Bonds: Improve alpha capture via internal crossing

Published on 28 February 2019

By crossing one fund’s ‘buy’ order with another’s ‘sell’ order, bond traders can save their investors considerable cost, however the mechanics and rules governing the process are complex. Cathy Gibson, head of dealing at Royal London Asset Management, James Wallin, senior VP at AllianceBernstein and Dan Hinxman, global head of institutional sales at TrueQuote, give the lowdown on how to manage crosses in order to drive best execution for a firm’s investors.

Dan Barnes Welcome to Trader TV fixed income – your insight into the trading climate for professional bond investors. I’m Dan Barnes. Crossing trades internally can save a huge amount of money for investors. However, it’s fraught with complexity. We’re speaking with Cathy Gibson, head of dealing at Royal London Asset Management, James Wallin, senior VP at AllianceBernstein, and Dan Hinxman, global head of institutional sales. at TrueQuote, to learn how the buy-side can deliver best execution through crossing at a lower cost. Cathy, James, welcome to Trader TV.

Cathy Gibson Thank you, Dan, a pleasure to be here.

James Wallin Nice to be online with you.

Dan Barnes How does an internaly crossed trade differ from a market filled order?

Cathy Gibson We have two funds who are buying and selling the same bond, and instead of going out to the market and buying and selling those with liquidity providers and paying full bid offer spread, we cross them between the two funds. Post-MiFID II, this means that we have to do it externally via a platform.

Dan Barnes And how would you compare the quality of execution you get with an internally crossed trade versus a market trade, Cathy?

Cathy Gibson So the quality of execution is much better on an internally crossed trade because we trade at mid,  so both the buyer and the seller of the fund benefit from mid-pricing as opposed to paying bid offer spread. So essentially it’s cheaper for our funds.

Dan Barnes So clearly there’s the need to capture the opportunity and then the mechanics of actually enabling that cross. What do you actually need on a trading desk in order to enable that to happen?

Cathy Gibson So you need a strong order management system that can actually identify crossing opportunities among a large trading blotter full of trades. Once you’ve identified them, then you need to have a venue, an OTF, whereby you can actually go out onto the platform and cross those trades at a mid price, usually determined by some sort of composite price.

Dan Barnes Because there’s the potential for one to get a mismatch, unless you’re very careful on that?

Cathy Gibson Exactly. We don’t want to favor one fund over the other funds.

Dan Barnes And James, how do you see that process being enabled on the trading desk? And how does that regulatory element creep into that?

James Wallin Well, I think, as Kathy mentioned, you need to flag the opportunity first, but then you need to have a methodology for identifying what the reason for selling on the one side is, and buying on the other side is. Actually, the selling is more critical, usually, to understand that you’re benefiting both clients. Examples are a cash flow where a client has to sell certain securities and yet, they’re still deemed desirable, or a situation where there’s been a rating or other changes in the ratings downgrade or another change in a characteristic of a security, that forces the client to sell an otherwise valued investment opportunity.

Dan Barnes Because you can say, you can take out the spread as that in itself is a quantifiable value, isn’t it?

James Wallin When you’re trading at the mid, assuming that both sides are benefiting from the trade, you’re clearly adding value because you’re eliminating the cost of the spread. What that is differs on a trade by trade basis.

Cathy Gibson The other non-quantifiable bit is actually the fact that you’re doing a trade and you’re not allowing information leakage into the market.

Dan Barnes Sure. So there’s no market impact?

There’s no market impact, correct.

Dan Barnes Are there any barriers to making a cross?

Cathy Gibson Barriers to making a cross would be lack of pricing transparency. So, where you’re trading a super illiquid bond and you can’t actually find evidence of where the fair value is, that becomes far more difficult. Ironically, they’re usually the best opportunities for crossing, because the bid offer spread is going to be the widest. So, you have put a lot of groundwork into evidencing your rationale and the pricing for those kind of trades.

Dan Barnes Okay, so that has to really be built into the best execution methodology?

Cathy Gibson Absolutely, and it involves working between portfolio manager, trader and sometimes compliance to agree that the level is appropriate for both the buyer and the seller of the fund.

Dan Barnes How are these challenges being overcome at the moment? Cathy, would you like to start?

Cathy Gibson I think there are some really good platforms out there now which have come on board, particularly in Europe, to allow us to do that cross trade. And also, I think the quality of the pricing and the composite pricing that we have for bonds, has really improved in the last number of years. So where we see a mid-price, our traders have to challenge the source of that mid-price far less than they used to have to do.

Dan Barnes In the States it seems that the rules are slightly more stringent on crossing trades. Is that actually a barrier to enabling crosses?

James Wallin The problem, as I alluded to previously, is that the regulatory framework here hasn’t caught up with the science of crossing or the art of crossing. And we need to get the S.E.C. to recognize our ability to use pricing service prices. And we need to get them to recognize that there’s a cost here that is appropriate, which shouldn’t be considered a commission, if you use a platform that allows you to set up, document, and clear your cross.

Dan Barnes Are end investors showing interest in crossing trades? And is there a way to show the benefits to them?

Cathy Gibson Yes, they are showing interest in cross trades. They will show interest in anything that adds alpha to their fund, and cross trade certainly does that. In terms of showing the benefits to them, they can see that in their trading cost analysis.

James Wallin I think the key with crossing and describing crossing as part of a comprehensive trading strategy, is to make sure you emphasize that it’s being done for the good of all clients. And, that’s in the context of the US regulatory environment again, where there have been a number, including recent situations, a number of issues with crossing and regulatory sanctions being applied for improper crossing.

Dan Barnes That’s great. James, Cathy, thank you very much.

Cathy Gibson Thank you.

Dan Barnes Now, Dan Hinxman, global head of institutional sales at TrueQuote, will give us his insights into how to make crossing effective. Dan, welcome to Trader TV.

Dan Hinxman Dan, thanks for having me here.

Dan Barnes So can you tell me, why do clients need to cross trades internally, and what are the challenges they face in managing that process?

Dan Hinxman They’re quite at liberty to trade like any other directional trade that they have within their order staging in the open market. But I think what we’ve seen over time is asset managers have seen significant efficiencies of conducting and identifying these internal crosses, and executing these internal cross trades. And they’ve seen huge efficiencies around best execution and TCA, as well as operational advantages. And I think, as well as those being efficiencies and advantages, I think they also present certain challenges as well.

Dan Barnes So what are those challenges and how do they need to be overcome?

Dan Hinxman The asset manager has the responsibility to meet the fiduciary duty of the underlying investor. And I think, what makes this a unique situation for a cross-trade situation, is that they have to do that at least two times over for the underlying investors, and to consider all of the factors for both parties. And that’s both from a best price perspective, that’s also from a completing the trade with the minimum amount of slippage for the size of the trade, and also from the minimum amount of disruption to that market, because obviously the asset management may have a residual portfolio position to protect in a particularly illiquid instrument. And the last thing they want to do is move that market away from a fair price point.

Dan Barnes And what do you have to have on the trading desk itself to enable this process?

Dan Hinxman Well, I think firstly, the asset manager needs to build into their best execution policy, whether that’s an internal document, or a client-facing document, or even a publicly, published document, that they have an internal, crossed trade policy within their best execution. And once they’ve done that, they need to be able to efficiently identify where crossed trades do occur. That normally happens in their order management system, in their order staging. And that needs to be done in a timely and efficient manner to allow them to conduct those trades as necessary. And then after that, they need to implement the process that they’ve chosen that best meets their best execution policies. So that could be their own internal measures, or that could be a platform like TrueQuote’s cross-trade, where they have a number of those factors that are considered for them in that process.

Dan Barnes Does the size or the type of asset manager affect where the crossing is more viable?

Dan Hinxman I think if you take the whole scope of of the broader buyside, very much so. So, if you take a sovereign wealth fund or a hedge fund who typically, when it really boils down, they tend to just be managing all of their trading activity to one or two or three handful of funds,  there’s less of a need to cross internally or less occurrence of where that might happen. Where if you take a very large asset manager who has hundreds of funds to manage and portfolios, the likelihood that there’s going to be inflows and outflows, and also different types of trades, so, you’re going to have your typical risk-on, risk-off trades that come through the execution desk. And at the same time, you’re going to get redemptions and daily and monthly rebalancing, particularly if they’re an index-linked asset management.

Dan Barnes So how far along are buy-side firms in making that change?

Dan Hinxman I think that their a fair way through the process, actually. Most asset managers have adopted an internal crossing policy, whether that’s both localized regionally or globally. And there are nuances to the view of crossing trades internally, globally, and how they then have implemented that. Their strategy over the top of that may be an adoption of a platform like TreQuote’s, or having their own internal process where they’ve satisfied their internal compliance and regulatory requirements.

Dan Barnes What are some of the operational issues?

Dan Hinxman So, I think the asset manager needs to make some considerations about operations, and that tends to start from things like consistency, whatever they implement as their best practice for crossing trades internally, can they replicate that process time and time again, to demonstrate that they’re treating all end investors the same, day in, day out, regardless of market conditions? And I think, also from an audit perspective, from an operational perspective, they need to have the processes perhaps within an electronic workflow. So it’s very easy to audit, and the information at hand, should there be some sort of query around that trade in days past the trade.

Dan Barnes That takes the the workload pressure off the trader to manually record all of that.

Dan Hinxman Yeah, absolutely. And simply from a scalability point of view,  we’re not just talking about one or two trades a day. These asset managers are quite often putting through hundreds of line items in a particular day. So, it could be a very laborious process if they’re having to do that very manually, using another protocol like RFQ, or bulk uploading to a particular dealer, and then having to do it two or three times over to make sure that they’ve got the best price between two or three dealers. You can see in that process there’s a lot of sharing of information, it’s a long process and it could be rife with human error. While having it in one, simple electronic workflow is very easy to keep track and make it a very scalable process day in, day out, and also globally. So, if you’ve got an execution desk based in London, it’s very easy for their APAC or their US desk to replicate exactly that same process.

Dan Barnes And what is it you see spurring them into using internal crossing?

Dan Hinxman Certain asset managers have taken their policy around internal crossings and championed it to their end investors, as a way of demonstrating the best execution and the cost savings associated with internal crosses. So, I think we’ll see more and more of that. I think, that will be championed internally that that becomes a sort of steady process within an asset manager.

Dan Barnes And finally, the TCA challenge, the transaction cost analysis-challenge in fixed income has always been massive. Do you think it’s easier to evidence best execution from an internal cross than perhaps it might be with a market trate?

Dan Hinxman I think it faces the same challenges. I think, from a best price point of view you can’t look at all of these parts of TCA independently. They’re intrinsically linked from the best price, the slippage of a trade, and the best outcome for the investor over a period of time, and the size of the trade, et cetera. So I think, you can look at it in all of its different component parts, but ultimately, what is nice is when you’ve got the process in place, it’s easy to reflect on that through an audit process, and be able to see why you made decisions, and you were consistent in the decisions you made to try to carry out the execution.

Dan Barnes That’s great. Dan, thank you very much.

Dan Hinxman Thank you, Dan.

Dan Barnes I’d like to thank Cathy Gibson of Royal London Asset Management, James Wallin of AllianceBernstein, and Dan Hinxman of TrueQuote for their insights into crossing trades, and of course you for watching. To catch our monthly reports on other markets or to subscribe to our newsletter, go to TraderTV.NET.