Real-Time Corporate Bond Prices: Panacea, or Pipedream?

The structure of the secondary corporate bond market needs to evolve so that buy side liquidity concerns are addressed. The old way of principal-based dealer liquidity simply cannot economically support the needs of a diverse marketplace. Balance sheet pressures are turning them into agents, even as margins compress. More efficient mechanisms of price discovery for a bond at a particular size are required to replace the traditional process of phone-based quoting.

The challenge is finding a market structure that can both balance competitive drive for flow, and let traders generate real-time prices for bond trades. Liquidity is too fragmented for an order-driven exchange for most bonds. Electronic request-for-quote (RFQ) protocols do not replace the nuanced negotiation needed to make a price without natural liquidity. Single-dealer platforms struggle to thrive in an environment of fragmented liquidity. The natural liquidity of buy side crossing networks cannot function without dealer price discovery.

Nevertheless, electronic trading is taking hold in the corporate bond markets, notably in the micro and odd-lot size marketplaces. Here, we have forms of electronic price discovery that can lead to flow and volume without the intermediation of a salesperson. Liquidity needs to be aggregated in order to build a consolidated marketplace across competiting networks. There needs to be electronic mechanisms for traders to source inventory via a targeted group of counterparties. The buy side will need protocols to communicate and negotitate bid/offers so that they may price a trade efficiently and independently.

For innovators looking to shape the market, it is important to understand the value of dealer prices. Dealers utilize relationship networks, place targeted calls, negotiate trades over the phone, clear trades using principal – all of which goes into pricing and executing a trade. The process by which dealers make a price on a bond must be translated into a new structure. New protocols are needed that allow the buy side trader to selectively target a network, communicate interest on a bond, and negotiate the bid/offer for the trade, while leveraging an intermediary to clear the trade. In areas of the markets, where dealers can no longer price a bond and source the liquidity directly, the buy side trader will need the tools to enable him to take more control over the execution process.

The stakes have never been higher. Secondary market liquidity is at its lowest point in recent memory. It is so bad that some traders at small funds now use exchange traded funds (ETFs) as vehicles to access exposure. Everyone knows the problem but no one has a solution. But while there may be obstacles and challenges to overcome, once breached, the process of transformation will happen faster than you imagine. Remember how quickly equity trading moved from the floor to all-electronic exchanges?

TABB Group Vision Note “Real-Time Corporate Bond Prices: Panacea or Pipedream?” is based on in-depth conversations with key participants in the corporate bond market, including brokers, dealers, exchanges, ATSs, hedge funds, asset managers, connectivity providers, and data providers. The study provides an in-depth assessment important structural developments of the corporate bond market as it evolves away from a principal based dealer liquidity model.