Earlier this summer, a trader in Bank of America’s fixed income, currencies, and commodities division got a mammoth request from a client: They needed to execute a bespoke $1.5 billion bond trade — a combination of buying and selling hundreds of securities across sectors. Price and efficiency, as always, were paramount.
The trader went to work, using algorithms and third-party composites to source and price the bonds, returning an aggregate cost to execute the package and a line-by-line breakdown. It took under an hour, and cost the client less than three basis points.
In the coming days, the Bank of America team offloaded the risk through more traditional trading methods as well as techniques like exchanging the underlying bonds for exchange-traded fund (ETF) shares to sell into the market.
A portfolio trade of that size and complexity would have been all but impossible until recently, let alone at a bid-offer spread of less than what it costs to execute an individual $25 million investment-grade bond trade, according to executives at Bank of America.
“Three years ago, that would’ve been unheard of,” Jon Klein, who oversees investment-grade credit trading in the US at the firm, told Business Insider.
“The scale of one of these trades, given the number of CUSIPS involved to price that sort of risk in a short period of time, is sort of exceptional,” he added, referring to the unique number used to identify and track individual stocks or bonds.
The bank says it has been able to apply technology and approaches that underpinned a boom in bond ETF assets to other big trades, and is shaking up its FICC division to make these trades more accessible for clients across the spectrum of products.
Bank of America is betting the ETF and portfolio-trading revolution in FICC is just beginning, and that investor demand for liquidity and transparency will further rev up the market. In July, it went live with a new centralized FICC ETF trading desk — helmed by Karen Fang— that aims to consolidate the technology and know-how it’s developed handling bond ETF, portfolio, and index trades and deploy that to other areas in FICC.
The new team is part of wider effort undertaken this spring to consolidate global cross-asset trading desks, including dedicated groups, also under Fang, focused on counterparty portfolio management as well as structured notes.
For years, banks across Wall Street have been trying to jump-start their FICC businesses as the overall pool of trading fees has been shrinking, declining 22% to $64 billion in 2018 from $82 billion in 2013, according to industry data and consulting firm Coalition.
Bank of America is the third-ranked FICC business on Wall Street, behind JPMorgan Chase and Citigroup, according to Coalition. Revenues continued their years-long slide across the industry in 2018 and the first half of 2019, and Bank of America’s numbers have been declining at a roughly 8% clip.
The firm is chasing volume by making big trades easier for clients, even while earning relatively narrow spreads — spreads that also have to compensate for the risk the bank takes on while pulling off trades.
The approach also requires trading desks that had typically operated autonomously to work more together, which could be a tough sell in an industry where teams and even individual traders often hive themselves off.
And to be sure, the bank’s competitors have experience in the mechanics behind credit ETF trading, too. High-frequency trading firms that have jumped into ETFs are also eyeing parts of the FICC market. But Bank of America says it is willing to focus on expanding the relatively low-margin trades to grab market share.
“It’s always easy to say, ‘We want to take a wait-and-see approach on some of these things because they’re going to crush our margins,'” Fang said. “But we can also take this as an opportunity to enhance our services to our clients, improve transparency and liquidity in the trading ecosystem, and maintain our market leadership position in the fixed-income business.”
Bond ETFs themselves have their critics, who say they trade unpredictably during periods of market stress, possibly resulting in mis-pricing of the underlying bonds. Asset managers and market-makers meanwhile argue bond ETFs can provide overall market liquidity.
The rise of Bond ETFs
A few years back, a billion-dollar bond portfolio trade might have happened once a month across the US market, according to industry executives and consultants. Now, these transactions are happening every week, and portfolio and ETF trades in the hundred-million-dollar range are executed many times a day.
Bank of America and other market-makers in this space have spent significantly on developing tools to make massive trades commonplace, contributing to the wide-scale growth of fixed-income ETFs.
It’s no secret that this area of the bond market is starting to balloon. Amid the broader active-to-passive investment revolution, the assets of bond ETFs in the US surpassed $1 trillion for the first time in June. BlackRock, the biggest bond ETF provider, is confident growth will continue, and expects those assets to double within five years.
“This is a result of clients’ needs for liquidity. That simple,” Klein says. “Clients need to buy or sell billions of dollars of securities, at any given point. And we need a framework that is able to handle that and respond to that consistently and over a long period of time, successfully. That’s where this has come from.”
But how we got to a place where $1 billion bespoke trades are becoming run-of-the mill, and where a storied credit-trading firm like Bank of America is launching a desk dedicated to facilitating them across FICC, is more nuanced.
ETFs — which bundle together securities into a single, liquid investment that provides low-cost, instant exposure to global markets — have been around for decades. But they’ve exploded post-financial crisis amid the broader shift from active to passive investing, with both retail and institutional investors jumping in.
BlackRock created the first bond ETFs in 2002 and aimed the product at retail investors. But bond ETFs have also been adopted by institutional investors looking for credit exposure as well as a way to hedge positions. Still, stocks make up the majority of the more than $5 trillion in ETF assets currently under management worldwide.
Fixed-income markets are far more complex. Instead of having a single ticker like a stock, a company can have dozens of listed bonds with different rates and maturities. Many bonds are still commonly traded over the phone, and some trade rarely, making them difficult to price.
Bond liquidity worsened after the financial crisis, after regulators imposed stricter capital requirements and bonds became more costly to hold on balance sheets, prompting banks to cut their inventories. As that was happening, rock-bottom interest rates unleashed record corporate debt issuance.
“Even five years ago, people were still struggling with how liquid the market was and the lack of dealer balance sheet was talked about so much,” Kevin McPartland, head of market structure and technology research at Greenwich Associates, told Business Insider. “And you don’t hear much about that anymore. Not because there’s more dealer balance sheet, but because the markets adapted.”
A ‘seismic change’ in credit trading
The advancement and spread of the ETF “create-and-redeem” process was instrumental, according to industry experts. The mechanism is something of hidden weapon for Bank of America, which has been ranked by ETF providers as an industry-leading platform for handling the process.
To ensure an ETF’s market price reflects the value of its underlying assets, authorized participants — usually market-makers like the big banks but increasingly prop traders like Jane Street, Virtu, and Susquehanna — monitor and adjust the supply of shares. There could be dozens of authorized participants for a given ETF, though usually only a handful are active.
So, for instance, if there’s a surge in demand for BlackRock’s iShares high-yield bond ETF (HYG), a market-maker like Bank of America might source a basket of underlying bonds that comprise the ETF from its inventory or the secondary market, and hand them off to BlackRock in exchange for newly created shares of HYG. BAML can then hold the shares on its balance sheet or sell them back on to the secondary market.
If there’s low demand, ETF participants undertake “redemption,” the inverse process: The dealer buys HYG shares on the market and exchanges them for the underlying bonds from BlackRock and then sells the bonds back into the secondary market.
In 2018, the fixed-income creation redemption volume in the primary market stood at $488 billion, according to Bloomberg data. It’s on pace for about $625 billion in 2019, a nearly 30% uptick.
The firm says its clearing subsidiary, ML Pro, is the top authorized participant in the industry for equity and fixed-income creation-and-redemptions, handling half of the market. Other independent, electronic market-makers use its platform as well.
The bank is a key partner in this process for some of the industry’s top ETF asset managers, including the likes of BlackRock, Invesco, and State Street.
“We get hundreds of bonds in a list, we price it, we go back, we create. It’s all a very seamless process,” said Sonali Theisen, who works closely with Fang and Klein as Bank of America’s head of FICC market structure.
The tools you’d use to transform 100 bonds into ETF shares — including algorithms and third-party composite pricing — are transferable to executing large portfolio trades more broadly.
“The growth in fixed-income ETFs is probably the single largest catalyst to the growth of portfolio trading in credit,” Greenwich Associates’ McPartland told Business Insider. “The technology that was built to manage the create-and-redeem process really is what’s being leveraged to help asset managers trade portfolios of bonds, even if it’s not related to an ETF.”
So, if a pension fund wants to quickly rebalance its fixed-income exposure, it could tap a broker-dealer like Bank of America to exchange a $500 million basket of bonds. Using the same ETF framework, the bank can quickly price the bonds as well as unload and hedge the sizable position it’s pulling onto its balance sheet.
“The machinery it takes to effectively price up a portfolio is precisely the machinery it takes to be an effective or a very modern authorized participant,” a senior executive at a large asset manager that issues ETFs told Business Insider. “And it’s hard to build that machinery up because a lot of the asset class is opaque.”
Like shooting a free-throw or throwing a dart, creating muscle memory in the process is key to doing it effectively, according to Theisen, and their FICC traders are executing multiple portfolio and ETF trades per day, regularly accessing the firm’s ETF create-and-redeem platform.
Their US credit desk has handled several hundred fixed-income ETF create-and-redeem or portfolio trades this year, on pace to double the number it did in 2018 and ten-fold what it did in 2017, the bank said. In terms of volume, they’re up as much as 40% from 2018 and 360% from 2017.
“More broadly than ETFs, we believe portfolios are going to become a bigger proportion of how clients want to execute, especially in a high volatility environment,” Theisen said.
These trends aren’t just changing Bank of America’s trading floor, they’re quickly altering the underlying fabric of the fixed-income markets.
Klein says the integration of create-and-redeem, third-party pricing, and portfolio trading is the first development he’s seen significantly alter liquidity for the firm’s fixed-income client base.
“That is the seismic change that is taking place in investment-grade bonds,” Klein said.
FICC portfolio trading is still in the toddler stages
Credit, especially investment-grade, has gained the most traction so far within FICC portfolio and ETF trading, but Bank of America’s ambitions are larger.
The firm is angling is to build on the ETF and portfolio-trading success on Klein’s team and consolidate those efforts across the rest of the trading floor — whether that’s emerging-market interest rates, municipals, mortgages, or commodities.
That’s why Fang, who previously ran FICC sales and structuring in the Americas, was tapped in March to oversee the new ETF trading desk working across the FICC product set, helping facilitate larger, ever more-tailored trades.
ETF and portfolio trading in most of the FICC asset classes are in the toddler stages, but Theisen said they’re already commanding interest and conversations from clients.
“It’s already happening, but we fully believe the pace is going to accelerate,” Theisen said.
Large-scale, cross-asset portfolio trading may not be in the short-term “an every-day trade, but it’s already a capability certain clients are working on,” Theisen said. “The ETF framework is paving the evolution of factor-based trading.”
Bank of America isn’t the only Wall Street bank competing in this space. Other top fixed-income trading firms like JPMorgan Chase, Citigroup, and Goldman Sachs are also handling large, complicated ETF and portfolio trades across FICC.
“It is a sophisticated problem to solve, and it’s an expensive problem to solve,” the senior asset management executive said.
“There’s a lot of investment in terms of the set up and the structure that the bank needs to facilitate this activity, as well as an explicit investment in technology,” he said, adding that there are only “a handful of players that can do this in a meaningful way,” and that Bank of America is performing well in the arena.
But Bank of America believes its approach, with a cross-FICC trading desk straddling all the lines of business, is distinct and will give them an edge.
“The knock on large banks is that we tend to be siloed and hard to navigate. If we can connect the dots, then we can deliver better on these cross-asset ETFs as well as multi-asset portfolio rebalancing, which is for sure going to happen more frequently,” Fang said.
‘Playing Tetris with all the blocks’
Fang, Theisen, and Klein readily acknowledge the task will not be easy.
Cross-asset portfolio trading in fixed-income is in the nascent stages, and just like the ETF and index-trading evolution in stocks, there will be growing pains. In this case, banks are navigating a slew of different asset classes instead of just one.
Gobbling up massive trades at a low cost could crush Bank of America’s margins, compared to how the trades might have been executed in the past. Such low fees could mean the firm isn’t getting compensated properly for the risk its taking, resulting in trading losses.
The risks aren’t lost on Bank of America’s leaders. But in theory, these cross-asset trading desks are designed to make it cheaper and more efficient to manage and hedge its exposure, with tentacles feeding on a buffet of assets across the FICC trading floor.
Or, if you prefer Theisen’s metaphor, “It’s kind of like playing Tetris with all the blocks or just the red blocks.”
“You have to be efficient about risk management and balance sheet usage everywhere, you have to leverage and collaborate where you can, and you have to make sure that you do this all real time,” Fang added, “And we rely on our client franchise and the velocity of our trading to net out risk factors wherever applicable.”
Part of the answer to neutralizing risks is simply repetition — the “muscle memory” component.
“Testing this out over and over and over again, banks can manage that risk a lot more precisely. And then they’re willing to trade in bigger size with bigger lists of bonds at a time,” McPartland said.
Politics is another hurdle. Banks are littered with the corpses of initiatives that languished because of internal squabbles and a lack of institutional support.
If these new cross-asset groups divert revenues away from individual business lines, that could spark infighting and resistance among traders who are compensated in part based on how much they pad the bottom line.
But the operation has the backing and sponsorship of senior management, including global FICC trading co-heads Jim DeMare and Bernie Mensah, and the bank says it’s set up to minimize friction with other desks, collaborating and sharing profits.
“You have to be willing to take away the silos first. Do the right thing and then figure out how to be fair to everyone. And that’s not without its growing pains, but it’s the right model,” Theisen said.
Bank of America’s FICC execs believe the increasing speed, transparency, and liquidity it can provide clients with these integrated teams will create more revenue to go around the trading floor.
Moreover, if the industry is barreling headlong in the direction of custom-fit, $1.5 billion portfolio and ETF trades regardless, they’re not interested in sacrificing long-term hegemony for short-term profits.
“This thing is going to evolve. ETF influence is not going to stop,” Fang said.
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