Overcoming illiquidity in OTC markets

Published on 22 October 2019

When over-the-counter markets are suffering from a limited liquidity supply, buy-side firms can struggle with price formation and counterparty selection. Those trading desks can be far more manoeuvrable if they are able to trade exchange-traded instruments such as futures, exchange-traded funds (ETFs) and options on ETFs. Lee Bartholomew, head of derivatives product R&D in fixed income at Eurex, outlines the strategies and skills that traders should consider when assessing instrument selection.

Dan Barnes I’m joined by Lee Bartholomew, head of derivatives product R&D for fixed income at Eurex. Lee, welcome back to Trader TV.

Lee Bartholomew Thank you very much for having me. It’s a pleasure to be back.

Dan Barnes So tell me if buy-side traders are finding liquidity in price formation difficult in over-the-counter cash markets, what are their alternatives?

Lee Bartholomew The heterogeneity of bonds means that it’s unable to achieve the optimal model that you see in the equity market. So, I think the way that the markets evolve, and by the markets, I mean the different segments of the different players, means that electronification is definitely playing a more pivotal role in the use of a trader’s toolkit, in essence. So, the electronification means that platforms are obviously seeing an opportunity to grow. You’ve then got the traditional role of an exchange which has largely been to have the point of contact in terms of alternative liquidity pools. And that’s largely in the listed space, whether that’s futures, or options, or index based products, or options on those index based products. And I think what you’re now seeing is, in the cash market, the liquidity has been split across various platforms. Now, what you see in the exchange world is, you have key players that have always been able to provide buckets of liquidity in their core franchises. You’re seeing the buy-side now that we’re looking at electronification and banks are under increasing pressure on their balance sheets and margins, and given the right environment, are looking to say, ‘we want to see more fungibility across the product suite.’ The drivers will be the ability of those exchanges, plus the south side to offer cross product margin.

Dan Barnes Trading in those liquidity pools. What difference does that make if bank balance sheet, for example, is very limited?

Lee Bartholomew For the buy-side, what they need to see is liquidity. When they’re looking at developing their technology and moving into execution, then you have to look at the full system that they’re using and then what tools do they have available on a desk level, and then where do those liquidity triggers point into? And what is the most important factor for them? Is it the cost of execution? Is it liquidity number one, or is it cost product margin? And I think those are the three areas which are the most interesting both to the buy-side and the sell-side going forward.

Dan Barnes Is it challenging for traders to work across both the listed and the OTC range of instruments?

Lee Bartholomew It’s what products can and exchange or alternative providers create in which you replicate some of that OTC risk. ETFs will be a prime example of that. So, you know, you can trade, I think, you can override the underlying cash bonds. You can trade the ETF, you can trade options on the ETF or what you’re seeing is people trade in index based products or a portfolio of bonds. I think that is where the market pushes towards, going forward.

Dan Barnes Lee, that’s been great.

Lee Bartholomew Thank you.