Some Advice For Would-Be Corporate Bond Market Structure Reformers
The alarms are once again sounding for corporate bond market reform. Blackrock published a note this week warning that the corporate bond market is “broken” and stated:
“We believe that the secondary trading environment for corporate bonds today is broken, and the extent of the breakage is masked by the current environment of low interest rates and low volatility, coupled with the positive impact of QE on credit markets. Market regulators are right to call for change now, while the benign state still exists. “
Blackrock is concerned that new bank regulations such as the Volcker Rule have gutted out the traditional middleman model where dealers would hold inventory and would act as a liquidity buffer in times of stress. Their concerns were also echoed by a recent speech by SEC Commissioner Dan Gallagher:
“There is significant risk that when the Fed starts to hike interest rates, outflows from high yielding and less liquid debt potentially could lead to a free fall in prices. We can address liquidity risks by facilitating electronic dealer-to-dealer and on-exchange transactions of these products. The exchanges and dealer community also need to participate in this discussion by providing “in the weeds” input on what rule changes may be needed to facilitate electronic debt market trading.”
While we at Themis Trading do not trade corporate bonds for our clients, we do think we know a little about “broken markets” and electronic stock trading. And for that reason, we would like to issue a few warnings to all the potential bond market reformers.
1- Beware of excessive venue fragmentation:
Back in the mid-90’s, the SEC started the process of breaking up the exchange duopoly with a series of regulations. Reformers called for more competition between exchanges and claimed this would force more innovation while lowering costs. While electronic trading did bring down costs, the competition that reformers wanted actually resulted in fragmentation. (multiple venues trading the same product with only minor speed and price differences). This fragmentation resulted in the shattering of liquidity into small pieces that needed to be glued back together. The result was the rise of high frequency trading.
2- Maintain a minimum spread:
While decimalization was a good idea, not maintaining a minimum spread destroyed the economics of traditional market makers forcing them to exit the business. These market makers were replaced by proprietary traders that do not have an obligation to maintain an orderly market.
3- Watch out for those nasty latency issues:
Venue fragmentation caused new arbitrage opportunities to form that were not based on the fundamentals of the security. Exchanges realized that there was actually more money to be made in selling their data through data feeds and proximity services like colocation. Trading strategies were developed just to take advantage of the timing difference between venues.
4- Be wary of payment for order flow:
The “competition” that the regulators wanted did indeed form. But venues could not figure a way to distinguish themselves since they were basically all very similar. The notion of “rebates” was created by a firm which was formerly a SOES-bandit. Rebates have distorted true price discovery and have helped create new trading strategies that have nothing to do with company fundamentals.
5- Be afraid of the dark:
While dark pools were initially designed to cross large blocks of stock between institutional investors, many have since morphed into broker-owned ping destinations with average trade size of less than 200 shares where predators lie in wait looking to pick off real order flow.
All of these issues (and more) are likely to come up if bond market reformers start to gain traction. We think it would be wise for would-be reformers to consult with a group of stock market professionals who can warn them of these upcoming issues and can hopefully prevent some of the same problems from surfacing.