Corporate Bonds and the ETF: Odd-Lot Arbitrage

There are three regulatory forces – TRACE, Basel III and Volcker – weakening the historical foundations of the dealer market structure, but corporate bond exchange-traded funds (ETFs) represent an even more significant driver of change. A need to translate equity-like ETF trading into bond liquidity is accelerating the adoption of new structures and technologies to trade the cash markets. RFQ and order-driven electronic networks in odd-lot markets are flourishing. Market makers are using indicative pricing and new measures of liquidity to shine a light into this once opaque market.

ETFs have ushered in an alternate source of (exchange-traded) liquidity and price information that is outside the dealer community. It opens access to the once-institutional-driven credit market and with it, the return of an active retail presence in bonds. New liquidity dynamics are emerging. Volatile fund flows lead to a concentration of activity across select, liquid issues. ETFs facilitate a structural interplay between retail and institutional flow that is driving efficiency, transparency and activity in select areas of the cash market.

Regulation is simply accelerating a re-design of today’s credit market structure. The block market has deteriorated. The need for small-size trading is driving liquidity across electronic, odd-lot size trading networks. Bond ETF creation (and redemption) is a microcosm of the market, and ETF market making fits directly into this change, helping segment the market further.

Central to the market structure debate is whether liquidity ought to be centralized or not. The long-held belief that corporate bonds can only trade over-the-counter (OTC) is a myth. Arguments against a live-price environment– that there are too many issues, that transaction flow skews one way, or that there is a lack of transparent price discovery and immediacy in execution– are being addressed. A new self-fulfilling prophecy is in motion. Liquidity begets liquidity. The nuances and subtleties of market making in corporate bond ETFs will lead toward an electronic, exchange-like market structure just at a time when regulation has broken up the old party.