Dominic Holland, head of credit e-trading at Deutsche Bank, explains how technology is filling a liquidity gap between broker-dealers and investment managers.
In the fixed-income markets, banks face an existential challenge. Dominic Holland, the head of credit e-trading at Deutsche Bank, believes that the smart application of IT offers a potential solution to this challenge.
The Basel III capital adequacy rules make it more expensive for banks to hold bonds, undermining their role of market maker in the fixed-income business. Previously, they would have been able to hold bonds in their inventory over a period of time, buying and selling as clients needed. The corporate bond market is naturally illiquid, a consequence of the number of instruments, of different tenors, that each issuer has on the market, and so a reduction in sell-side liquidity provision creates a real strain on the service that dealers can provide to their buy-side clients.
“The discussion around liquidity in the corporate bond market tends to focus around the dealer balance sheet and dealer’s willingness to warehouse risk given the effects of prudential regulation,” says Mr Holland. “But what has always been key to a strong relationship is a mixture of capital and information. Having your information well organised at this stage of the evolutionary cycle is very important, because to some degree you can replace capital with information.”
The solution that Mr Holland’s team devised was to use information to increase efficiency. Where a dealer is able to increase its ability to track where bonds are and improve its capacity to transfer and trade those bonds, it can increase the turnover of its inventory, so that a small pool of instruments could be more effectively used to supply counterparties. That, in turn, would potentially provide a real benefit to clients.
“What we are trying to do is organise information,” says Mr Holland. “Identifying where we can assist, and stepping back where we don’t have the right ability to assist.”
The removal of sell-side liquidity has resulted in a transfer of execution risk in the credit markets from the sell side to the buy side, effectively increasing buy-side execution costs. Investment firms need to work out where to trade and the price to trade at, but the more they exchange information around price and order size with their counterparts, the more they reveal about their own order and this information leakage allows other traders to squeeze them on price. What they need is to trade large size orders at a good price, without revealing their own hand to lots of market participants.
Deutsche Bank’s Autobahn single dealer platform is used by clients to access liquidity across assets. It was decided to develop Autobahn’s functionality with the use of third-party platform ‘Honeycomb’, provided by technology firm Algomi, which is designed to help track and automate information on inventory within dealers. Algomi technology is being further adopted by both buy-side and sell-side institutions, with approximately 70 firms signing up since it launched in 2014.
“The system we developed, Autobahn PALM [platform for automated liquidity management], helps our sales force to find liquidity and helps us service our clients more effectively,” says Mr Holland. “The team can enter client-specific information when they receive an enquiry, or they can upload what is held in a portfolio onto a centralised database, then when the sales team is approached by a client with an enquiry or if it needs to trade, that information is entered and a set of possible actions are presented to the sales person, based on the information we have globally.”
PALM also alerts the bank’s sales team when an opportunity for one of their clients has been identified, so if an asset manager has expressed an interest in buying an illiquid bond with particular characteristics, when another client later appears as a match for the other side of the trade, even after several weeks, the sales team can bridge that gap without the bank having to hold on to the bonds and incur cost.
“By being smart about the use of our client’s trading data, we are more effective in finding liquidity for our clients and, in turn, creating more trading opportunities,” says Mr Holland. “It increases efficiency, balance sheet velocity and thus liquidity.”
Technology is also enabling new models of trading between counterparties. Until recently, electronic marketplaces offered a method of matching buy-side and sell-side but did not automate the execution of trades. Now all-to-all matching, and trading, is possible as new venues are launched and existing markets evolve. However, there are so many launching into the competitive market that they are likely to fragment liquidity in the short term.
“There are some very good ideas out there, innovative ideas that have enabled new platforms, but their challenge will be to get to critical mass,” says Mr Holland. “The success of any of these ventures will be based on the number of firms they can persuade to sign up.”