Fred Ponzo, managing partner at consultancy Greyspark Partners and Stu Taylor, chief executive and co-founder of Algomi share their views on the impact regulation is having on the structure and trading of the bond markets. Comments from recent trading podcast “Electronic Trading vs. Voice Trading“.
Stu: I think the regulation is really hitting the markets in at least two ways now. In certain cases we are actually getting mandated methods of execution where the regulators are trying to push the creation of new types of venues. In the US, it is swap execution facilities (SEFs) while in Europe, there are proposals for multilateral trading facilities (MTFs) and organised trading facilities (OTFs). Whilst they will have some success and applicability to some products, I think the more far-reaching regulation having an impact is the capital charges under Basel III. Traditionally, banks have played a market-making role and have put their own balance sheet to work for many of the OTC products in the secondary markets.
The regulations are in essence penalising excessive risk taking and the result, which has been well documented in the financial press, is a massive reduction in the inventory of bonds that banks are willing to hold. This has caused volumes to drop in the secondary markets and liquidity to dry up across a wide range of assets but particularly the more illiquid ones. I think that the chase for execution venues in one sense is a bit of a misnomer because the most important thing people should keep in mind is the impact that these regulations will have on the secondary market.
Fred: I agree with what Stu has said. The capital charges under Basel III are the ones that are essentially having the biggest impact but where I slightly disagree is on the intent. There is a general view, shared mainly by the banks that the regulators and the central banks to a certain extent, didn’t think through their role as liquidity providers. I don’t believe that’s the case but don’t get me wrong, I’m not saying that regulations are as clean, simple and legible as they could and should be. However, there is a clear intent from the legislators to prevent the banks from taking principal positions. They are trying to squeeze risk taking out of the banking system to avoid having to bail them out again if they get it wrong.
There is a substantial amount of anecdotal evidence where non-bank liquidity providers are actually picking up the slack, whether it’s in FX, interest rate as well as credit default swaps (CDS), all single name and index. For that type of non-bank liquidity provider, the ability to trade on an electronic medium is a great enabler, because it reduces their own cost. That doesn’t mean, again, voice is out of the question, but ultimately that he legislators and regulators want to turn the banks into agents.
Stu: If I could pick up on some of Fred’s comments there. I agree to a certain extent, however I do think electronic platforms as a means of execution in certain cases is already not proving to work effectively. Certainly in something like the CDS index product, we see around 90% to 95% of the volume being executed electronically because it is a very commoditised and liquid product. It is a very different story though when you move into the single name part of the CDS market. Even though we’re getting the requirement to execute some of those trades on a SEF, in essence anecdotally we’re hearing that many of those trades are actually arranged off platform and are just basically sent through to the SEF for execution. In other words, what you have is trade reporting by another name.
Fred: In the case of CDS, I would argue that it is because the US regulators in particular got it the wrong way around. The mandatory condition to have a functioning electronic liquidity provision mechanism is just central clearing. Right now, there is a mandate to centrally clear index CDS but the single name CDS are not yet onto CCPs. My expectation is as that as soon as the central clearing for the single name is in place the electronic execution will pick up. Until then, I agree with Stu in that there is a credit element in the sense that who you trade with does matter due to the price formation and therefore you need to know your counterparty, and the best way to do that is to negotiate and talk to that person. Once that goes away, I’m reasonably confident that the most traded of those single name contracts will see their electronic parts, or a proportion of their electronic trading, increase. Until then, I agree it’s just not worth it.
* For more information on this topic please listen to our podcast –“Electronic Trading vs. Voice Trading“
