If A Tree Falls In The Forest

chris-white

By Chris White, CEO, ViableMkts.

Illuminating the true costs of corporate bond electronic trading requires expanding the criteria for evaluating platforms.

In the not so distant past, there was a lively debate regarding the usefulness of electronic trading in the corporate bond market. Gradually, as key developments like the introduction of List RFQs (request for quotes) by MarketAxess illustrated the potential market-wide benefits of electronic trading, the tectonic plates that upheld the traditional concept of corporate bond trading shifted. Currently, electronic corporate bond trading has not only evolved to become an essential component for secondary trading, eTrading is considered by many to be the panacea for resolving the perceived corporate bond liquidity crisis.

The $64,000 Question (needs adjustment for inflation)
The value proposition for corporate bond electronic trading has been most compelling for large, buy-side institutions. Therefore, it is no surprise that increasing eTrading adoption is a priority for many major asset managers. However, at the core of this strategy is a lingering question that grows more important with each year that electronic trading becomes more established:

What does it cost to trade corporate bonds electronically?
It is very surprising that as buy-side institutions laud corporate bond electronic trading, very few fixed income asset managers know the true details of their transaction costs. In other modernized markets like equities, asset managers must be intimately aware of transaction cost details for electronic trading for two crucial reasons: 1) Electronic transaction fees can have a material impact on fund performance 2) Finding the best possible price for electronic trading is a part of the “reasonable diligence” mandated by FINRA’s best execution requirements

For buy-side institutions to properly incorporate electronic trading into their long-term strategy for corporate bond trading, the current blind spot regarding the true costs of electronic trading must be resolved.

More electronic trading volume, more problems
On today’s most dominant corporate bond RFQ platform, the original cost model was simple. Dealers paid a subscription fee to have access to buy-side client inquiry, plus a per-trade transaction cost whenever their response to an RFQ resulted in a trade. Buy-side clients were only charged a very small subscription fee (normally waived if they performed a minimum volume of trades per month) and were charged nothing for sending and trading RFQs.

All was well in the early days, but as platform activity grew, a flaw in the pricing structure became obvious.

The more corporate bond dealers embraced electronic trading by responding to, and winning, buy-side RFQs, the more it cost them. Something had to be done to share the RFQ cost burden between dealers and buy-side institutions or the momentum in electronic trading would have come to a halt.
It’s so hard to say goodbye to yesterday Creating a model that shifted some of the RFQ trading costs to the buy-side was no small feat. Under the previous cost structure, buy-side institutions were absolved of any material fees, so naturally, there was tremendous push back to the concept of a buy-side transaction fee.

The second challenge was logistical. If an explicit buy-side transaction fee were to be charged on every electronic corporate bond trade, the executing asset manager would have to the transaction fee to the accounts they represent. It is common for a medium to large sized asset manager to represent 100s or even 1000s of sub accounts, which makes properly coordinating bond allocations a Herculean task. Adding more complexity to the account management process by including transaction cost allocations was (and remains) a non-starter for large buy-side institutions.

Ultimately, the solution that resolved the obstacles facing a buy-side corporate bond transaction fee is the current source of opacity in today’s market.

am_1q1_2017Hear No Transaction Costs, Speak No Transaction Costs, See No Transaction Costs
The solution was simple, but brilliant. Embed a transaction fee in the RFQ workflow, never make the cost visible to the buy-side client and collect the transaction fee from the dealer. Wait….what?

If a trade occurs without a visible fee, was it free?
Under the then new and now current corporate bond RFQ pricing model, two very interesting paradoxical questions arise:

1) Is this “price adjustment” a transaction fee or not?
2) Are buy-side clients paying?

Before we answer the first question, let’s first review the definition for transaction fee:

“A charge an intermediary, such as a broker-dealer or bank, assesses for assisting in the sale or purchase of a security”

In the example provided, the platform assisted in the sale of the WMT bonds. As compensation for this service, the bid for the buy-side client’s bonds is adjusted lower than the intended bid of $102.35, with the platform realizing the difference between the intended bid and traded bid ($102.35 – 102.25 = $.10 paid to the platform). This is most definitely a transaction fee. The buy-side not seeing the cost doesn’t change that.

As for the second question, from the perspective of the buy-side, the price adjustment inhibits their ability to trade against a more favourable price. This means the buy-side institution and all the clients they represent ARE paying to trade corporate bond RFQs, even if they don’t sign a check against a physical invoice.

Proponents of corporate bond electronic trading will tell you that there is “Growing evidence of the cost savings that can be achieved on electronic platforms may also be helping to align buy-side liquidity provision with Finra best execution requirements”.

This is based on a theory that simply building a network through electronic trading and expanding the network through broader adoption and open protocols realizes the best possible price. To a point, yes, having more participants responding to an RFQ can help improve pricing, but there is a saturation point where the cost benefit of more participants is de minimis when compared to a material reduction in the platform transaction fees.

The path towards achieving best-execution in corporate bond electronic trading starts with expanding the criteria for evaluating platforms. Strictly measuring the soundness of a platform based on the number of dealers and average daily volume is woefully incomplete.

Platform transaction fees, actively traded Cusips and quality of dealer participants are just a few of the areas that need to be included in the evaluation process. If done properly, any buy-side institution will be able to avoid significant waste and optimize their performance by finding the most appropriate electronic trading environment for their order flow.

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