Trader Talk

There's a new player in the bond trading business

Traders work on the floor of the New York Stock Exchange.
Brendan McDermid | Reuters

There's a new player in the bond trading business.

Everyone knows it's getting harder to trade bonds. Jamie Dimon, Bill Gross and others have all complained about the lack of liquidity. Enter Liquidnet, which runs a dark pool for electronic trading in stocks. On Tuesday, the firm began operating a dark pool to trade bonds.

They're the latest organization to try to bring bond trading into the twenty-first century, by trading electronically. CEO Seth Merrin's hope is that it will attract much-needed liquidity to the industry.

It's an old problem: there is no central facility to trade bonds, like a stock exchange.

Partly, it's because bonds are much more heterogeneous than stocks. There's about 5,000 listed stocks in the U.S., but roughly 2 million individual tradeable bonds.

Bonds traditionally trade over-the-counter, between dealers—usually banks, and there have been attempts to get bonds to trade electronically, just like stocks do. Those efforts have been met with very limited success, however, partly because the banks who control the trading don't want to do it.

That was fine when banks had capital to trade bonds, but because of all the new regulations, that capital has gone away.

Merrin says that as of June, 2015, dealer inventories in bonds are down 75 to 90 percent to roughly $18 billion—a drop in the bucket in a $7.8 trillion market. Meanwhile, the amount of corporate issuance has shot up dramatically because of the low interest rates.

A lot more bonds with a lot less liquidity is a recipe for trouble, Merrin says.

So far, Liquidnet has signed up 120 asset managers from the U.S. and Europe. Those include large insurance firms, mutual fund firms, pension funds, hedge funds. It's a good start, but it's only a fraction of the more than 800 participants in the stock dark pool.

One of the difficulties of trading bonds is that there are literally tens of thousands of them, although there are about 5,000 that trade most frequently. So how to trade them?

Each bond has a CUSIP, an individual identifier. If there is no match, there is no information shared. If there is a match, you can trade the bond.

Still, there may be other ways to facilitate trading. If you're selling a bond, it has a specific CUSIP. However, if you are buying bonds, you may want to buy bonds with just specific characteristics. You might be able to say you want $100 million in bonds, with an AA rating, that matures in 2020, with a 3 percent yield, in the Industrial sector.

Merrin says that he hopes to have the capability to do just that shortly.

Will Liquidnet succeed? It's not clear. There have been several other attempts to trade bonds electronically, without success. Certainly one problem was the banks, who did not want to participate in any program that would shrink the handsome spreads they make trading bonds.

There are other firms trading bonds electronically. Many Treasuries and mortgage-backed securities trade on Tradeweb.

MarketAxess began trading in 2000 and has been public since 2004. It has had some success trading U.S. high grade corporates, eurobonds, emerging market bonds, and U.S. agency securities such as Fannie Mae.

TruMid began operations in April. They operate what they call a "Swarm," a 10-minute trading session that focuses on a predetermined set of securities.

With only three days of operations, Merrin declined to provide data on trading volume, other than to say he was pleased with the start. He promised hard data after a month of operations.

Let's hope at least some of these projects succeed. If we get a bond selloff, we will need all the liquidity we can get.