Pricing data in fixed income markets – Is transparency truly an issue?

Jason Waight, head of regulatory affairs, Europe at MarketAxess, explains how investment in commercial transparency solutions has proven itself in 2020, and why this leaves a question mark over the potential value of a centralised bond tape

Jason Waight

The support for a European consolidated tape on fixed income prices from the European Commission was launched in the wake of a similar initiative for the equity market. But it risks tracking the same path too closely. Equity liquidity is very different to fixed income liquidity, and so is pricing. It may not deliver the same value.

Transparency in bond markets is readily available and, as some fixed income fund managers and dealers found in March, it is a real advantage to those who have it. MarketAxess Open Trading – the firm’s all-to-all trading network for buy- and sell-side participants – saw much greater diversity in trading during March than usual: for example, more than 250 hedge fund traders from 142 firms executed one or more trades against a previous average of 60 firms per month. 

Those traders needed to be sure of the prices of those trades. Because, even with the emergence of all-to-all trading and new liquidity providers, bond markets are primarily based on risk trading, which means every trade needs to be costed by a counterparty to reflect the risk it carries. By contrast, equity markets use very little risk trading today, changing the dynamic of liquidity provision. Equity trading has other significant differences: for example, it is considerably more concentrated. The number of bonds issued by companies in the major US equity indexes is typically 10 to 20 times the number of equities issued. Bonds generate returns through yield more than capital gains, reducing secondary trading activity. The US at least has a single currency, government bond market and central bank. Europe is more diverse. 

The US currently offers a post-trade tape of prices. The Trade Reporting and Compliance Engine – known as Trace – is operated by a trade association, the Financial Industry Regulatory Authority. Europe’s plan is currently to develop a commercial model or, in its absence, to have the tape managed by the European Securities and Markets Authority.

Building prices in bond markets carries the same challenge as finding liquidity – it has a cost. The value that good price formation can produce has been clear this year, when several dealers were able to continually support trading for their clients in the most volatile markets and a number of investment managers proved themselves capable price-makers in all-to-all trading. In both cases, they had good transparency into the market, based on commercially available data and their analytical tools.

The sell-side firms gained market share across their client base by pricing when rivals could not. Buy-side firms were picked off from bargain investments, which their peers were forced to sell. The range of investment in transparency solutions could not have been demonstrated more effectively. While some asset managers were generating alpha, others could not calculate the net asset value of portfolios as they had no access to solid pricing sources. There is not an absence of transparency in European bond markets, but rather a price for access to better transparency.

More red tape? 

Europe’s project to improve transparency by building a centralised consolidated tape of bond prices risks foundering on the rocks of the equity model. Policy-makers do not always understand the difference between fixed income and equity markets, as has been evident from the revised Markets in Financial Instruments Directive (Mifid II). Its efforts to provide data around the most liquid bonds, and best execution reporting, have struggled. 

Bond markets represent a collection of instruments that trade infrequently and episodically, so the market has had to develop sophisticated methods for trying to work out what the price of a bond is. In equities, the exchange’s trading ticker can be used, which sees considerably more regular, frequent activity. 

Building an additional source that is required to support pricing does not equal better sourcing. More data is only useful in a situation where data is easily consolidated and normalised. The experience of Mifid II has been that trading operations may be obliged to capture and aggregate data for the purposes of reporting it, only to find that the outputs the reports generate are of limited or no practical use. 

If Europe builds a tape that compliance teams perceive should be used for benchmarking, but the data itself is not reflective of real market activity, there is a very real danger that trading will suffer. This would be, at best, from a greater compliance workload – on top of existing levels – and, at worst, from having to filter bad data from good when engaged in pricing and evaluating market activity. 

A recent report by Greenwich Associates found that buy-side traders spend 29% of their time reviewing post-trade or transaction cost analysis data, and 39% speaking with compliance. Pre-trade information is their primary source for deciding which counterpart to trade with. Making data better – rather than more numerous – will be the only way to reduce the burden on buy-side bond traders, allowing them to focus on getting better prices for their investors.

Better data 

Traders who excelled in the highly volatile markets of March 2020 had assessed the cost and value of evaluated pricing and composite pricing tools, and invested in them where needed. These investment firms have figured out ways to build prices using consolidating dealer runs and commercial data feeds. 

When they acquire these sources, they are able to test and judge the quality of inputs that the data sources use, which gives them confidence in the numbers they see and the decision they make based upon them. 

A single tape of pricing data in Europe may tick a box for compliance purposes, but is highly unlikely to improve the quality of price formation for asset managers or the dealers that support them. Asset managers can increase their transparency in the market by engaging with rigorously tested data sources, and using those through the organisation to ensure a single view of data is held, consistently, across functions. Data sources can only provide support for multiple functions – trading, portfolio management and risks – if they are sufficiently robust, which means they must have a solid data heritage and transparent composition. 

It is these sources that investment firms should be engaging with today, ahead of any additional market volatility that might be likely as we head towards an election in the US and potentially further economic impacts of Covid‑19. 

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