“Bid 50mm of the XYZ 0.75’s of 46.”
The once-simple process of bidding a bond for the buy side is growing more complex. Basel III, MiFID II, EMIR, Dodd-Frank, the Volcker provision and a host of other regulations are adding more steps, checks and validation points to the sales-trader’s and trader’s (or simply “traders”) workflow.
In this three-part series, we will look at how the trader’s workflow is changing in response to the new and anticipated regulatory mandates. In part 2, we will discuss new quantitative approaches and technologies that institutional investors are using to practically implement the detailed requirements underpinning these new regulations. And, in part 3, we will focus on how the pre-/post-trade transparency provisions and obligations to trade on venue included in MiFID II, once implemented, will further impact trader workflow as well as the dealer’s ability to supply/provide liquidity to customers.
Regulation Is Not Necessarily Impacting Liquidity…Yet
Market makers almost always facilitate a customer inquiry with a principal price, [which was a function of – or calculated based on] a “relative” benchmark, bond structure specific and underlying credit considerations and potentially carry/financing considerations. Despite all press reports to the contrary, it appears that the new regulations have yet to change this approach to calculating a price. Economists at the Federal Reserve Bank of New York concluded that during the taper-tantrum in 2013, “dealers were less willing to employ their balance sheets as market participants reassessed fixed-income valuations and repriced interest rate risk in response to heightened uncertainty around the stance of monetary policy” rather than “regulatory constraints.”
This conclusion was again confirmed at the Bloomberg Trading Solutions Sell Side Forum in New York on February 9 when we asked an audience of fixed income sales traders, “Are you reducing your ability to supply liquidity to your customers?” The vast majority of respondents cited lack of profitability and market conditions, such as negative carry, little volatility and flow as being the culprit.
For those old enough to remember, this was a reaction/behavior similar to what happened in 1992–1994 when the Federal Reserve stayed at 3% interest rates for a prolonged period and then lifted off.
But That Will Change …
Regulation will dramatically change the trader’s approach to pricing a bond—it has to. Time, liquidity profile, cost of capital, clearing eligibility and other market conditions must begin to be factored into the bid. In the future, price will no longer simply be a function of value.
This view was also reflected at the Bloomberg Trading Solutions Sell Side Forum when participants were asked: “Has your firm integrated balance sheet/cost of capital considerations into your pricing?” 40% answered either yes or indicated that their firm was planning to incorporate them.
Regulation and Workflows: Here Comes the Boom …
We believe that currently the vast majority of market participants are in a “tween” stage in responding to the regulations. Regulatory regimes have, in most cases, established principles to comply by; these principles have been translated into corporate policies and procedures, but a wide gap remains between these high-level guidelines and the practical implementation on the front line. That gap is closing because technology and quantitative methods are emerging that will enable dealers to adopt a framework that creates an efficient, repeatable, rules-based evaluation structure. Let’s look at how that might occur with a specific focus on liquidity risk.
The first step of the new regulatory regime in regards to incoming customer request workflow has to include an assessment of the asset’s downstream impact on the firm’s balance sheet and whether the security is compliant with the firm’s regulatory obligations, i.e., how valuable is this asset to me as a dealer in this new world? The amount of individual regulatory considerations is extensive (and it is only going to get worse). For the dealer, customer facilitation will be about balance sheet allocation. There are two considerations: (1) what security “profiles” can the trader even consider; and (2) is there balance sheet available to even facilitate the trade? For example, for a trader to consider giving a price to a customer on 50MM XYZ 0.75 of ‘46’, the trader must understand the liquidity of the bond to determine if they can find an ultimate home for the bond. Now, more than ever, that means will the firm be able to find a customer and thus be able to move it off the balance sheet in a timely manner? Let’s assume for the moment that there exists a quantitative multi-factor framework to create an independent liquidity profile and score for an individual bond (Bloomberg has a solution, which we touch on in more detail in Part 2).
A practical application of such a quantitative method would be to create a scoring methodology that describes the asset and appropriately guides the trader in a consistent manner. For example, the firm could segregate assets based on the score where internal policy would dictate (or at least inform) trader bid/no-bid action. Consider the following groups/bands/categories:
- Group 1—the bond is highly liquid, has a high velocity and the size of the inquiry has a low anticipated holding (carry) period, thus giving the trader the confidence to allocate balance sheet and make a price;
- Group 2—the bond is less liquid bond, but the trader is allowed to provide a bid to facilitate a trade with a “good” customer;
- Group 3—may imply that the trader will facilitate the customer order by buying half and working the other half. This type of trading— “getting my good relationship started”—is popular in equities and may apply only to more liquid fixed income issues. This is where the regulation may change the dealer capacity (role) from principal to agency (or riskless/matched principal);
- Group 4—may imply that although the trader cannot position the asset into inventory, the firm has clients that may be interested in the asset so sales-traders will “shop” the bond; And,
- Group 5—may imply that the dealer has neither the capacity nor network of clients—so trying to find an interested counterparty would be not be an effective use of the firm’s resources.
For Groups 1, 2 and 3, the next question the trader has to ask is, “Do I have room in my inventory to position it?” In addition to other risk management provisions, some firms may decide to use the liquidity score to section their inventory into “liquidity” buckets, with each bucket containing a notional limit. If there is room in one of the “liquidity buckets” to position the asset, then the trader can set a price. Now, balance sheet “rental” needs to be and, more importantly, can be a practical consideration in addition to historically important metrics such as the relative value, financing, etc.
Be on the lookout for part 2, where Bloomberg will look more deeply into practical implementation: how quantitative innovations enable liquidity scoring and “carry-time” estimates for balance sheet cost estimation and, eventually, balance sheet optimization.
