There is a bondage twist to complex corporate bond markets

As any well-informed financial markets person can tell you, the move to electronic trading and execution of corporate bonds is just on the horizon. It has been just on the horizon since I first wrote about it back in 1999, and it will stay there until a lot of people such as corporate treasurers, lawyers and other fee-seeking intermediaries are forced into big changes in the way they do business.

Along with others, I was too optimistic about technology conquering the “Fourteen Families” corporate-bond oligarchy of Wall Street. And technology developments back then were necessary, but not sufficient. The bond “desks” were able to crush the trading innovators they did not buy off with dead-end pilot projects.

Since the 2008 crisis, though, the constraints on the banks and dealers that were imposed by compliance, alongside trading capital restrictions, have broken their hold on liquidity provision in corporate credit. As even the policy people in Washington have noticed, “all to all”, tech-enabled trading has not taken the place of the bond desks in providing liquidity. Nothing has, which is a problem when you have an $8tn market with increasingly erratic price discovery even before there is a financial crisis to freeze up people’s decision making.

While the financial geek community, which we try to represent in this column, had been trying to draw attention to the credit market liquidity problem since the autumn of 2011, the policy people chose to ignore the whole thing.

The largest asset managers started making public noises about bond market liquidity last autumn as a number of regulatory deadlines approached. A BlackRock “viewpoint” published in September 2014 baldly stated that, “We believe the secondary trading environment for corporate bonds today is broken, and the extent of the breakage is masked by the current economic environment of low interest rates and low volatility.”

I agreed with most of BlackRock’s recommendations to fix the problems, but I did not buy their point that corporate bond features should be standardised.

Well, I was wrong about that. As BlackRock documented, there was one type of General Electric common equity security and 905 GE bonds outstanding, each with its own special documentation tweaked to GE’s advantage. There are now about 49,000 separate corporate issues in the US, close to 10 times the number of common stock issues. Why is that? Basically, when there is too much money chasing too little investment product, there is what you could call a bondage twist to this market, where the issuer is the dominant partner in the relationship, and the asset managers on the buyside are submissive.

There is more of a balance of power between buyers and sellers in equities and futures, and the terms of each issue of common stock or futures contract are much simpler. Electronic platforms for trading shares and derivatives have been able to provide customer-order driven liquidity, since nobody has to have their lawyers search through the documentation for shares to make sure that one block is the same as the last or the next one.

Bond buyers, on the other hand, had to keep in mind every little qualifying phrase on those 49,000 issues. So even sophisticated online trading houses were a bit surprised at how little customer activity they had from their credit market sites.

But this can be fixed, and the swaps market shows how. From the late 1980s, ISDA, the swaps dealer association, has worked on standardising a master agreement for servicing over-the-counter derivatives contracts. As swaps started out as a clubby little world for banks to exchange contracts, there was not a trust or legitimacy issue, at least not until the legislators and regulators got seriously involved after 2008.

Because swaps documentation was simpler, and because pre-crisis capital requirements were less burdensome, ISDA-compliant swaps took over the price discovery function that should have been performed by the corporate bond market. Bring the relative simplicity of the swaps docs to the credit market and price discovery will follow.

The corporate treasurers and their lawyers will argue that their issuance is special, just like their kids, and every bond should be pampered with its custom-made covenants. They would be listened to with the same indulgence a tailor shows for the eldest son of an old customer, except that bond liquidity is now a public policy issue. Kind of like banks.

It is clear from bank and SEC data that the unit cost of trading bigger bond issues is lower due to their having greater proportionate turnover.

According to Barclays’ calculation of “liquidity cost scores”, transaction costs for US corporate credit increased 55 per cent from January 2007 to January 2015. For US high yield, ie junk, the unit costs over the same period increased 21 per cent; they were already pretty expensive to trade.

If in the next crisis the public, through the Fed or some other means, has to become the liquidity provider of last resort they are going to notice the size of the bill. So they will want something done.

That something could involve making a short list of relatively simple bond documentation forms, specified in an amendment to the Trust Indenture Act of 1939, which provides the legitimacy for all public bond offerings in the US. It is now only 37 pages long, and adding a few pages will be a lot simpler than another Dodd-Frank law.

People in my neighbourhood live off those transaction costs, but not every creature on the savannah gets to survive. The quicker ones can find ways to repackage old bonds into new standard forms. They had better do something. In its present form, the bond business is just needlessly complex.