The stampede of investors and dealers into highly liquid rates products during and in the immediate aftermath of the global credit crisis dramatically altered the composition of US fixed income markets.
History suggests that this trend should reverse itself in relatively short order as investors and banks reacquire their risk appetite and the sell-side uses its remarkable powers of innovation to create new high-margin products.
However, the imposition of new capital requirements and derivatives rules, coupled with new perspectives on risk management among both buy-side institutions and sell-side firms suggest that it could be different this time round.
The results of Greenwich Associates’ 2010 US Fixed Income Investors Study demonstrate that the market is already witnessing the transformation of US fixed income trading into a more liquid, transparent and technology-based business.
“The end result could be a market that is much less reliant on dealer liquidity,” says Greenwich Associates consultant Tim Sangston. “In such an environment, institutions would seek out dealers with strong electronic trading systems for their enlarged rates trading business, and they would gravitate to firms with strong options and futures platforms to facilitate centrally cleared and exchange-traded derivatives transactions.”
For the past two years, US fixed income trading volume has fluctuated between peaks and valleys driven by crisis and recovery. On an aggregated basis, fixed income trading volume among a matched sample of institutions declined roughly ten per cent during the 12 month period ending April 2010, after increasing 15 per cent the previous year. Throughout that two-year period, one trend remained consistent: US fixed income trading activity shifted away from credit and securitised products into rates products, and it has not reverted to pre-crisis patterns.
Rates products, including agency securities, government bonds, interest-rate derivatives and mortgage pass-throughs, made up slightly more than 70 per cent of US fixed income trading volume in 2006–2007; since 2008 that share has remained at or above 80 per cent, according to Greenwich Associates.
This realignment reflects both the diminished risk appetite of institutional investors and the recalibration of sell-side business models in the wake of the crisis. As such, following several months of historically strong market performance at the end of 2009, it seemed reasonable to assume that the shift towards rates products would prove cyclical: as markets settled and investors regained confidence they would continue to seek out the yield associated with less liquid products, and as sell-side firms recovered from their balance sheet issues they once again would have capital to devote to products that deliver margins much higher than those attainable in rates products.
Lingering uncertainties about market conditions and structure call those assumptions into question and raise the possibility that the current shift in US fixed income markets towards rates products might prove a more lasting change. For investors, the onset of a sovereign debt crisis in Europe has prompted a renewed flight to quality — with the main beneficiary being US treasuries.
From the perspective of the sell-side, the passage of the Dodd-Frank bill with its new, stricter capital requirements and revised rules on securitisation will change the economics of the business, reducing margins on credit and securitised products and increasing the relative attractiveness of rates business. The movement of swaps trading to centralised clearing and exchanges remains a wildcard. All of these factors will likely slow the process of sell-side innovation and the roll-out of new fixed-income products.
“The business of the future could look much different from the business of the recent past,” says Greenwich Associates consultant Woody Canaday. “With much of the derivatives business moving to a centrally cleared and exchange-traded environment and with the growing rates business placing a new emphasis on electronic trading, large dealers with sophisticated technology platforms and existing futures and options business that facilitate clearing and administrative services will be at a considerable advantage.”
