A misconception has permeated the corporate bond and other fixed-income markets. It’s the idea that technology can solve the liquidity problem for institutional investor.
Ever since the 2008 financial crisis, scores of companies have developed electronic trading platforms, each touted as the better mousetrap that will entice the buy side to come with their trades.
The dirty little secret is that no amount of technology can solve this particular problem. Technology is wonderful for aggregating and re-allocating existing liquidity in the market, but it cannot conjure trade counterparties for illiquid CUSIPs out of thin air.
Thanks to the Dodd-Frank Act and Basel II’s capital requirements, dealers are no longer warehousing illiquid issues on their balance sheets. Over the past eight years, that inventory has migrated on to the buy side’s balance sheets, which means most of the secondary market will eventually boil down to buy-side-to-buy-side transactions.
Many of the trades will have dealer acting as intermediaries, but not using their balance sheets to the to complete the trades.
There have been attempts to create buy-side-to-buy-side trading platforms, such as BlackRock’s Aladdin platform. Although their business model sounds good on paper, they never really seem to attract the liquidity levels of more established dealer-to-client or dealer-to-dealer counterparts.
This is because buy-side traders are deathly afraid of being price makers. The governance committees have them too well trained to find the best price from three or more dealers or relying on third-party pricing vendors for a reference price.
This needs to change and it needs to change quickly. Like it or not, the buy side is the new warehouser of liquidity and along with that comes the role of price maker.
It makes no sense to rely on dealers for a reference price, if dealers do not have a full picture of available liquidity on which to base their prices.
The buy side want to keep doing business as usual, but it’s going to be a recipe for disaster when the prices being used do not reflect the true nature of the market.
Either buy-side firms need to convince their governance committees that the firms have a better sense of the liquidity situation than their dealer so they should be allowed to make prices or the market should belt in and prepare for a bumpy ride.
