Building bonds
In response to the second priority, the company purchased bond trading platform Vega-Chi early in 2014 and used that as the starting point for Liquidnet Fixed Income, which launched a dark pool in September 2015. Vega-Chi's founder, businessman Constantinos Antoniades, is now head of fixed income at Liqudnet and continues to run Liquidnet Fixed Income. A year after its official launch, the platform currently has
215 active firms.
According to Pumfrey, the main challenges in the bond market are twofold. First, the amount of inventory provided by the sell side is down 80-90% since 2008. At the same time, there has been a massive increase in bond issuance.
These factors have been exacerbated by historically low interest rates, together with periods of market volatility, not least in reaction to recent events including the UK’s surprise vote in favour of Brexit in June, as well as the victory of US presidential candidate Donald Trump in the US election in November 2016.
Meanwhile, the G20 global regulatory agenda and particularly MiFID II continues to have a transformative effect on the global bond market.

“MiFID II will have a huge impact on fixed income markets. It’s similar to where the equities markets was before electronic trading completely change the market structure,” said Pumfrey. “One challenge is that unlike the equities market, there is no reference price. Being able to aggregate data sources to help define the right price for a bond is key to enabling transparent and efficient trading.”

One possible strategy to resolve some of the challenges in fixed income is to allow
the sharing of order indications in a dark pool and trading with other buy-side
firms directly. With market participants trading in the dark, market impact is minimised and price improvement is maximised. In a more transparent fixed income world, there is a need for detailed TCA, which is in a relatively nascent stage of development in fixed income compared to equities.
While a number of market participants have talked about this over the years, little has changed in terms of the consolidated tape, despite it being one of the central recommendations of AFME prior to MiFID. It is widely known that a number of large exchanges make a significant portion of their profits from market data and the provision of a consolidated tape would in theory undermine that revenue source and as a result they are reluctant to see change in this area.

“The consolidated tape never emerged because data is so profitable,” said Pumfrey. “There are vested interests that need to be overcome. However, that can only happen when there is a mandate which forces a change and so far not enough market participants have been willing to do that. Nevertheless, the direction of travel is clear: a key objective of MiFID II is increased transparency and therefore perhaps further down the line change could be afoot".

Currently, a key focus for Liquidnet in Europe is to continue building the fixed income member community. The aim is to get the number of liquidity providers up from 71 to 100 plus next year in Europe. As part of that plan, the company will continue to focus on innovation on the platform, as well as integration with
OMS vendors to ensure that liquidity can flow onto the platform in the most efficient way.

“Volatile markets, and low interest rates means that market participants that own bonds become concerned about access to liquidity when they have to trade. This issue has been a concern for some time and it shows no sign of abating,” said Pumfrey. “As Liquidnet's fixed income member community continues to grow, there
will greater diversity which will further build liquidity. We expect to double our match rates in six months and when that happens, we believe that daily trading volumes will significantly increase.”

The hunt for liquidity

Mark Pumfrey, CEO for EMEA, Liquidnet

Liquidnet’s origins go back to 1999 and 2000, when founder Seth Merrin, CEO of and founder of Liquidnet, met with a number of US asset management companies to discuss how to make equities trading more efficient. Of these, around 40 agreed
to support the idea of blotter sweeping order management systems to find large blocks of stock, and Liquidnet was founded. Now, sixteen years on from the launch, Liquidnet is a well-known part of the buy-side trading landscape.

On joining the company in December 2012, Pumfrey decided to evaluate what the company's clients wanted to see. His background in equity leadership positions
at Bank of America Merrill Lynch in EMEA had taught him how critical relationships
are to ensure a business understands what its client’s requirements are.

“The ongoing dialogue with our members means that we can align the development of our equity and fixed income platforms and trading tools to their ongoing needs," he told the Buy-Side Perspectives. “Liquidnet is a Member community and therefore this inclusive approach is intrinsic to everything that we do. When Seth Merrin started the business he opened a conversation about how to create a new way to source liquidity, he made ongoing client engagement part of Liquidnet's DNA.”

What Pumfrey found is that there were two things the 830 Liquidnet members wanted. The first was improvements to trading behaviour, for example to stop traders from ‘fading’, which occurs when a trader has a match, but fails to execute. The other was a fixed income offering, where the community felt that there was a need for a similar kind of platform to Liquidnet’s equities offering.
This requirement has been driven by regulatory changes; the reduced inventory
from the sell side and the expanding universe of fixed income instruments, all of which have combined to create a dearth of bond market liquidity.

To tackle the first issue, Pumfrey introduced a plan involving member education and tough rules on behaviour.

“When we went into more depth with traders, we found that most times poor execution behaviour is not intentional, rather issues arise because the trader can’t find a way to make their workflow work. So we focused on improving their integration with Liquidnet to make it as easy for them as possible to trade effectively.”

STATISTICS FOR LIQUIDNET FIXED INCOME:

• Has traded $1.7billion in Europe since launch
• Average indication size is $4.5 million
• Average execution size is $2.5 million a trade
• Has 71 institutions providing liquidity in Europe

The changing shape of the sell side
One of the significant factors affecting the buy side globally is the changing role of the sell side, and in particular the reduced resources available to brokers.
The reduction in head count in recent years, including a notable decrease in the number of sales traders combined with the reduction in the amount of balance sheet available for fixed income trading has had a severe impact on the buy-side's ability to access liquidity in this market. The impact of these pressures has been compounded by the additional effect of regulatory changes under MiFID II, specifically the unbundling of payment for research and execution which has reduced the amount of research available in both fixed income and equity markets, with the small and mid-cap stocks sectors being particularly hard-hit.

“The balance of power is shifting between buy side and sell side,” said Pumfrey. “Regulation is putting more responsibility on the buy side and they need to bolster their trading capabilities to cope with that pressure. The issue for the sell side is to work out exactly what its value proposition is to the buy side. If you run a sell side business you have to be honest to your clients and yourself about where you can genuinely add value.”

According to Pumfrey, this new environment means that the buy side also has greater responsibility than before. Among other things, unbundling has contributed to a huge increase in the amount of data the buy side needs and has to process. The use of client commissions to pay for research may well be on its way out. Overall, the buy side may move towards paying for research out of its own P&L, but for now many will
rely on RPAs linked to CSAs.

“Unbundling is a sensible process,” he said. “Being able to access high quality research is essential for the buy side. But the critical question is how will the buy side obtain and pay for this research. Meanwhile, responsibility for best execution now rests with the buy side, whereas it used to be the responsibility of the broker. On the positive side, unbundling shines a light on the level of service the buy side is getting, which should be good for everyone as the quality should improve as a result and waste will be reduced.”

MiFID II is currently heading towards the final stages ahead of implementation in
January 2018. While the UK referendum on Brexit in June 2016 resulted in a
majority vote in favour of leaving the EU, Liquidnet estimates that this is unlikely to
occur before 2019, while MiFID II will be implemented in 2018; i.e. MiFID II will still
apply in the UK.

“Lack of transparency has protected some firms in the past,” added Pumfrey. “Existing and forthcoming regulation is changing all of that and the intentions are clear. The spotlight which was shone on the banks is now shifting onto the buy side as a whole which is creating a greater sense of focus and ensuring firms are delivering greater value.”

STATISTICS AT A GLANCE

• Liquidnet’s EMEA equity platform has doubled its market share over the last 12 months
• Average daily principal traded compound annual growth has increased by 22% since 2013
• Since its launch just over a year ago, more than $4bn in corporate bonds have been traded on Liquidnet's fixed income trading platform and there are more than 200 members
• The main focus of the firm is solving the issues of its institutional Membership
community through innovation – arming traders with new ways to capture alpha for their firms.
• A priority for Liquidnet is to help its Members prepare for the impact of MiFID II, this initiative is being driven by Rebecca Healey, who joined the firm in July 2016 as Head of Market Structure & Strategy.
• In total, Liquidnet is present in 44 markets
• In Asia over the past few years, Liquidnet has opened new markets in India and Taiwan. A big opportunity in Asia according to Pumfrey is to repeat the success Liquidnet had in Europe and US with its Next Generation algos.

The importance of innovation
For Liquidnet, a significant part of that value is innovation. The platform created Targeted Invitations as a tool for the buy side to unlock latent liquidity; it also launched its Next Generation algo suite in early January which includes its dark aggregator – Liquidnet Dark – which has grown significantly to account for around
a third of the company’s volumes.

“There’s not been a lot of innovation in the industry in the last few years,” said Pumfrey. “One big advantage we have is that we have the singular objective of helping the buy side trade achieve best execution. MiFID II is forcing them to take greater control of execution performance which requires them to have a new class of tools and technology in order to achieve this. At Liquidnet we are focused on providing them with innovative trading and analytical tools including advanced data analysis, adaptive learning algos, liquidity search tools and real-time analytics.
“We just recently held our annual member summit in the US, and one of the streams was dedicated to discussing the company’s latest technology developments that we are working on,” he added. “We not only showcase our newest ideas and enhancements but also offers our members the opportunity to offer suggestions. This is part of our innovation hub – Liquidnet Labs. Targeted Invitations is a good example of our newest innovation which we designed through collaborating closely with our members. We launched it on our equities platform last year and it is now available in Fixed Income as well. Out of Liquidnet's 350 employees, around 200 of them are dedicated to technology which is testament to how important innovation is to us.
We believe this approach makes us nimble and able to respond to our
clients’ needs which of course is a huge advantage".

Elliott Holley
Head of Global Buy-side Research
eholley@kandkgc.com
+44(0)7759 476779