The corporate bond liquidity challenge: rethinking the market ICSA AGM, Stockholm, May 24 th 2016 Andy Hill

What do we mean by liquidity? The corporate bond liquidity challenge  “The ability to get a price in the size you require, when you need it”?  The ability to trade without major market impact?  Can liquidity be measured?  MiFID II/R liquidity measures  Bloomberg’s LQA  Interactive Data’s Liquidity Indicators  What are the appropriate determinants?  Bid-ask spread? Market depth? Expected time to execute? Market impact? Historical volume and prints? Characteristics of instrument? Distribution of holders?  Should liquidity measures be based on trade data, or on what failed to trade?  Is liquidity dynamic?  Should liquidity have a cost? 3232

Factors affecting bond market efficiency and liquidity The corporate bond liquidity challenge3  Regulation  Basel III, MiFID II/R, EMIR, MAR, Volcker, Dodd-Frank.....  Macro-economic conditions and monetary policy  Buyer of last resort  Spread compression and the search for yield  Returns vs fundamentals  Structural trends in the holders of bonds  Record issuance, all sat with the buy-side  Everybody the same way (no other side of the trade)

The traditional fixed income liquidity model The corporate bond liquidity challenge 3434 Market Maker Client A Client B Client C Client J Client X Client Y Client Z Provides for:  Ready two-way pricing  Immediacy of execution

The principal dealer (or market-maker) model The corporate bond liquidity challenge5 Essential ingredients for the model:  Availability of capital (balance sheet) to hold long and short-positions and warehouse risk  Availability of an efficient and liquid derivatives market (such as single-name CDS) to hedge dealer positions  Availability of an efficient and liquid repo market to fund dealer positions  Skills and experience of the trader

The principal dealer (or market-maker) model The corporate bond liquidity challenge6 Undermining the model:  Availability of capital (balance sheet) to hold long and short-positions and warehouse risk  Increased cost of capital (Basel III & IV)  Volker Rule and restrictions on bank proprietary trading  Availability of an efficient and liquid derivatives market (such as single-name CDS) to hedge dealer positions  EMIR and other central-clearing or margining requirements for derivatives  Availability of an efficient and liquid repo market to fund dealer positions  Leverage Ratio, NSFR,....  QE: negative rates and excess reserves  Skills and experience of the trader  Ongoing attrition of experienced staff and ‘juniorization’ of trading desks

The evolving dealer model The corporate bond liquidity challenge 3737 Principal trader Principal broker Agency broker What we lose is:  Ready two-way pricing  Immediacy of execution Changes in dealer behaviour:  Smaller inventories and faster turnover  More considered allocation of balance sheet  Deeper client engagement and awareness of needs  More specialization and focus on competitive advantage  More streamlined trading and sales desks

Future potential challenges to bond market efficiency and liquidity The corporate bond liquidity challenge 3838  MiFID II/R pre- and post-trade transparency requirements (for bonds and single name CDS)  MiFID II/R best-execution requirements  CSDR mandatory buy-ins  Even higher capital and funding costs (FRTB, NSFR)  Other miscellaneous regulatory challenges (e.g. MAR disclosure requirements)  ECB’s Corporate Sector Purchase Programme  Ongoing macro-economic and geopolitical risks  The ‘unknown unkowns’

How is the market responding? The corporate bond liquidity challenge  Electronification: new initiatives, platforms, tools, and protocols  Connectivity & Data  Changes in buy-side behaviour  Primary vs secondary  Buy-to-hold  Dealer relationships  Use of alternative products, such as bond ETFs and CDS indices  New, non-bank liquidity providers (‘principal trading firms’)  Discussions on changes in issuance practice (‘benchmarking’)  CMU Call for Evidence and the ‘better regulation’ initiative 3939

Rethinking the market The corporate bond liquidity challenge 3 10  Do we have to accept that liquidity is a limited resource, that requires hard work to source, and comes at a cost?  Will we move away from a liquidity model that is dependent on market-makers, or will we always be reliant on broker-dealers to some extent?  Do we redesign the ‘shape’ of the corporate debt markets to fit the established liquidity models of other markets (the ‘equitization’ of the bond markets), or do we design new models and protocols that best fit the market?  Can the corporate bond markets ever become fully exchange or platform based, or will they always require a basis of human interaction and relationships between participants that are built on experience, trust, and mutual understanding?  Can the corporate bond markets continue to serve their economic function of bringing investors and capital raisers together, efficiently and effectively?