Smart Market Making in a Dynamic Environment

Published on 23 October 2023

How dealers optimise access to structured and flow products for buy-side clients

Demand for structured and flow instruments can be highly changeable as interest rate uncertainty persists. Pontus Eriksson of FIS, with Alexis Cooper and Stefan Auerweck of Bank of America discuss how a sell-side firm can support its clients across assets, in both complex and vanilla instruments, in order to provide investors with the best possible outcome when generating returns in an environment characterised by inflation, central bank responses, and volatile corporate market.

Dan Barnes Welcome to Trader TV, your insight into institutional trading. I’m Dan Barnes. Sell-side firms face considerable pressure to support clients in a rising rate environment, by providing access to both complex and vanilla investment instruments. To discuss how banks can optimize this process are Pontus Eriksson from FIS, and from Bank of America we have Stefan Auerweck and Alexis Cooper. Guys, welcome to the show.

Pontus Eriksson Thank you.

Alexis Cooper Thank you.

Stefan Auerweck Thanks.

Dan Barnes How does a rising rate environment and market volatility affect appetite for different investment products?

Pontus Eriksson First, we have a high rate environment. We have uncertainty of the direction of rate changes. We have a number of people who are not sure of where to go in the market, and simply there’s a tense atmosphere. We also have market electronification and the wider digitalization trend that is fuelling the transition to more electronic trading. We see also a continued appetite in high volume equities. We see fixed income. We see high yield coming in. We have an increased interest in own issued products. We also have an appetite from the retail markets to institutional markets to high net worth individuals. And the common theme is that we see a cross asset class need. In the retail space, for example, there is drive towards more trading equities and certificates and bonds and ETFs, etc. So we see definite democratization of markets and users becoming more advanced.

Dan Barnes That’s great, thank you. Alexis, from your perspective, how are you seeing demand for different types of instruments change?

Alexis Cooper Broadly, the last 12 months in the European credit market has been characterized by an inverted yield curve and wider credit spreads. This, of course, has given rise to changes in client behavior. For example, there are interesting opportunities in relatively short dated bonds now. This might be a rotation out of lower yielding longer duration or perhaps a reinvestment of cash previously put in bank deposits, which were quite low yielding. We’ve also seen an up in quality trade, with outflows in private credit and illiquid assets, and inflows into liquid credit, which are now at attractive investment yields.

Stefan Auerweck As Alexis touched upon, there has been a big shift into more shorter duration, into more vanilla products. So, in the rates world, that means interest rate swaps, sovereign bonds. In general, our clients have been moving out of alternative investments like real estate, the private equity, into these vanilla products. And while the European interest rate market has always been highly electronic, there have been some new developments over the past five years or so. Rule based trading, for example, or axe distribution, and some of the clients returning to the market might not be up to speed with these new tools, but they’re very interested to learn about how they can use these new developments to help their execution and be more efficient.

Dan Barnes So, Pontus, what sort of operational pressures is that potentially putting on banks?

Pontus Eriksson Market making and principal risk trading are two interdependent business areas, and they have been under significant regulatory stress in recent years. And we are seeing many market making desks are being run by fewer and fewer people. So there’s a lot of automation, exception management and oversight and operability requirements, and more of a surveillance type operation where technology sits in the front seat. Working across desks to support pricing and delivery of liquidity needs coordinated risk and pricing systems. So we need to create a single environment for trading a risk to increase the efficiency of how you conduct risk transfer. You need to work across asset classes in a single view of risk, and I think without strong pricing and risk management and prudent risk management, this is just very difficult. So, more broadly, we see that many banks and brokers, they are bringing together the market making function, the brokerage function, and the matching via internal markets, to source internal flow and the overall position management and risk control under the same sort of roof.

Dan Barnes And then Stefan, from your position, how do you see those pressures manifesting?

Stefan Auerweck 99% of the tickets we see on the desk are now electronic. And not only that; over the past five years, this has increased threefold. That puts a huge strain on our systems, on our traders. There is a lot of focus on portfolio rebalancing on month end now, so within a very short timeframe – maybe five, ten minutes – we see thousands upon thousands of requests. So there’s a constant need to find innovative solutions to manage these new challenges that are coming up.

Alexis Cooper Similarly, in the European credit space, volumes have increased dramatically over the years, but there hasn’t been a similar increase in the number of traders, so automation has been key. Looking into the European investment grade credit market in particular, about 45% of the market is traded electronically right now. Within that electronic business, around 25% of our volume is executed using an algorithm on our side. Now that’s volume. In terms of tickets, that’s about 50%, and if you expand further to all quotes we give – i.e. including those that don’t result in a trade – about 75% of our tickets quoted are priced by an algorithm on our side.

Dan Barnes How does access to different types of liquidity support client service levels?

Alexis Cooper We, of course, have so many different types of clients with different investment targets and different investment theses. As an example, in the high yield space in European credit right now, many analysts at our clients are poring over balance sheets to analyze what effect refinancing debt over the next few years at higher yields will have on those companies and what that will do to their credit spreads. In some cases, this brings interest from distressed debt investors. On the flip side, while still in the high yielding space, in bank AT1 debt – the most subordinated part of the bank cap structure – banks have broadly passed the market test of the write down of Credit Suisse AT1 bonds in March, and we have a whole variety of global investors happy to buy new AT1 debt. Moving to the structured side, one of the popular strategies in our quantitative investment strategies business are the fragility indices. This is where we deliver in total return format the returns from harvesting certain rich volatility risk premia, whilst with an overlay of a defensive risk hedge. This is ultimately hedged by the banks using vanilla rates and credit instruments, and we’re only able to deliver this by bringing together lots of liquidity sources across the rates and credit markets.

Dan Barnes And Stefan, what can improve the efficiencies of client service?

Stefan Auerweck I think communication is key here; so that means both internal communication with our technology, with our e-sales, voice sales and trading, but also with clients. We strive to customize our offering to clients’ needs in terms of access, skews for example, we want to be as transparent as possible. As Bank of America, we have invested hugely in our international presence. That means we can access a wider variety of clients, products, can be more aggressive in pricing and warehousing the risk. So, all of this together, I think, makes efficiency.

Alexis Cooper Ultimately, we’re going to be driven by the evolution in client demand facilitated by technological developments.

Dan Barnes So, Pontus, how do you see client servicing evolving?

Pontus Eriksson We see a continuation of electronification of markets in all of these areas, market making, brokerage, and so on. We see a lot of markets becoming global. We see a lot of execution flow being outsourced to larger players, so payment for order flow, for example. We also see a convergence between buy-side and sell-side, as buy-side becomes more and more sophisticated. There is a number of forces in electronification, such as automation, and there’s also cost pressure, algo trading, and now artificial intelligence that’s going to come in and create, you know, a whole new area.

Dan Barnes I’d like to thank Pontus, Stefan and Alexis for their insights today and, of course, you for watching. To catch our other shows – and Trader TV This Week every Monday at 6:45 a.m. – go to tradertv.net.