Higher rates could trigger liquidity shortages in fixed income

Deutsche Bank leads in market share

Question mark, interest rates Question mark, interest rates

A downturn in global fixed-income markets brought on by an uptick in interest rates or other causes could trigger liquidity shortages for institutional investors. So warns consultancy Greenwich Associates in a new report in which it names the leading dealers in global fixed income.

According to that report, Deutsche Bank leads the global fixed-income market with a 10.7% share of overall trading volume. Barclays is second with a market share of 9.8%, followed by J.P. Morgan at 8.8%, and Citi and Goldman Sachs, which are tied with market shares of 8.0 to 8.1%. These firms are the 2012 Greenwich Share Leaders in Global Fixed Income.

Barclays is the 2012 Greenwich Quality Leader in Global Fixed Income. Greenwich Quality Leaders are firms that receive quality ratings from their institutional clients that top those awarded to competitors by a statistically significant margin.

Global Sorting Process in Fixed Income

Fixed-income markets continued their global sorting process in 2012 as major dealers adjusted their business models for the post-crisis regulatory environment. The exit of some global banks from key fixed-income business lines in the face of strict new capital requirements and retrenchment among many others put market share in fixed-income trading up for grabs last year. The end result: A continued loss of aggregate market share for the world’s biggest fixed-income dealers, with some firms picking up volume, others losing it and freed-up trading business being broadly disseminated among top 10 and even top 20 dealers.

In the end, this process could result in a market in which leading dealers actually increase their dominance and their aggregate market share in the trading of many fixed-income products. The reason: In highly liquid fixed-income products, or flow products, the ultimate competitive advantage in the new market structure might well be scale. Large amounts of trading volume provide dealers with insights into the location of supply and demand, thereby creating opportunities for trade crossing. Heavy trading volumes are necessary to generate acceptable levels of return on the sizable investments required to build and maintain the technology infrastructure for electronic trading, aggressive inventory management and collateral management in derivatives trading.

“For these reasons it quite likely that in highly liquid rates and credit products the big will get bigger as top-tier dealers leverage the benefits of scale to win even bigger shares of the market,” says Greenwich Associates consultant Woody Canaday.

New Dealer Business Models Increase Risk of Liquidity Shortages

As 2013 gets underway, fixed-income markets are functioning quite smoothly, despite fears that new capital requirements on banks would sap liquidity from institutional trading. Institutions should not be lulled into a false sense of security, however. The risks of a mild or even severe liquidity event remain elevated due to attrition in the inventories of the world’s largest fixed-income dealers and the elimination of bank proprietary trading desks.

In the ongoing global bond rally, liquidity is not hard to find. But a look at the underlying market structure reveals a potentially dangerous fissure. Virtually all major banks have slashed their fixed- income inventories and shuttered proprietary trading desks that prior to the crisis represented an important source of supplemental market liquidity. To generate liquidity for their clients, dealers are increasingly relying on trade crossing among institutional clients, often carried out on electronic platforms. This process works well as long as buyers are in abundance.

“But what happens when interest rates begin to rise and fixed-income markets begin to sell off?,” asks Greenwich Associates consultant Andrew Awad. “When everyone wants to sell, there will be no one on the other side to cross trades with and capital-constrained banks will have no interest in assuming their traditional role of liquidity backstops.”

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