Liquidity and Collateral: getting the blood to flow again

Cash is a dirty word for some cultures, but not for financial services, on the contrary. But I am not talking about the old images of the stingy bankers holding on to their $ bills or about Scrooge McDuck.

Banks, custodians, CCPs, CSDs and exchanges are the financial institutions that enable the exchange of cash for securities, the movement of cash between bank accounts, the securitization of cash, the transformation of cash into collateral. Without these markets players entire economies cannot function: they are the safe and resilient pipes and the pipe operators that enable companies to be financed, investors to invest, prices to be made, etc.

The difference between Liquidity and Collateral is that Liquidity is the money used for overnight funding during the settlement, is the money that is in the treasury of a corporate or a bank to finance short term money needs, whereas collateral is usually a security that is given as a pledge to guarantee that one has enough money for a transaction, to bear the risk of a transaction, to be able to exchange it against cash if need be in a Repo transaction, at a CCP or a broker. Collateral was historically required to be of very high quality: high grade government bonds, sovereign or agencies. However these have become extremely rare as collateral is required for many more purposes now than ever to guarantee the stability and safety of every transaction. Banks have very little of it because keeping collateral on one’s balance sheet is extremely expensive from a regulatory stand-point. But if nobody oils the pipes, they cannot work anymore. 

We have seen in our recent European Post-Trade Infrastructure Evolution: Switching Gears for the Long Run report that where collateral really needed to be optimized today was before settlement, and across assets and for listed and OTC assets. Until today this was not possible as assets were very rarely optimized between equities and fixed income, and that un-cleared derivatives, never making it to a CCP, where always excluded from cross-margining or netting opportunities offered, except after the settlement at the ICSDs but this is sometimes too late in the trade value chain.

This is changing though as Repo platforms and ICSDs have realized they needed to step in to enhance the fluidity of the financial blood. Today we are seeing a myriad of new initiatives that aim at creating some sort of “Collateral Exchange” whereby securities can be upgraded or transformed into more attractive collateral, or even exchanged against another one that is more useful at the time. Elixium with Tradition and Euroclear, Euronext’s Collateral Exchange, BoNY’s DBVX, 360T with Clearstream, the list is already long and is bound to get longer. We are excited to see how these new solutions will pan out and will be watching this space very closely. More in our two upcoming Celent reports about respectively collateral management and post trade technology.

Lessons of Bondcube

We have been following the development of Bondcube since early 2013 after its foundation in 2012. Founded by CEO Paul Reynolds and CTO Mark Germain, Bondcube had a unique vision to support trader workflow in fixed income to support greater liquidity in the market. While many FinTech start-ups focus on B2C and the client experience, Bondcube was squarely focused on B2B and workflow support for traders. While Bondcube leveraged new Web 2.0 capabilities such as chat and tracking, it was essentially a new tool for an existing audience with the vision created from former industry insiders trying to create something new. The central idea was that Bondcube could revive large order execution, minimize the market impact of search, and be disruptive to existing marketplaces like MarketAxess, Bloomberg and Tradeweb. It planned to optimize trading via chat and by leveraging historical inquiries. We understand it was marketed at zero cost to buyside and (relatively) cheap connectivity for dealers. Bondcube decided to focus on both the Europe and the US, like existing competitors. An investment by Deutsche Boerse AG suggested that Bondcube might have some legs to build traction, but today’s news on liquidation suggests that further funding was needed and the shareholders declined to do so. Brad Bailey is compiling an updated report on the platforms in the market today, but this is clearly a sign that the market is still sorting through the various ideas and that incumbency (and inertia?) still has great value. Also, sometimes the market asks for change but then does not actually adopt the change it’s clamoring for. All too often the buy side says “Yes! Yes!” but does not adopt new options rapidly, but only after long trials and testing. Capital (and patience) can disappear before the testing and optimization process is complete.

Cash safe haven for investors and corporates?

I was writing a piece of research on the ABS and Repo markets in Europe this Summer and stumbled onto an innovative product offered by MTS and Newedge, Agency Cash Management (ACM) and thought, “wow, this is really innovative and this is what the market needs”. ACM does provide a tri-partite Repo system whereby investors, in an electronic auction regulated platform, enter into a repo trade with banks via tri-partite agents, exchanging their extra cash against good collateral, lending securely and concurrently earning a fee for it. This is really spot on to me as many investors nowadays have extra cash that they do not know where to invest, that they do not want to leave on a bank deposit account because they don’t trust their bank’s creditworthiness anymore, or that they do not want to invest in a Money Market Mutual Fund because they got burnt during the crisis. However they do want to get some return for lending that cash to someone. ACM does exactly that. This is theory obviously, in practice going after all the potentially cash-rich investors, getting them to sign tri-partite contracts with tri-partite agents is going to take some time. Also, in the good quality collateral constrained environment that we are in, banks may not have all this good collateral to offer against these piles of cash, but then again they may find a way to transform bad collateral in good one, this is what banks (and shadow banks and shadow banking products) excel at doing. EurexRepo and Eurex Clearing are working on a similar offering to ACM that should launch in 4Q2012. The model is created to offer banks that are current GC Pooling clients a facility to enter into a Repo trade with their coporate clients, in an electronic and centrally cleared environment. Cleastream is the tri-partite agent here and can take care of the collateral management, which is becoming ever more useful. Practically it may be as hard to get corporates as to get investors to sign tri-partite repo agent contracts, but the theory holds: cash-rich corporates, like investors, do not want to leave their cash on a deposit account, want a secured way to place their cash and want a fee for it. We see both as really innovative products that respond to real market needs: watch this space.

Fixed Income transparency is taking centre stage in Europe

Two weeks ago at the Afme (Association for Financial Markets in Europe) conference in London, Fixed Income finally took centre stage! After years of talking about Equities, ATS then MTF, the rise and fall of hedge funds, high frequency trading and MiFID, maybe a little help from the financial crisis and thereafter (or was it before?) from regulators with MiFID2, Basel3, Solvency2 and the proposed Volcker rule there is finally enough meat on the table to have a full meal, even for our great financial champions. Extremely high quality of speakers, extremely high quality of panels, extremely high quality of attendance, but what struck me most was that we have to watch this space: competition could be heating up… It all started in 2010 when the Cassiopeia Committee, supported by the French ministry of Finance and Economy, sent out an open request for information (why not a request for proposal?) for an electronic institutional European corporate bond trading MTF, together with a set of extremely detailed guidelines on how to do it best according to them, including an all-to-all platform (meaning open to buy and sell-side members), order-book and CCP. Three proposals for new projects were made, one by NyseEuronext, one by MTS, and one by TradingScreen (another one, they realised, already existed for retail, EuroTLX) and there was no winner because this was not a competition. In Italy, when MiFID was transposed by legislative decree into Italian law, the way Fixed Income assets became traded was no different than the way Equities were traded. In fact, now Italian retail liquidity in Fixed Income is fragmented between one exchange (Borsa Italiana), four MTFs (amongst which EuroTLX) and seventeen internalizers. And to guarantee best execution in Fixed Income some Italian brokers route orders to the venue where liquidity and the best price are and enable asset managers to rebalance their portfolios through DMA systems. Of course this is not institutional flow, it is retail (roughly €50k). It probably is impossible to see such a model being extended to institutional sizes. In European Fixed Income historically most institutional trades were done over-the-counter with a bilateral agreement. There was no order-book, no clearing house, not even commissions, banks still today get paid with a piece of the bid-ask spread they quote to the buy-side. How could you expect a Fixed Income trader to price €50k or €20M with the same spread since if they do not get paid a commission proportional to the size of the trade? But transparency is a goal many European asset managers are aiming for and if they already get some pre and/or post-trade data from brokers or electronic platforms such as MarketAxess, or Tradeweb, there is no consolidated tape or TRACE-like data in Europe yet. Hopefully regulators will find a public or private provider for a European Tape, and MiFID2 will impose new and more stringent reporting rules that will not hinder liquidity or reduce trade sizes as some argue. Liquidity is also not comparable between Equities and Fixed Income: there are many more securities (just think of the Nestlé stock just being one and its numerous sister bonds with many different structures, coupons and maturities) and only 3-5% of them are actually liquid. Typically they trade right after the issuance, but then die away, except for unforeseen events such as downgrades. We have seen a lot of these recently in European govies but it has also meant that European corporate bonds’ liquidity has dried up. Will this change with MiFID2? To me the fact that some of the new electronic institutional fixed income platforms have pricings based on commissions and order-books is a clear push towards transparency. It looks like current market players are also preparing for MiFID2. Bloomberg for example, could in time become an OTF with firm prices for the buy-side; Vega-Chi, will be offering not only convertible bonds but also financials and high yield European bonds to the buy-side; UBS PIN-FI, already offers a wholesale platform for the buy-side with firm prices next to its retail odd-lot business. How many more of these projects are in the pipeline? The story does not say however how, post MiFID2, buy or sell-side firms will have to go through the headache of having to decide to which platform they are going to have to link up to guarantee best execution to a pension fund or insurance client, and how to integrate it best with risk management systems, and how much it will cost in terms of resources and money… We all know how much traders like to work on such operational projects, let alone the traders of the asset managers… And… Did I mention that most of these traders do not have an order management system (OMS) or execution management system (EMS) to route liquidity to the best platforms or trading venues? Because, remember, this is not Equity, it’s Fixed Income, traders actually do have to stream liquidity themselves because rarely here do they find firm orders, they’re mostly looking at Requests for Quotes (RFQs) that still have to be negotiated. I think I have a topic for my next research… To be continued!