Covid Re-Exposed Bond Market’s Liquidity Problems—Is Change Finally Here?

Technologically speaking, the bond markets have long lagged behind the stock markets. While equities investors have for years benefitted from new technologies like machine-learning algorithms that help them pick the best stocks, fixed-income investors still operate in a highly manual, paper-intensive world, relying on phones as a primary means to make trades, even into the new decade. 

Since the financial collapse of 2008, a great deal of time, thought, and funds have been devoted to ironing out the data quality, regulatory, and transparency issues that plague the bond market, which greatly outpaces the global equity market in size. According to the Securities Industry and Financial Markets Association (Sifma), global long-term bond market issuance increased by 19.7% to $21.0 trillion in 2019, while global equity issuance decreased by 0.9% to $540.5 billion. Despite the bond market’s colossal size advantage, it doesn’t stack up as well against the equities realm when it comes to modernity.

In a 2016 speech, former vice chairman of the Federal Reserve Stanley Fischer asked the question, “Do we have a liquidity problem post-crisis?” Following the effects of the Covid-19 pandemic that caused dysfunction in the bond market, others are still asking the same question, and whether the structural change that has been debated and lobbied for years is finally here.

“In March and April, the corporate bond market was incredibly dislocated around pricing information, and those dislocations illustrated some huge liabilities that are the result of really poor quality of data in the marketplace,” says Chris White, CEO of BondCliq. The company aims to improve bond-market data by creating an industry utility that will give investors equal access to bid, ask, and size data in the corporate bond market, and dealers a clearer view of the market by listing their pricing and quote data.

As Covid-19 infection rates climbed and cities locked down, buy-side institutions had trouble coming up with accurate portfolio valuations. In some areas, White says, the problem got so bad that certain funds closed their doors and didn’t allow investors to liquidate their assets because they couldn’t confidently calculate the funds’ values. This then played out in the corporate bond exchange-traded funds (ETFs) market, where some products were trading at prices that looked very different from the net asset values being calculated for them at end of day.

In response, the Securities and Exchange Commission (SEC) convened its asset management advisory committee, which released a set of recommendations regarding pandemic volatility and exchange-traded products, and outlining how the Commission, along with the Financial Industry Regulatory Authority (Finra), would regulate price transparency.

The guidance raises possible changes meant to enhance transparency and price discovery in fixed-income markets such as aggregating firms’ bids and offers through Finra’s Trade Reporting and Compliance Engine (Trace), evolving market standards to encourage more use of firms’ quotes, disseminating a national best bid and offer, imposing tighter reporting and public dissemination requirements for bonds. SEC guidance also raises the question of instituting a firm quote rule, which would require dealers to be able to trade at least X amount with whoever engages them.

The bond market survived the early, uncertain days of the pandemic, though one could argue that if not for the Fed’s bailout, it might not have. Almost certainly another crisis will unfold, and something will have to save the market if it doesn’t save itself first.

“The biggest shift, let’s say, that we see taking place [due to] Covid is the acceleration of this trend toward diversifying liquidity sources they have access to, and increasing the liquidity sources they have access to, and also embracing what are called the new electronic trading protocols so that they are well-equipped to trade under all market conditions,” says Constantinos Antoniades, Liquidnet’s head of fixed income. Examples of electronic protocols are requests for quotes (RFQs), or all-to-all, in which buyers can anonymously post orders to the entire market.

Antoniades makes a slight distinction in where the liquidity problem arose this spring. He says that liquidity, in an absolute sense, was never in peril—evidenced by Liquidnet doubling its liquidity and volumes in the first and second quarters of 2020—but liquidity quality plummeted specifically within RFQs. However, RFQs constitute the most common electronic protocol used in bond trading.

“Historically, when market conditions are easy, they are in what is called peacetime. Asset managers don’t have urgent flows, and their flows are small, [so] RFQ works very well. But if you go into a set of market conditions that are more stressful, more volatile, with flows becoming bigger, the RFQ protocol is not sufficient to channel those orders,” Antoniades says.

A second major issue that remains is pre-trade transparency. It varies by location, and different clients have different pre-trade views of the market. On the positive side, Antoniades says, commercial initiatives, as opposed to regulatory ones, have made headway in improving the quality of data aggregation, but they may need more time to bloom than regulators allow.

One issue that could stem from the SEC’s recommendations, says White, is that if dealers feel like everything they bid or offer is going to be publicly reported to Finra, they’ll stop bidding and offering on many bonds. In other words, releasing all of their pre-trade activity into the public with no control over how that information is displayed, managed, and shared, is a turn-off. Secondly, a firm quote rule would effectively limit dealers’ control over who can access their liquidity in the credit markets, where differentiating customers is a large part of dealers’ strategies.

“You don’t have a say—that’s the whole thing. We’re saying, the marketplace, ‘Let’s work on this together,’” White says. “As a private initiative creating public transparency, that’s much more palatable now when you look at what could possibly happen with regulated transparency.”

There is no consensus on whether mandated or market-led solutions are better for the industry. Kevin McPartland, head of market structure and technology research at Greenwich Associates, tends to side with the latter, but says the solutions should have strong oversight.

The SEC’s recommendations, if imposed, would constitute a very large change in market structure. “I suspect we would really need to see more evidence that the structure as it works today is not functioning and needs that level of shake-up. And I’m not sure we saw that,” McPartland says.