Entrepreneurs seeking structural change in the corporate bond market should focus first on creating alternatives to corporate bond mutual funds.
I first learned of a supposed, Dodd-Frank-induced liquidity problem in the corporate bond market about two years ago. A friend from an inter-dealer-brokerage firm who knew of my prior work to bring an exchange to the U.S. Treasury market called to encourage me to train my sights on corporate bonds. I was skeptical, not least because one of my customers dealt in corporate bonds and seemed to have a good business doing so, but decided to at least follow the market more closely.
Since, Tabb Group and a number of other analysts and market observers have written about the need for alternative execution venues for corporate bonds. They report that because of Dodd-Frank and other regulatory initiatives, dealers have become less willing to commit capital to the corporate bond market. Several of the electronic routing venues do decent volume in odd lots, but according to these reports, the so-called buy side is frustrated and wants someone to come forward with a more general solution. Accounts of what the buy side supposedly wants vary from a peer-to-peer market to a full-fledged exchange.
This clamor for new corporate-bond-trading systems arises at an unusual time. The primary market is strong and has been for several years. Companies are taking advantage of low interest rates to issue bonds in large volumes. Logically, a healthy secondary market should ensue, and dealers should be more than willing to support their syndicate operations with capital for secondary trading. Issuers once expected such support from their underwriters.
If the reports of meager capital commitments from dealers are indeed accurate, promoters of new venues should be wary, not encouraged. Dealers are money-motivated. If their capital allocations to corporate bonds are falling relative to their allocations to other endeavors, one possibility is that something other than regulation may be too blame. While I loathe government regulation as much or more than anyone, other markets may simply be more attractive to these dealers than the corporate market is at present.
Dealers are reluctant to let any customer trades flow elsewhere. The risk is too great that new venues will expand into new markets. All dealers of any substance attempt to estimate what share of a customer’s total available business they receive. As a tactical matter, dealers will even lose money to win greater shares of such business. So I put little stock in the notion that dealers are ready to concede anything in the corporate bond market.
But let us consider the customer side of the ledger. Are large asset managers so frustrated with dealer commitments to corporate bonds that they would lead a stampede to alternative venues?
I doubt it. Large asset managers are beholden to large dealers. Almost twenty years into the Internet revolution, I have yet to see one of these large asset management firms step out of line and challenge the prevailing market structure. I have heard several of them say, “Yes, we would love an alternative and would use it.” But when push comes to shove, timidity prevails. The market is littered with the bones of entrepreneurial ventures that relied on promises of large asset managers. Venture capital firms have invested and lost hundreds of millions of dollars on failed corporate bond platforms. Even the largest custody bank that accounts for almost a third of institutional assets has tried and failed to win support for a credible, functional, well-capitalized, alternative platform for corporate bond trading. When time came for its customers to put up, they shut up.
All markets evolve. The corporate bond market has yet to reach a final state where no further change is desirable or feasible. But large asset managers who are supposedly unhappy with their dealers will not supply the motive force for a new market structure. In fact, these asset managers are the problem, and entrepreneurs should focus their efforts on providing alternatives to them, not to dealers.
Outside of a handful of names for a brief period of time after issuance, corporate bonds are not (yet) suitable for exchange trading. They trade over the counter because they should trade over the counter. They lack the price continuity that is a prerequisite for exchange trading. If it is ever to develop, this continuity must develop naturally. It cannot be forced or fomented by the sudden appearance of an exchange.
The juiciest targets for entrepreneurial efforts in the corporate bond market are not the dealers, who actually provide a useful economic function, but the large asset managers, who for the most part do not. The most vulnerable among these are the investment companies operating as corporate bond mutual funds. These funds are demonstrably among the most inefficient investment vehicles ever devised.
Bringing forward alternatives that will spare consumers and companies the inefficiencies of corporate bond funds will lead in due course to a better secondary market for corporate bonds. Reliance on complaints from large asset managers about the quotes they receive from their dealers is a fool’s errand.
TabbForum first published this essay, under the same heading, on November 6, 2013.