Vanguard, the asset management giant with $3.8 trillion under its belt, has a few things to say about the bond market.
The fund manager just published commentary on “innovation and evolution in the fixed income market,” looking at trends in bond liquidity and trading.
You’ll recall, falling liquidity in the bond market is a problem that traders have been crying about for a while now. The argument is that it makes trading in large sizes harder, and bond prices more volatile.
But Vanguard says that liquidity conditions aren’t as bad as has been made out, and that the structure of the market is evolving to meet new challenges.
It also issued a series of recommendations that are sure to be read with interest by just about anyone involved in bond trading.
“Corporate bond markets have grown considerably over the last several years, just as dealers’ appetite to hold bonds in inventory to facilitate trades has diminished,” the note said.
“This shift in dynamics, though undeniable, is not a harbinger of doom, nor is it the end of the story. Rather, it’s the beginning of a new chapter that highlights the resiliency of the financial markets and the imagination of many of its participants. The market and its participants are doing what they always do — adapting, innovating, and evolving.”
In particular, Vanguard cites the rise of electronic trading in the bond market as evidence of an evolution taking place in market structure. We’ve written before about the rise of electronic trading in fixed income, currencies and commodities.
High-frequency trader firms are now dominating the US Treasury market, and an upstart tech-driven marketmaker is now one of the biggest players in the FX market. And according to a recent study by the Securities Industry and Financial Markets Association, 20% of corporate bonds were traded electronically in 2015, more than double the figure for 2013.
Vanguard said that the increased use of technology in bond trading had led to less-profitable trading for some, but also a more diverse and vibrant marketplace. It said:
“Trading has become less profitable for some, but at the same time doors have opened for new ways of linking buyers and sellers and maintaining a vibrant marketplace. This real, sustainable vibrancy stands in stark contrast to the often-repeated narrative that the shift in market dynamics spells trouble for the fixed income market and its participants.”
That’s not to say that trading in the corporate bond market can’t be improved.
With that in mind, Vanguard put forward five key recommendations that it said would “bolster an already strong system by focusing on several core principles.” In doing, Vanguard is sure to kick off a conversation on Wall Street.
When BlackRock said that the bond market was “broken” in 2014, it dominated discourse in the bond market for some time. Given Vanguard’s standing, this most recent commentary is sure to be pored over by investment banks, electronic trading specialists and bond market participants.
We’ve copied Vanguard’s recommendations in full below. Take a look:
- Limit trading fragmentation. Focusing trading on a limited number of electronic venues, or aggregating trade information, will help ensure that the diverse universe of buyers and sellers will converge and liquidity will be concentrated. In addition, reduced fragmentation likely will mean lower search costs and more intense price competition.
- Further develop all-to-all networks. As noted earlier, these networks allow direct interaction between buyers and sellers. For example, asset managers can interact directly with dealers and other asset managers with whom they may not have a direct trading relationship. The result: lower costs and additional sources of liquidity. Also, these networks enable traditional buy-side firms to participate as “price makers” (but not market makers) when in the best interest of clients. The overall market benefits when buy-side firms more regularly participate directly as buyers and sellers.
- Integrate trading and order-management systems. Electronic platforms must evolve to better integrate trading systems with buy-side order-management systems in order to increase efficiencies and reduce search costs. For example, the ability to find bonds for potential sale or purchase based on their characteristics would enable buy-side firms to more easily identify substitute securities.
- Provide greater price transparency. A greater degree of pre-trade price transparency on electronic platforms is a necessary step in the evolution of fixed income markets. Continuous price setting, similar to that experienced in the move to electronic trading in equity markets, will undoubtedly encourage participation. Not insignificantly, pre-trade security price data also support compliance with best-execution regulation — a benefit to both financial services firms and their investors. Vanguard is generally supportive of current regulatory efforts in the United States and Europe to expand post-trade reporting of secondary fixed income market transactions because of the benefits to investors.
- Protect against information leakage. Information is king, and transparency provides plenty of advantages for investors and market participants, but there can be too much of a good thing. Platforms must protect against unwanted dissemination of information from order-management systems. We must ensure that negotiations and trading activity are not unintentionally or unnecessarily shared.