From the Desk: Finding value in a brave new fixed income world

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Today’s fixed income market barely resembles what it looked like in the 1990s, when John Orrock got his start as a trader. In fact, the market barely resembles what it looked like just a decade ago, when electronic bond trading finally began to take off and post-crisis regulatory changes were just starting to be introduced. Between then and now, new technology and an evolving market structure have also led to fundamental shifts in the way fixed income is traded, as the sell side has gradually lost pricing power.

Orrock, managing director for Cowen’s fixed income outsourced trading operation in Europe, has had a front-row seat to those changes. That means his clients get the benefit not only of his vast trading experience, but also his deep knowledge of how the fixed income market has developed.

In the latest edition of our From the Desk series, we hear from Orrock about how funds can thrive in this brave new world of fixed income trading. He explains how an outsourced trading provider can offer a slew of benefits, from the expertise of experienced traders to significantly enhanced access to debt market liquidity from a wide range of sources. The net result is better pricing and execution in a market that presents a unique set of challenges.

Q: You were a buy-side trader for close to 20 years. Then a regulatory change gave you the idea of moving into outsourced trading. Could you explain that journey

A: MiFID required a disintermediation between risk-taking groups and trading groups within asset managers because of the conflict of interest that acting on behalf of investors’ money presented. So, asset managers started to centralise dealing desks and physically move the traders away from risk-taking portfolio managers.

The natural progression, in my view, was that you could actually take that function completely outside the fund. When the regulator is pointing in a direction, don’t stand in the way, is the way I look at it.

Q: Outsourced trading for equities is fairly established, but it is less common in fixed income, which is much more complicated than equity trading. Why does it make sense for a fund to go down this route?

A: Fixed-income execution is very subjective, unlike equities, where you have an exchange not just for price discovery but also to actually define liquidity. You also have more depth of market. For every one equity you can perhaps have 200 bonds. Take Ford, for example. Each of those bonds has its own story.

The other big difference is that the market makers in fixed income are human beings with all the nuances that they offer. So, with it being so subjective, you need expertise and knowledge of the market in order to be able to define what best execution is. What we offer is a breadth of both sell side and buy side expertise, to actually be able to offer the subjective answers to what best execution on any given day is. We offer access to a wider range of liquidity sources than funds generally will have, and we can then provide judgment and subjective colour around a quote to determine if it is worth engaging with.

Q: The fixed income market has also been undergoing major structural changes, in terms of the relationship between the buy-side and the sell-side and how firms source liquidity. How does that affect the job of providing an effective trading service?

The street balance sheet has reduced versus the buy side. The risk appetite feels as if that has reduced even more. Our job now is no longer to actually work with market makers and use their balance sheet. Our job, as outsourced traders, is to find the other side of the trade. How we do that varies, depending on the order.

There is a misconception in the electronification of the market that one fund is not finding another. That is not the case. Invariably, everyone is doing the same thing. So, it takes a bit more skill to find the other side of the trade. You find yourself working with people and market makers who are in tune with all the big players, who can actually find the other side of that trade, rather than just use their balance sheet, which they can no longer do. That ability was taken away by the regulator. The regulator has effectively regulated liquidity out of the market.

Q: Meanwhile, there has been widescale technological change in financial markets. Has that also altered the way you find fixed income value?

Technology has dramatically improved, but if you could fully electronify fixed income, it would have been done a long time ago. Smaller high-touch business has now become totally electronic and very efficient. Where that doesn’t work is when there is a need to speak to someone, either for very illiquid bonds or bond sizes that are market-moving.

No matter how you try to do it, at some point you have to give up information. As soon as you do, you need to quickly get the trade done or I can guarantee that by the end of the day or the next morning, that information will be reflected in the price. I know from my experience that you need somebody who can carefully manage that information and go to the people who are most likely to be able to give you the other side to that trade.

Q: As an outsourced trading provider, do you have access to more electronic platforms than a single trader or a two-man trading desk would have? Is there an economy of scale factor?

We will certainly have as many, and probably more, because of the breadth of asset classes that we cover. But I think it is more about knowing when to use them and knowing when not to use them. That is probably where we have the edge. There are times when you really don’t want to advertise things, and one call is the only call you should make.

The temptation is just to use it. It is convenient, it is STP, So, they will want to just use it indiscriminately. We are in the market all day and we will know whether right now is the right time to send that bond out electronically or whether we should be managing it by voice.

Q: What about programme trading? Is that something that an outsourced trading provider can offer that not every fund can do on its own?

A: There has been growth in that and, certainly, that is something that we can help with. Banks are now offering to price the whole portfolio, rather than the individual pieces. Say there are 50 bonds that you want to sell or buy, and two are unbuyable or unsellable. You package them up with the other 48 and you can get it done. That is part of the attraction of portfolio trading.

Q: In addition to trading services, an outsourced provider can offer TCA. How important is that for clients?

A: It is not just the trading that is subjective. How you look at liquidity and transaction costs is also subjective. There are some TCA tools coming out now. They are helpful, but I think we have to bear in mind that you have to be able to have that expertise to look at the TCA. The tools may not apply to a particular trade if it’s too big or too illiquid.

Q: Does outsourced fixed income trading make sense for larger funds as well?

It depends on the DNA of the firm and how they work. I think the costs of running trading, the general costs for asset managers and the pressures on those are no secret.

So, as an example, I spoke to a CIO, and he said, ‘It is not really for me’. And then he said, ‘But if I look at this one part of my business, I actually need maybe half of a trader, but I have actually got a full time-trader because that is what we do’. He then also needs someone to back him up for six weeks of the year, so he ends up having two people. He said, ‘If someone came along to me and they could cut that cost in half, I would probably have to look at it’.

Q: It’s not just about cost. There is also the question of where you have expertise.

A: If you are a big asset manager but you haven’t really got an EM trader, but 2% of your trades are EM, you may want to come to us for your EM trades. We have got the expertise.

It just depends on the mandate. I think that from a bigger outsourcing point of view, the MiFID bit is what is creating interest. And after Covid, portfolio managers also have learned to work without their traders sitting nearby. For the last two years, all the traders have been outside the firm.

Q: We’ve talked about market evolution and fund managers’ needs. Could you sum up the big picture for funds that might want to consider outsourced fixed income trading?

A: There are general arguments for the outsourced model that apply to all asset classes, particularly around the efficiency of your operating business. What differentiates us in the fixed-income space is that access to liquidity is not the same for everybody – it’s all about size and presence. If you want to feature prominently on a broker dealer list, outsourcing gets a bigger seat at the table and allows firms to engage with liquidity that they would be unable to access otherwise.

In addition, outsourced trading tends to just imply we can buy and sell your bonds for you. What I would like to do is make it clear that we offer much more than that. We actually offer the same service that an in-house trading team would offer, which is liquidity scores, transaction costs, and control of information. We are not just buying and selling. We are giving you the full service.

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