Market Innovations Boost EGB Liquidity In Volatile Times

Innovations in the European Government Bond (EGB) market – from new sources of liquidity to automated no-touch trading – are helping traders in an environment of surging inflation, geopolitical concerns and looming quantitative tightening

The European monetary policy environment entered into a new paradigm during 2022 with the era of ultra-low rates supported by quantitative easing (QE) fast disappearing into memory.

The ECB deposit facility rate, which was -50 basis points (bps) only back in June, has already reached 200bps and is set to continue increasing amid the risk of surging inflation across the euro area becoming entrenched. The ECB has also announced that quantitative tightening will start in 2023.

A panel of expert speakers from across the European Government Bond market assembled in Brussels at the AFME Annual Government Bond Conference at the end of 2022 to discuss the implications for liquidity.

Delegates were asked how they see the EGB liquidity situation evolving over the coming year; more than half viewed it negatively (48% negatively and 3% very negatively) while just 19% viewed it positively.

Adapting To Volatility

Rates markets volatility has been the result of multiple factors, from the war in Ukraine and connected energy price spikes to a combination of other inflationary sources, including disrupted global supply chains and Covid-19 lockdowns in China.

The ECB response has obvious implications for issuers and traders and therefore their activity on platforms. The market must attract support from new buyers as the central bank reverses its strategy – as the Bank of England found in late October.

While the speakers agreed that a return to more normal yields is a positive development and likely to attract investors to EGBs, the accompanying volatility and uncertainty is far less welcome. Volatility is resulting in far wider bid-offer spreads, affecting some countries’ government bonds more than others, as well as focusing attention on duration risk.

Geopolitical concern remains perhaps the most elevated threat hanging over the market, according to the panel. Meanwhile, a lack of monetary policy certainty, particularly about the terminal rate, is perhaps the greatest reason for the drying up of liquidity.

The first big impact on the EGB market has been to trading volumes. “September 2022 was our largest ever month for average daily-traded volume in Euro-denominated governments bonds,” said Roderick Joniaux, responsible for European Government Bonds Product at Tradeweb.

UK volumes surged even more, especially around the time of the mini-Budget. “Gilts set new records as well. To put it in perspective, October 2022 was twice as big in volume terms as October 2021. That is 100% growth, when October 2021 was already a record at the time.”

Inflation-linked products such as inflation swaps and inflation-linked loans also experienced a significant pickup in trading volumes.

The second market impact could logically be expected in the prices traders receive back when raising RFQs. However, dealer-quote ratios have been holding up very well in both Euro and Sterling, around 85% in volume terms for both currencies in October, according to Joniaux. “That lead to a very satisfactory client-hit ratio of 75% in both currencies, meaning three-fourths of the volume that clients wanted to trade in both markets was actually traded, a very solid number.”

The third key consequence was for the cost of liquidity. “Obviously, the cost of liquidity had been higher in the last few weeks of September and October,” said Joniaux. “But we didn’t see a huge widening, nowhere close to where we were in March 2020 at the peak of the Covid-19 volatility.”

The key question for Tradeweb – a leader in automated execution – is whether the new environment is impacting the trend for how its clients approach trading. “The reality is it has not,” said Joniaux, noting that the shift from voice to electronic trading and from electronic to automation continues and shows little sign of stopping. “In October, 70% of client-side tickets were fully automated… which is a huge number.”

“It’s not anymore about whether clients automate their small size trades or not, it’s about how much and how wide can you automate.”

Joniaux also reported that the issuer split on the platform has been “very stable”. They have continued to trade across the entire spectrum of yield curves, and “we didn’t see investors focus solely on larger issuers only, or on benchmark bonds only”.

Innovation Bolsters Market Liquidity

Innovation is appearing from multiple sources, pushing the EGB market to the next phase of digitisation for data, execution and connectivity. “This definitely opens up new opportunities, in turn helping liquidity. There is innovation on all sides,” says Joniaux, including from buy-side entities.

Established players such as Tradeweb, which executed its first electronic EGB RFQ well over 20 years ago, continue to innovate. “Probably now more than ever, innovation is at the core of our business,” said Joniaux. “It is what we do.”

Tradeweb engages in collaborative innovation, working with clients to find their workflow pain points, solve problems and create new functionalities and trading protocols. It is looking at ever larger order sizes, so traders’ can focus their attention on furthering more strategic automation choices.

For example, Tradeweb clients have the ability to automatically send trades at predetermined times or market conditions. “We’re now into the next stage of innovation, going to low-touch but also no-touch trading,” says Joniaux.

“Clients are now able to schedule automated trades to go out at a certain time, and to automatically merge orders in the same ISIN before sending them. This potentially creates larger trades instead of multiple small trades, which not only leads to efficiency gains but also creates greater incentives for dealers to quote.”

Innovation From All Corners

New entrants including Fintechs are also innovating. “Some of them have a very strong vision and clearly aim to bring something new to the market,” he adds.

Liquidity providers are also making enhancements. Joniaux notes that some market makers are providing 100% firm liquidity in rates markets, such as for U.S. Treasuries and now starting in EGBs. “Clearly, this is a new type of liquidity that the D2C market did not have before,” he adds.

New entrants to rates markets, including high-frequency trading firms, are also bringing fresh pools of liquidity. These are adding to traditional market makers, such as Citi who were represented on the panel and discussed how they are innovating by creating new algorithmic trading desks.

Joniaux finally notes that regulators are also innovating and the market awaits the result of the MiFIR Review, which may or may not positively impact liquidity. “But, at the end of the day, it's the ability of market makers to take risks, backed by their balance sheets, that remains the jet fuel of liquidity.”

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Tradeweb Government Bond Update - December 2022