Buy-side Awards 2016
The big Wall Street dealers once had a near monopoly on information in the bond market, which gave them an edge over customers and would-be competitors alike. Those days are gone. The emergence of new trading venues and data sources has levelled the playing field. Clients are better informed, and dealers are losing their clout.
Anyone wanting a better idea of the changes shaking up the world of bond trading should take a closer look at Alliance Bernstein (AB), which manages $281 billion in fixed-income assets. The New York-based asset manager has built a proprietary system – Alfa (automated liquidity filtering and analytics) – to aggregate information on the bond market, giving it an unprecedented level of pre-trade transparency.
“The key to best execution is having better information before you trade, and that’s what Alfa is delivering to us,” says James Switzer, global head of credit trading at AB. “We see more transparency than almost anybody.”
The technology has allowed AB to slash execution costs on some trades by as much as 60% over the past year, while improving the speed and efficiency of its trading. “We see the difference,” he says. “It's alpha generating. It's helping us to become more efficient, to run portfolios faster and smarter.”
Alfa automatically collects and organises around 10 gigabytes of price and liquidity data each day from myriad sources. Currently, over 60 dealers send their daily run sheets – essentially lists of indicative prices on a selection of bonds – to AB via Bloomberg and Tradeweb. Another 17 dealers share their inventories and axes via Neptune, a recently launched messaging system.
We've proven that when we're the liquidity provider – buying when we can, not when we have to – we add the most alpha to the portfolio. Every time we provide liquidity, it's a big edge
Tim Morbelli, AB
The firm is also connected to several electronic bond-trading venues, such as Bloomberg, Electronifie, GFI Matching, MarketAxess, Tradeweb, Trumid and UBS Bond Port.
The pre-trade data from dealers and exchanges is combined with post-trade data from the US’s Financial Industry Regulatory Authority's (Finra) trade reporting and compliance engine (Trace) to piece together a portrait of liquidity and transaction costs in the bond market.
Armed with this information, AB has stepped confidently into the role of liquidity provider on all-to-all trading venues such as MarketAxess Open Trading – with impressive results.
Transaction cost analysis (TCA) performed jointly with MarketAxess reveals that AB saves 4.39 basis points on average when it provides liquidity on investment-grade bonds offered on Open Trading, compared with the Trace benchmark.
“We've proven that when we're the liquidity provider – buying when we can, not when we have to – we add the most alpha to the portfolio,” says Tim Morbelli, vice-president of credit trading at AB. "Every time we provide liquidity, it's a big edge."
Bid/ask spreads on investment grade bonds have ranged from 9.98bp to 7.75bp over the year to date, according to MarketAxess – which puts AB’s transaction cost savings at anywhere between 40% and 60%.
“We like what we're seeing from these new trading venues,” says Switzer. “But without an aggregator to scan and digest all this information, we wouldn't be able to take advantage of these developments.”
The TCA, which covers the first three quarters of 2016, also shows that AB saves 0.85bp on average versus the Trace benchmark on all its high-grade bond trades across all-to-all and bilateral request-for-quote (RFQ) protocols.
The impact of Alfa is not limited to transaction cost savings, however. The system has changed the way the firm thinks about liquidity and has helped foster a more dynamic approach to portfolio management.
“Alfa gives us a more comprehensive view of liquidity and allows us to better understand where we can generate risk premium at the intersection of our fundamental views and the prevailing liquidity conditions,” says Ashish Shah, chief investment officer for global credit and head of fixed income at AB.
Liquidity in the credit markets tends to be feast or famine. Dealer balance sheet constraints, coupled with the ban on proprietary trading, have left active asset managers at the mercy of retail flows and the episodic rebalancing of passive or systematic strategies.
“It creates these big selling waves – which are relatively concentrated, but heavily dislocated,” says Shah. “That represents both a risk – in that if you own those securities, you have to take a mark – but also a massive opportunity. Alfa allows us to engage with this market much more rapidly and in such a way that we’re able to extract a return for providing liquidity.”
That has made a big difference to AB’s performance in a market where transaction costs are sometimes so high as to eclipse the expected returns of otherwise sound investments.
“The challenge these days is to understand what it is you want to do fundamentally and then time that so the market pays you a risk premium to do it,” he says.
Alfa gives us a more comprehensive view of liquidity and allows us to better understand where we can generate risk premium at the intersection of our fundamental views and the prevailing liquidity conditions
Ashish Shah, AB
“That used to be a very transparent process when everyone knew the price of bonds. Today, the price is a greater unknown and it can deviate from fair value much more rapidly than many market participants can react.”
With Alfa, AB has been able to identify and capitalise on those situations where markets dislocate, sell-off and overshoot. “That’s when we’re at our best as an active manager,” says Morbelli. “We have watch lists built into Alfa, so we can react to these events very quickly. When someone is looking for liquidity, they give you 10 or maybe 20 minutes to respond, and we can do that.”
This flexible approach to trading came to the fore in the first quarter of 2016, when energy bonds were hit by plunging oil prices. AB’s portfolio managers provided the trading desk with a list of energy bonds to offload. A dealer bid one of the bonds at 4.25%, which Alfa flagged as a poor price relative to where the bond had traded previously and where similar bonds were trading currently.
The firm opted to wait for a better price. Two hours later, Alfa notified the traders there was an offer wanted for the bond on Open Trading. AB responded as a liquidity provider and sold the bond at 3.65%. “That’s a big differential from where we were bid by a dealer, and that’s the difference between being a liquidity provider and a liquidity taker,” says Morbelli.
That was not an isolated incident. The firm is always looking for opportunities to sell or add to positions in its active portfolios as liquidity conditions change. “When the opportunity to be a liquidity provider presents itself, we can move quickly,” he says.
AB’s passive strategies have also benefited from Alfa. “The speed at which we fund these mandates has improved dramatically,” says Switzer. “It used to take weeks, and we get them funded in days now.”
Making a difference
AB typically uses credit default swap (CDS) indexes and total return swaps (TRS) to quickly obtain the necessary exposure for its passive portfolios, and then sources the cash bonds from the market at a more leisurely pace. Alfa has been a difference-maker in this regard, enabling the firm to build out its passive portfolios more efficiently and flexibly.
“We can’t always buy the bonds we want for a [passive] portfolio,” says Switzer. “Alfa helps us to identify replacement securities with the same characteristics, such as duration, ratings and yield. We might end up with a portfolio that only has 50% of the securities we originally wanted. We can be flexible.”
Switzer and Morbelli insist there is a lot more to come from Alfa. Since it began using the system for investment-grade and high-yield bond trading in New York in October 2015, AB has expanded it to cover structured products as well as emerging markets and municipal bonds. Alfa has also been rolled out in the firm’s offices in London and Hong Kong.
“There is an enormous amount of US dollar product that we traditionally traded in New York, which we trade in London now,” says Switzer. “The liquidity is better there, because Asia is active during London hours, and Asia has become a much bigger buyer base. When we start the day in New York, most of what we need to get done is already done in London.”
There is an enormous amount of US dollar product that we traditionally traded in New York, which we trade in London now. The liquidity is better there, because Asia is active during London hours, and Asia has become a much bigger buyer base. When we start the day in New York, most of what we need to get done is already done in London
Ashish Shah, AB
The firm continues to explore other potential applications for Alfa. For instance, the trading desk is working with the firm’s quant team to create a reference price for bonds –the ‘Alfa price’ – that incorporates data collected from multiple trading venues and dealers.
“We think we can come up with a better gauge of the true value of a bond with the ability to see the underlying inputs that create the price, which we can then compare to external pricing sources,” says Morbelli. “In the process, we’re also creating our own liquidity analysis of a particular bond.”
Switzer believes the Alfa price will be a more accurate representation of pricing and liquidity in the market at any given in point in time compared with currently available measures: “It will mean that if a portfolio manager gives a trader an order, we can go and execute with no misunderstandings over the price or the ability to source the bond.”
Alfa could also help AB to comply with regulations, such as Markets in Financial Instruments Directive (Mifid) II and the US Securities and Exchange Commission’s (SEC) new liquidity risk management rules, which take effect in 2018.
“Alfa perfectly complements the transparency and information flow mandates of Mifid II and the SEC’s liquidity rule,” says James Wallin, a senior vice-president in AB’s fixed-income group.
“One of the great paradoxes of Mifid II is that it requires you to have pre-trade transparency and to comply with an intense reporting and best-execution regime, but it doesn’t allow you to go out and get quotes from dealers and ask for a hard price unless you’re ready to trade. Alfa aggregates a wide variety of information that we need for these new compliance regimes, and it’s going to make it a lot easier for us to meet our Mifid II requirements.”
The potential applications are so wide-ranging that trading venues, technology firms and even rival asset managers have enquired about licensing the technology behind Alfa for their own use.
“A number of people have asked if we would consider a joint venture,” says Switzer. “We are seriously considering it. Eventually, we will lose our first-mover advantage, and we don’t mind that. If more people are using technology like Alfa, there will be better liquidity in the market, bid/offer spreads will shrink and all-to-all trading will grow.”
The big question is whether dealers will support the emergence of platforms such as Alfa, which give the buy side the tools to source liquidity elsewhere. Switzer believes they will: “The dealer model is changing. People that ran equity trading are taking over the fixed-income desks. They’re running an equity model, which is based on efficiency, client connectivity and technology.”
AB has not faced any pushback from dealers to date – quite the opposite, in fact.
“All the dealers have sent their technology people here. They want to get connected so their runs get picked up by Alfa,” says Morbelli.
And with good reason. AB’s trading volumes are up 45% compared with last year – a trend that broadly coincides with the launch of Alfa in October 2015.
“Our wallet share has gotten bigger, and our dealers know it,” says Switzer.
Dealers that connect to Alfa have noticed immediate benefits. For instance, only one dealer supplied information on its inventory of US bonds via Neptune when it first launched. “In the first week, we did seven trades with them based on their Neptune feed,” says Morbelli. “When we told the other dealers, they all turned on their US desks within Neptune so they could communicate their inventories and axes.”
Switzer insists everyone in the market benefits from technologies such as Alfa – including dealers: “Alfa wasn’t designed to disintermediate the dealers. It was designed to help us connect with them more, so we know who to go to and when.”