Evolution, Revolutions, and Obligated Liquidity

Regulatory 05 Sep 2012

Though most of the world (even, I suspect, a large part of the trading-savvy world) likely sees the discussion of the mechanics of the trading of corporate bonds as a somewhat wonky pastime, Anthony J. Perrotta Jr. infuses some drama into it in a recent essay in TabbForum, invoking Charles Darwin, the American rebellion against George III, and other exciting topics for conversation.

The gist of the story he wants to tell, though, is this: in the 1990s, some market participants tried to introduce a an exchange-like model for (anonymous) trading in the corporate debt market.  Perrotta, the former head of credit derivatives in the U.S. at Tradeweb, calls them “pioneers” on a “visionary quest.” Trading Edge created its BondLink at this time. But Trading Edge’s principals and others with similar ideas weren’t really proposing anything that fit a need. The older, more personal, phone-call based model was working; simulating a central limit order book didn’t increase profitability, so there was no catalyst.

Indeed, early in 2002 Trading Link as an independent entity disappeared, swallowed by Market Axess.

More Incremental Change

By 2002, a more incremental change seemed plausible. A more tempered group of visionaries focused on moving corporate debt trading away from the telephones onto screens. This electronic request-for-quote model kept the decentralized market structure, while introducing efficiencies and lowering execution costs.  This time there was a catalyst, the growth of the credit market, which “made the execution process increasingly taxing on human resources.”

The RFQ model, a click-to-trade billboard system, itself became the primary driver of the growing trading volumes over the next ten years, right through the crisis of 2008.  Perrotta rather puckishly associates this with Charles Darwin, contrasting evolution with revolution, visionary re-makings with incremental adaptations.

The crisis of 2008 inspired its own adaptations. Dealers had to reduce the amount of “obligated liquidity,” that is, the supply of bids/offers they had on demand for their most coveted clients. In a related development, the clients had to expand their lists of preferred counterparties from a dozen or less up to or beyond 100 to be confident they had gotten the right price.

Here is where the RFQ proved its mettle. This would have been tricky to arrange through telephone calls, but the RFQ “enabled clients to easily search multiple counterparties in a quick, orderly fashion.”

Although in time the market put the worst of the crisis behind it, the wider circles of counterparties remained. Those clients had felt abandoned by their dealers over that reduction of obligated liquidity, and didn’t want to return to dependence. This created a new level of contentiousness among participants, and over the intervening years the RFQ model itself has come to seem “fatigued.” The feeling has grown that it is time for another adaptation. Meanwhile, “anecdotal evidence indicates response rates are at all-time lows.”

Paths From Here

Here is where we get to the nub of Perrotta’s thesis: there are two very different paths forward. An ominous conjunction of regulatory influences, from Washington and from Basel, seems to be pushing for something like a CLOB. He is not very explicit about this point in the TABB piece, but in an email exchange Perrotta elaborated for me.

“The Volcker Rule,” he said, “is the most important aspect of regulatory change because it may ultimately change the manner in which banks can position risk.”

Also, at least part of what is on his mind is the controversy over the meaning of the Dodd-Frank Act’s use of the phrase “available to trade,” authorizing regulators to press trading into designated contract markets and swap execution facilities. In our exchange, Perrotta said that for cash corporate, “available to trade” doesn’t describe a facility, but is simply a definition of liquidity.

The point, though, is that any LOB in this market will be a limited method of execution, and a CLOB, which was an illogical discontinuous leap in the 1990s and would still be an illogical leap today, doesn’t address the actual difficulties of RFQ at all.

Rather, he suggests, the creative minds of the industry can and should produce another “evolutionary upgrade.”

As is often the case, the Comments that this analysis has elicited are as much worth a read as the analysis itself. George Bollenbacher opined that whether the corporate bond market has the right structure may not be “the most important question.” A better question might be “what is the economically efficient amount of liquidity.” That sounds less than dramatic, but about right.

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