Inside Market Data Web Seminar: Credit Appetites Return, Driving Consistency, Automation

After lean years for the fixed-income markets since the 2008 credit crunch and an ensuing flight to safety of government debt, trading firms and institutional investors are starting to dip their toes into the credit markets once again with renewed optimism, leading to renewed demand for fixed-income market data.

Despite ongoing economic uncertainty, market participants are predicting renewed interest in corporate debt and credit derivatives in 2011, along with a continued drive towards standardization and electronic execution venues, and demand for data across the board, along with the need to understand each dataset and to incorporate it with others to achieve consistent valuations and to analyze trading and risk, according to panelists and audience polls during a recent webinar hosted by Inside Market Data.

Trading volumes in some fixed-income asset classes has returned to pre-credit crunch levels, according to the Securities Industry and Financial Markets Association, with Treasury bonds and corporate debt starting 2011 higher than pre-crisis levels, while volume continues to fluctuate in agency bonds, and trading in municipal bonds is not only at half of pre-crisis levels, but is actually down more than 10 percent on last year.

However, despite current geo-political events and natural disasters, the markets are experiencing a return to stability overall, allowing corporations to use any cash on their balance sheets to invest and re-tool, according to Ed Ventura, president of consultancy Ventura Management Associates. Along with Ventura, Stuart Grant, financial services business development manager at Sybase, attributed this in part to a shift in recent years from quantitative to fundamental-based research and analysis, and firms breaking down internal data silos between different businesses to ensure firm-wide consistent data for reliable evaluations.

“Over the past year, the need for data has increased throughout organizations,” said Frank Dos Santos, vice president of global evaluations at Standard & Poor’s. “There is a need internally to understand the assets held in inventory on firms’ balance sheets, and… what would affect valuations of those assets, and events that occur in the marketplace, such as the recent earthquake in Japan. One thing that the credit crisis brought out was that there wasn’t a keen understanding of what made up specific securitizations or the mortgages that comprised them. So now understanding where a loan was made, the structure backing that loan, how it has performed over the history of the loan or the securitization—all of that has become much more of a need.”

This stability is driving firms to renew their interest in corporate debt, with 33 percent of firms expecting to trade more corporate bonds this year, compared to 10 percent in 2010, according to an audience poll during the webinar [see Fig. 2]. It is also driving renewed interest in credit derivatives, with 12.5 percent of firms expecting to trade more instruments such as credit default swaps and collateralized debt obligations in 2011, whereas no respondents anticipated trading more credit derivatives when polled during the same webinar last year—while those planning to reduce their credit derivative trading halved from 50 percent to 26.8 percent this year.

A major contributor towards the areas of increase is relatively conservative valuations of new debt, meaning “there is cheap debt out there… and there are deals to be done,” requiring a corresponding increase in data to support this trading, Grant said.

These gains appear to be at the expense of government, agency and municipal bonds, where the number of firms planning to trade more fell from 55 to 25 percent this year, and just over a quarter of firms polled said they would trade less of these assets during 2011—compared to none expecting to decrease trading in this area last year [see Fig. 3]—as firms feel more comfortable exiting the safe haven of Treasury bonds for more profitable assets, while credit issues are making municipal bonds less attractive.

“When you look at the overall economic conditions, particularly in the US, local governments, municipalities and the like are struggling with budgetary concerns, and a good number of municipalities may be looking at default, so I think you’ve seen their credit ratings going down quite a bit, which may or may not impact the trading of those instruments,” Ventura said. “But a lot of money still seems to be parked in the safe haven of Treasuries, so there is still some uncertainty out there.”

This “wait-and-see” attitude is clearly impacting institutional demand for municipal issues, but the underlying uncertainty is prompting firms to be more critical of the data they receive, said Kerry White, managing director of asset servicing at Bank of New York Mellon. “Today, when we are challenged by our clients over fair value of a valuation, it is because they also need to certify that it is a fair value, and they ask many more questions—they don’t just want to understand the ingredients of a price; they also want to understand the recipe. And when you look at things like algorithmic models … they want to understand more about how a price was derived,” she said.

The Automation Agenda
However, firms aren’t just using algorithms for modeling prices for new asset classes—some are also beginning to use algorithmic trading models to execute trades in some fixed-income classes, according to Grant. “Over the past 12 months, we’ve seen organizations starting to move into investing in new product creation—and more complex product creation—but also in the development of algorithmic trading models for fixed income. And this is an area that is obviously changing the way firms traditionally operate significantly,” he said. “Some organizations are trying to leverage their algo capabilities from other asset classes and use those as a starting point, but often find those aren’t suitable, as fixed-income asset classes are too complex to be modeled in the same way.”

Although Grant acknowledges that algo trading in fixed income is “embryonic at best,” one factor that could contribute to increased takeup would be a migration from over-the-counter broker platforms and traditional voice brokerage to broader, exchange-style trading venues—a trend that is already well-established among the more liquid asset classes, and which is also underway in the credit derivative market with regulatory initiatives to de-risk swaps trading by moving it to centrally-cleared Swap Execution Facilities, if not directly onto exchanges.

A sustained migration to electronic execution venues is already underway, with major shifts even since last year’s webinar. According to the results of an audience poll, 14 percent of respondents now conduct their fixed-income trading exclusively on electronic, exchange-style platforms, compared to just over 8 percent last year, while those using a mix of exchange-style and single-dealer broker platforms doubled from a similar level last year to nearly 18 percent of respondents this year. While those using an equal, broad mix of execution venues remained similar to last year, at 38 percent of respondents, the numbers mostly using OTC broker platforms and voice brokerage decreased from 42 percent in 2010 to 23.5 percent this year, reflecting a move towards broad electronic trading venues [see Fig. 4].

However, while there are benefits of moving to open marketplaces, there are also challenges around the standardization required for electronic trading.

“In terms of moving to a more centrally-cleared model, I would expect more consistency from a pricing perspective…. And clearly it would give clients a lot more insight into who—and of what quality—their counterparties are,” White said, while Ventura also noted that trading instruments on exchanges or exchange-style platforms requires consistency around terminology and definitions of the instruments traded. 

“The instruments that can be traded on an [exchange-style] marketplace are those that are readily definable. A lot of what these responses show is a big move towards the corporate market, and in the corporate market you have the TRACE reporting feed, which is available to institutions and individuals, giving some sort of transparency into the level and size of trades in the corporate market—and I think that is a factor in everybody looking to the corporate market right now, since it is easily identifiable and exchange-like,” Dos Santos said.

Drivers of Demand
Another challenge to the adoption of algo trading of fixed income instruments is that—just as firms experienced issues in the past stemming from incomplete underlying terms and conditions data—even for the most liquid types of bonds, “the amount and frequency of historical data available… doesn’t provide strong trend information on which algos can be based,” making it harder to predict the outcome of events affecting the bond markets than in equities or foreign exchange, Grant said.

Perhaps reflecting the infancy of this area, the largest rise in the type of dataset considered most important by the audience was for reliable evaluated prices on illiquid instruments, which doubled from just over 17 percent of respondents in 2010 to nearly 35 percent this year, though real-time prices for liquid assets, along with credit ratings and fixed-income research, also grew in importance [see Fig. 5].

The panel suggested that while the appetite for more data may be there, with budgets still under scrutiny, firms may not necessarily have the resources in-house to achieve their aims, prompting them to work more closely with data providers.

“The major events that occurred in the marketplace—particularly the credit crisis—have driven more people to look externally for independent valuations. Meanwhile, the evolution of accounting standards—particularly their emphasis on independent checks and validation—has also driven people to third parties,” said Dos Santos, adding that some of Standard & Poor’s clients don’t have the ability to perform the loan-level analysis required to understand valuations of CDOs or commercial mortgage-backed securities.

Grant also highlighted budgetary issues as hindering broader data usage—especially in the importance of underlying credit curve data, which more than halved from 23 percent to just over 10 percent this year. “Lots of organizations that we work with are struggling to maintain a historical view of curve data, and it’s too expensive for them to regenerate those curves at some point in future if they need them, so they are willing to work with simplified curve data or third-party curve data,” he said.

Reference data also fell in importance over last year, according to the audience, though Ventura said it will continue to be a critical factor, especially when creating new, complex instruments. “Reference data comes down to the ‘Five Cs’: coverage, consistency, is it compliant, is it complete, and what is the cost—not just of having the data, but also of not having the data,” he said.

But overall, the changes in trading patterns will have positive impacts on data consumption—though it may also create technical challenges around sourcing and reacting to data, Grant said, predicting an increase in the volume of data sources, a need to capture new sources of information, and issues for some firms to gain access to enough sources of information.

“Part of the complexity that we’re seeing is that people are changing the patterns of the data they consume on a day-to-day basis,” he said. “And as organizations move their capital allocations around more rapidly than in the past, based on the markets and their appetites, the ability for their development environment to keep up will be absolutely crucial to success. We may even get to a point where we start to see intra-day changes in investment allocation decisions—which may require on-boarding a new source of data, or increasing the velocity of existing information—and this is where firms are going to hit problems.”

“Clearly, demand is changing. But—especially for evaluated prices—there is greater confidence on the part of investors in vendors and the reliability of their pricing. And to the need for independence, it is becoming more apparent that there is a risk on the part of clients to maintain these curves themselves,” White said.

In summary, Dos Santos said, “Transparency is the number one theme, and I think more market data will become more available to the marketplace,” with other panelists agreeing that increased availability of data—and the ability to harmonize and integrate data to provide consistent pricing, evaluations and risk analysis—will be key factors in ensuring the fixed income markets’ return to health and stability.