Gone today, find another way

Regulation has combined with macroeconomic uncertainty to reduce liquidity in emerging market sovereign bonds, but this is fuelling a more proactive approach to order management on many trading desks.

Of all the varied consequences of the post-crisis financial reform programme for financing and trading, from rising costs to increasing complexity of market structure, it is the changing nature of liquidity that most often tops the agenda. Increasingly frequent instances of gaps in liquidity have spooked some policymakers, highlighting the impact of the constraints that have been placed on traditional market-making.

This decline in liquidity has become evident across a number of financial markets, but it has been particularly noticeable in emerging markets, where the structural effects of regulation have combined with macroeconomic uncertainty. As banks have scaled back the provision of liquidity, there has been increased selling pressure on many EM assets, creating a challenging environment for investors.

“We have seen times over the past year when liquidity has been particularly poor, driven mainly by negative investor sentiment and one-sided selling pressure. It does create a somewhat dysfunctional market when there are no market-makers willing to absorb short-term volatility,” said Soumyanshu Bhattacharya, institutional portfolio manager in the emerging markets sovereign team at BlueBay Asset Management.

Illiquidity can mean different things to different participants, but simply put it refers to a situation where it becomes harder, or even impossible, to buy or sell an asset at a reasonable price. A liquid market therefore depends not just on consistently high trading volume, but also on tight and reliable pricing. And just because a market has high turnover, it does not necessarily have deep liquidity.

Ironically, EM bond issuance has grown significantly since the financial crisis. The total EM debt universe surpassed US$13.5trn in 2014, up from just US$6.5trn in 2007, according to a recent report by the Institute of International Finance.

However, secondary market liquidity has failed to keep pace with bond issuance since the “taper tantrum” in 2013, when the US Federal Reserve’s decision to cease quantitative easing fuelled a dramatic sell-off in emerging markets. Fast-forward to 2015, and the expectation of an imminent rate rise in the US could have a similar effect.

“Emerging markets are particularly susceptible to illiquidity because everyone is sensitive to the Fed hiking interest rates and the knock-on effect that may have in shifting money back to the US market, especially in the sovereign space,” said Lee Sanders, head of FX and money markets execution and UK and Asia fixed-income trading at AXA Investment Managers.

Available data on EM liquidity already show some cause for concern. In hard currency sovereign bonds, turnover ratios – represented as quarterly trading volumes over outstanding bonds – have more than halved since the crisis, according to the IIF. Brazil and Hong Kong have been among the worst hit markets for sovereign bonds, while corporate bonds have suffered badly in China, Brazil and Mexico.

A drop in liquidity may not always be obvious to all participants, particularly when transaction volume remains robust. But it is felt acutely at the level of the buyside trading desk, where orders coming in from portfolio managers often cannot be executed with the same level of efficiency and speed as in the past.

AXA, for example, keeps constant tabs on the proportion of orders that are completed on an intraday basis, and has found that EM now performs significantly worse than rates and credit.

“For the nearly 10% of EM orders that we can’t complete intraday, that is invariably due to poor liquidity and having to work part of the order over a longer period of time. We see illiquidity in both wider bid-ask spreads, as banks have to charge more to take down risk, and also, in some cases, a complete lack of market-making,” said Sanders.

It’s the regulation…

Of the many factors that can influence liquidity, it is the capacity of banks to provide pricing and make markets that appears to have changed most significantly. In the years since the crisis, banks have faced a barrage of new rules and constraints that have quite simply slashed their ability to hold risk on their balance sheets.

From the Dodd-Frank Act’s ban on proprietary trading to the Basel III package of rules on capital, leverage and liquidity, the cumulative impact of these regulations has forced banks to either retreat from market-making altogether, or to opt for an agency style of trading whereby they act broadly as intermediaries rather than principal risk takers.

“The change in liquidity leads to greater volatility because banks can no longer take large positions on their own books and work them for a period of time. With no cushion provided by market-makers and an increasingly one-way market, asset prices are prone to much sharper movements than in the past,” said Shankar Narayanaswamy, head of credit strategy and financials research at Standard Chartered.

…and the dynamics

But it is not just regulation that is adversely affecting liquidity in emerging markets. The dynamics of the investor community are also shifting, according to Narayanaswamy.

“The industry is becoming more dominated by real-money investors rather than hedge funds and trading desks, and they tend to buy and hold rather than trade actively, which reduces liquidity,” he said.

“Reduced liquidity is not unique to the bond markets, but the problem is more acute in the EM bond space, because the proportion of buy-and-hold investors in EM bonds is higher and credit risk and liquidity risk are also higher, making it more expensive to provide liquidity,” said Narayanaswamy.

Confronting the challenge

Among the more influential market participants to have publicly confronted the liquidity challenge in recent months is BlackRock, the world’s largest asset manager. In a July 2015 paper, BlackRock argued that the dialogue now needs to shift from the problem to the solution, and asset managers must evolve their trading, portfolio construction and risk management appropriately to meet the changes in market liquidity.

BlackRock itself, the paper said, has made significant changes to its fixed-income trading practices and will now act as a price maker as well as a price taker if it is beneficial to liquidity.

“The industry is becoming more dominated by real-money investors rather than hedge funds and trading desks, and they tend to buy and hold rather than trade actively, which reduces liquidity”

That doesn’t mean the firm has become a market-maker, but rather that it will determine the price it is willing to pay for a bond and then actively seek it out, rather than simply requesting quotes and taking the best price it can find from a dealer.

“Adapting behaviour from a price taker to a price maker has required supplementing our fixed-income trading capabilities with new skill sets and analytical tools,” wrote BlackRock in the paper. “When asset managers become price makers, they contribute to price discovery and create an additional source of liquidity, which enhances market structure for everyone.”

Similar changes are beginning to take root across the buyside as portfolio managers and trading desks deal with reduced liquidity and accept that it is unlikely to be short-lived. While not all firms have transitioned as explicitly as BlackRock from price taking to price making, many have started to take a much more active approach to sourcing liquidity.

For AXA, that means building a global trading network and being more discerning in its choice of counterparty.

“We need to work our orders much more closely with the market, using counterparties on the ground in Asian and US timezones, because we can no longer rely on the large global banks to take down all of the risk for us; we need to source local demand as well. By using local liquidity providers in niche markets, we often do better on price than if we use global counterparties,” said Sanders.

Keeping a close watch on the liquidity of the investment portfolio is also critical, added BlueBay’s Bhattacharya. “We are very consciously monitoring and managing the proportion of illiquid names in our portfolio and we have a scorecard where traders constantly update the liquidity of the securities they trade – that has been a deliberate focus in our portfolio construction process in recent years,” he said.

An uptick in electronic trading is also on the cards, as fixed-income platforms allow trading desks to more easily sift prices from the sell side and gauge the depth of liquidity across the market. Further, intuitive use of technology can sometimes allow buyside firms to connect with one another to find the other side of a trade without recourse to the sell side.

“There is an increasing preference for screen-based trading, especially for smaller tickets, because both sides can see multiple prices on-screen and reduce cost. Some large buyside firms are also getting together to create dark pools where they can clear bonds themselves without having to use an intermediary,” said Standard Chartered’s Narayanaswamy.

All of this adds up to an environment in which market conventions and trading practices are evolving rapidly as market conditions change. While the reduction in liquidity is often seen as a negative consequence of regulation, it is clearly creating a more proactive mentality on many trading desks.

“Illiquidity isn’t a vacuum on prices; it just means we have to work a lot harder to close deals and get the best price for our fund managers. Younger traders are learning a lot in this environment because it is making them more agile and thoughtful about where and how they execute trades, and we rely very heavily on analytics to show where we can get best execution,” said Sanders.