Quarterly Retail Par Volume US$ (000s)
Source: TABB Group, TRACE Fact Book
The challenge in these environments has been discovering depth of book and tight two-way quotes across a broad range of CUSIPS. It has been hard to establish limit order books for bonds. Equity and bond market characteristics are just different. In contrast to the equity market, bond issuance is fragmented. There is little to no standardization across the large number of corporate bond CUSIPs, which are collectively diverse in tenor and features. Unique nuances of bond markets prevent liquidity from being easily centralized. The relationship between the sell side and the buy side has also been institutionalized and culturally ingrained over time in an over-the-counter (OTC) environment. About 400 corporate bonds are listed on the New York Stock Exchange's bond market, but trading is very light.
As a result, retail click-to-trade environments are an attractive alternative for an institution wanting to execute a small order. Retail investors are not subject to the same portfolio allocation needs as institutional investors, they do not feel obliged to follow on-the-run trade lifecycles (since liquidity can be found for off-the-runs in small size). In other words, it is easier to establish two-way markets in the retail marketplace than in institutional markets.
Click-to-trade retail markets like BondDesk provide immediacy of execution and, in a certain universe of CUSIPS, the same level of liquidity as an electronic limit order book. According to our analysis, BondDesk currently displays two sided live markets on 5,121 CUSIPS that have offering lots between $100M and $500M. Seventy-seven percent are investment grade (IG) bonds, and 23% are high yield (HY) bonds. Average trade size quotes are $230,000 for IG bonds, and roughly $210,000 for HY bonds. On average about three dealers are making prices in these CUSIPS, with as many as nineteen dealers quoting in some instances. When we looked at the spreads on these CUSIPS we found 1,321 with a bid-ask spread of less than 10 basis points. More than a hundred buy-side institutions are now active on the platform, up from 84 the previous year.
The transition from voice to electronic is changing the nature of the corporate market. As the principal model wanes, more business is being conducted on an agency basis. The advent of electronic venues and reduction in dealer inventory allow more customer-to-customer trading to occur in addition ticket sizes are falling and the universe of customers is expanding. As TABB Group discusses in our report, “US Fixed Income Market: State of the Industry 2012,” customer-to-customer trades on an agency basis have increased as the principal model faces pressure. Meanwhile, trade sizes have fallen by nearly 37% since 2007.
The question on everyone’s lips is whether the corporate bond market might go the same way as equities, which, propelled by Reg NMS, embarked on a journey of ticket size reduction, bid/ask spread compression, and explosive volume growth. Are Basel III and the Volcker Rule the equivalent of Reg NMS for bonds? In our report, “Corporate Bond Market Transformation: Dealers, Platforms, Investors,” for which we spoke to 24 firms, three-quarters of dealers agree that there will be more electronic trading in corporate bonds in the future and that the two main consequences of this will be tighter bid/ask spreads and smaller ticket sizes. Forty percent of the firms we spoke to say they have seen ticket sizes shrink in the past six months, some by as much as 25%, because of liquidity challenges in the secondary market.
The road map for changes in corporate bond trading remains a matter of debate. The jury is out on whether corporate bonds can ever trade like stocks. But we are already witnessing corporate bond electronic markets that bear many hallmarks of the equities world, regardless of the structural differences between the asset classes: smaller orders, a successful comingling of retail and institutional flow, customer-to-customer matching propelled by regulation, and, most important, volume growth and a demonstration of liquidity. In the absence of some wholesale revolution in the fixed income market, these retail marketplaces are proving to be one part of a healthy evolution.