquid derivatives market (such as single-name CDS) to
hedge dealer positions
 EMIR and other central-clearing or margining requirements for derivatives
 Availability of an efficient and liquid repo market to fund dealer positions
 Leverage Ratio, NSFR,....
 QE: negative rates and excess reserves
 Skills and experience of the trader
 Ongoing attrition of experienced staff and ‘juniorization’ of trading desks
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The corporate bond liquidity challenge
The evolving dealer model
Principal
trader
Principal
broker
Agency
broker
Changes in dealer behaviour:
Smaller inventories and faster turnover
More considered allocation of balance sheet
Deeper client engagement and awareness of needs
More specialization and focus on competitive advantage
More streamlined trading and sales desks
What we lose is:
Ready two-way pricing
Immediacy of execution
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The corporate bond liquidity challenge
Future potential challenges to bond market efficiency and liquidity
 MiFID II/R pre- and post-trade transparency requirements (for bonds and single name
CDS)
 MiFID II/R best-execution requirements
 CSDR mandatory buy-ins
 Even higher capital and funding costs (FRTB, NSFR)
 Other miscellaneous regulatory challenges (e.g. MAR disclosure requirements)
 ECB’s Corporate Sector Purchase Programme
 Ongoing macro-economic and geopolitical risks
 The ‘unknown unkowns’
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The corporate bond liquidity challenge
How is the market responding?
 Electronification: new initiatives, platforms, tools, and protocols
 Changes in buy-side behaviour
 Use of alternative products, such as bond ETFs and CDS indices
 New, non-bank liquidity providers (‘principal trading firms’)
 Discussions on changes in issuance practice (‘benchmarking’)
 CMU Call for Evidence and the ‘better regulation’ initiative
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The corporate bond liquidity challenge
Electronification of the market
Electronification has the potential to provide a wide range of efficiencies for trading:
 Pre-trade
 Price discovery and trade negotiation
 Execution
 Click to trade, smart order routing, algorithm based trading (potentially including the
simultaneous execution of reference hedges)
 Post-trade
 Settlement and confirmation (‘straight through processing’)
 Data capture and management
 Regulatory reporting, transaction cost analysis (TCA), cost expectation, counterparty
evaluation, risk management, price discovery
 Ancillary services
 Trade analytics, liquidity scoring, portfolio analysis
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The corporate bond liquidity challenge
Evolution of electronifcation in the corporate bond market
Two key threads:
 Connectivity
 The ability to access ever more diverse and disparate sources of liquidity
 Data
 The ability to identify where those sources of liquidity are and to find the other side of the
trade
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The corporate bond liquidity challenge
Evolution of bond market e-trading protocols
Early initiatives:
 Central limit order books (CLOBs) for inter-dealer market
 Disclosed request for quote (RFQ) systems for dealer-to-client market
 Streaming for dealer-to-client
More recently:
 Opening up of RFQ to ‘all-to-all’, counter-pricing, and anonymous
 Standardized auctions (‘liquidity windows’)
 ‘Sweeps’ for matching odd-lots
 Anonymous matching for large blocks
 But dealer-to-client RFQ still dominates
Today:
 Matching systems (or ‘information networks’)
 Identifying sources of liquidity, and more axe driven rather than quote driven (more ‘point- 312
to-point’ than ‘all-to-all’)
The corporate bond liquidity challenge
Changes in buy-side behaviour
 More reliance on primary market and less on secondary
 Longer-term views (‘buy-to-hold’)
 Broadening as well as deepening dealer relationships
 Greater use of data (axe lists, trade history, etc.) to identify liquidity sources
 Utilizing other products, such as ETFs or CDS indices
 Utilizing e-solutions which offer new counterparty networks and trading protocols
 Greater use of internal ‘crossing’ between funds
 Becoming ‘price deciders’ rather than ‘price takers’
 “Working harder than ever before”
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The corporate bond liquidity challenge
Conclusion: rethinking the market
 Do we have to accept that liquidity is a limited resource, that requires hard work to
source, and comes at a cost?
 Will we move away from a liquidity model that is dependent on market-makers, or will
we always be reliant on broker-dealers to some extent?
 Do we redesign the ‘shape’ of the corporate debt markets to fit the established liquidity
models of other markets (the ‘equitization’ of the bond markets), or do we design new
models and protocols that best fit the market?
 Can the corporate bond markets ever become fully exchange or platform based, or will
they always require a basis of human interaction and relationships between participants
that are built on experience, trust, and mutual understanding?
 Can the corporate bond markets continue to serve their economic function of bringing
investors and capital raisers together, efficiently and effectively?
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The corporate bond liquidity challenge
Bibliography
Addressing Market Liquidity: A Broader Perspective on Today’s Bond Markets, BlackRock, February 2016
Fixed income market liquidity, CGFS Papers, No 55, January 2016
Market liquidity – resilient or fleeting? Global Financial Stability Report: Vulnerabilities, legacies and policy challenges: risks
rotating to emerging markets, Chapter 2, October 2015
Global financial markets liquidity study, PWC, August 2015
Liquidity wars: Who wins and loses in the race to the bottom? Citi Research, June 2015
The Liquidity Conundrum: Shifting risks, what it means, Wholesale and Investment Banking Outlook Blue Paper, Oliver Wyman
and Morgan Stanley, March 2015
The current state and future evolution of the European investment grade corporate bond secondary market: perspectives from
the market, ICMA, November 2014
Market-making and proprietary trading: industry trends, drivers and policy implications, CGFS Papers, No 52, November 2014
The liquidity challenge: exploring and exploiting (il)liquidity, BlackRock, June 2014
Economic Importance of Corporate Bond markets, ICMA, March 2013
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The corporate bond liquidity challenge
About the SMPC
The ICMA Secondary Market Practices Committee is an open forum for sell-side and buyside member firms active in the European investment grade corporate bond secondary
market. Through open dialogue and engagement, as well as through its subsidiary working
groups and work-streams, it seeks to be the representative body of the European corporate
bond secondary market: addressing practical issues directly relevant to market
practitioners; standardizing market best practice; disseminating relevant market
information; and promoting the best interests of an efficient and liquid market.
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The corporate bond liquidity challenge
About the author
 Andy Hill is a Senior Director in ICMA’s Market Practice and Regulatory Policy group. For
seventeen years he has been a repo and money-market trader, for ten years of which he
was an Executive Director at Goldman Sachs. He has also worked as a consultant in the
Aid and Development sector, primarily based in Cambodia, and previously served on the
Board of the Cambodian NGO Education Partnership in Phnom Penh while under a
Goldman Sachs Public Service Fellowship. He holds a BSc (Hons) in Business Studies from
Cass Business School and an MSc in Poverty Reduction and Development Management
from the University of Birmingham.
 Email: [email protected]
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The corporate bond liquidity challenge
This paper is provided for information purposes only and should not be relied upon as legal, financial, or other professional
advice. While the information contained herein is taken from sources believed to be reliable, ICMA does not represent or warrant
that it is accurate or complete and neither ICMA nor its employees shall have any liability arising from or relating to the use of this
publication or its contents.
© International Capital Market Association (ICMA), Zurich, 2015. All rights reserved. No part of this publication may be
reproduced or transmitted in any form or by any means without permission from ICMA.
Contact: [email protected]
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