Institutional investors, including mutual fund managers, will be able to lend their bonds to Wall Street and help fixed-income trading markets get moving again, once a new electronic platform becomes available next year. That’s the idea behind DelphX, a communications network that will allow Wall Street banks to get around regulators’ restrictions on their securities inventories, essentially renting positions from investors to support trading. By renting, not owning, banks won’t have to put up expensive capital to facilitate market making.
Larry Fondren, founder and CEO of Malvern, Pennsylvania–based DelphX, expects the product to go live in the first quarter of 2016. Wall Street, big bond investors and regulators have been painting a picture of broken trading markets and the potential for a crisis to erupt once interest rates start moving up and bond prices fall. But the difficulty big investors are having buying and selling large blocks of bonds has also created enticing opportunities for eager entrepreneurs like DelphX.
DelphX’s idea leverages an indisputable fact: Wall Street’s bond holdings have shrunk 80 percent, by some estimates, since the highs in 2007. At the same time, corporations have issued record amounts of debt to take advantage of record-low interest rates. Investors searching for higher-yielding securities have gorged on the new bond issues. Total assets in high-yield mutual funds alone have grown to $286 billion, up from $176 billion four years ago, according to Chicago-based fund tracker Morningstar.
Fondren says that the company’s platform is an electronic trading network that allows banks to negotiate future deals with investors and then place a hold on specific securities through DelphX. The securities that are covered by the contractual agreement are called cached inventory. Through DelphX, banks can get access to the securities to fulfill the transaction within a specified time period. “Dealers set up pools of reserved inventory this way, but they’re not on the dealer’s balance sheet,” says Fondren. Conversely, investors get incentives to do the transaction. “Investors get alpha by allowing the dealers to place a hold on their securities,” he adds.
In the 1990s Fondren developed and operated InterVest, the first regulated market for electronic trading of corporate bonds and asset-backed securities.
As an example: A dealer may offer insurance companies, which are some of the most regular buyers of corporate bonds, a better price on popular new issues in return for the right to buy the security back at a higher price some time in the future. The transaction would give the insurance company access to new bonds and the dealer a potential inventory to sell if markets become more favorable. “In many ways the insurance company would be passively making markets,” adds Fondren. DelphX holds all cached inventory in its system confidentially. Before banks became subject to increased capital charges and other restrictions on proprietary trading, they would have held back part of a new issue for their own trading books, hoping the price would rise and then selling the securities into the market.
Fondren says, “We’ve given dealers back the ability to intermediate liquidity. They don’t buy and hold. Dealers buy in order to sell.” He adds, “Bond inventory has to move, just like product in a hardware store.”
Kevin McPartland, principal of market structure and technology at Greenwich Associates in Stamford, Connecticut, says, “If this alleviates the balance-sheet concerns on the sell side, then this could be a huge deal.” McPartland notes that there are issues still to be worked out with cached inventory, such as regulators’ take on the agreements, “but nothing that is insurmountable. Everybody is trying to adapt to the new world.”
McPartland, who authored a recent study on the state of electronic trading of corporate bonds, emphasized that new entrants are seeing a respectable level of success in breaking into the fixed-income market.
Although a number of innovations are relying on changes in the way the market is structured, DelphX’s platform keeps participants playing familiar roles. “All-to-all” trading protocols, for instance, allow a bond manager to connect with a competing firm to find the other side of a trade. But money managers have long relied on intermediaries to support their trading needs, and behavioral changes could be far down the road. With DelphX’s platform, a dealer who gets a call from a big client looking for a $50 million position, say, can then put out multiple caching offers to investors who may hold the security. The dealer gets the ability to structure inventory held on the balance sheets of other investors.
“Investors are selling off some of their upside for a limited period of time,” says Brad Golding, a New York–based managing director and portfolio manager at Christofferson, Robb & Co., a global credit money manager.
Rick Perretti, an executive vice president formerly at Dallas-based Southwest Securities in taxable fixed income who recently joined a credit hedge fund, says DelphX is innovative on a number of fronts, including its plan to turn fee protocols on their head. Instead of charging dealers for every transaction they execute through the platform, DelphX will charge a monthly fee to money managers for unlimited trades. The fee structure will encourage more dealers to sign on, especially regional brokerage firms. “Regionals operate most efficiently with smaller insurance companies and other accounts. If you combine their model with DelphX, regional dealers can start to move up, solicit larger money managers and play a larger role in the market. There needs to be some solutions that can unclog this drain,” he says.
Golding says the concept of charging money managers is reasonable in theory, especially if dealers are likely to show prices on day one because of the pricing structure. “Investors are complaining about liquidity. This gives them an innovative platform that could help them in a crisis,” he argues. DelphX allows “dealers to quickly move bonds off their balance sheets and still have inventory for their sales and marketing people to work with.”
Not everybody thinks electronic trading platforms and other solutions will fix problems that have popped up in bond markets. Marc Pinto, a managing director in the financial institutions group at Moody’s Investors Service, says, “These only help at the margins.” But despite all the chatter in the market about the lack of liquidity, Moody’s doesn’t think a crisis is waiting to happen. Robard Williams, a vice president and senior credit officer at Moody’s, thinks market structure will ultimately work. “As market volatility picks up and as investment clients demand it, banks will be there. If the return is there, they will participate,” he says.
Follow Julie Segal on Twitter at @julie_segal.
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