Market volatility caused by COVID-19 has made fixed income trading more opaque than usual, causing spreads on mortgage-backed securities to significantly widen. How can Dealerweb make price discovery easier for mortgage traders, and enhance market transparency?
- Fixed income trading protocols are much different than stock market trading protocols. Equity trading uses an at-the-post market, while fixed income trades on an an over-the-counter basis.
- As a consequence, price discovery is less transparent in fixed income trading than in equity trading, especially in volatile times. COVID-19 has made this particularly acute, deeply impacting mortgage-backed securities spreads in March.
- To expand price discovery and improve transparency, Refinitiv is making interdealer broker (IDB) mortgage pricing available to clients.
Equity and fixed income trading represent the two different classic market structures. Equities are what is known as an at-the-post market where all trades take place at a single location – i.e. the ‘post’.
While the shift to electronic trading has freed equity trading from the physical post of the trading floor, trading remains structured around this concept. Most importantly, there is a single clearing for all transactions of a stock, so there is transparency on the last price and volume traded. Also, since at any point in time there is only one price, by default it is the ‘best’ price.
Fixed income largely trades on an over-the-counter (OTC) basis. Dealers simultaneously quote prices, so it is less clear that a trade is at the ‘best’ available price. Compared with equities, the OTC market has less transparency on where the market has just traded.
Fixed income dealers create some transparency by posting bid/ask prices. But these prices are only indicative. To get a tradable price, customers must submit to dealers a Tradeweb ‘request for quote’ (RFQ).
While the OTC posting of indicative prices provides adequate transparency in a normal market environment, it can become opaque in times of high volatility.
Higher volatility typically leads to wider bid/ask spreads, making it more difficult to know where the market is trading. Posted indicative prices often become stale in a fast market and then the requested quote is far from what was posted.
Volatile fixed income markets
COVID-19 has been a devastating force for global markets, sending stock prices careening lower and pushing bond yields to record lows.
It has also caused volatility to surge across all asset classes, but fixed income markets were the most intensely impacted. As is shown in Figure 1, bid/ask spreads on ‘to be announced’ mortgage-backed securities (TBA MBS) widened out dramatically in March making it difficult to accurately price trades and assess market risk.
The turmoil caused an almost unprecedented breakdown in the historic correlation relationships between different markets. A collapse in liquidity led to a loss of real-time pricing, which forced the Fed to make unprecedented infusions of liquidity both in size and breadth of markets.
While equities have partially recovered, and volatility has subsided, the outlook for the months ahead continues to look very cloudy. There is still serious risk that disappointing economic numbers could stress credit markets, causing dislocations similar to that which occurred in March.
To improve transparency around liquidity and risk pricing, Refinitiv is making Dealerweb (inter broker-dealer) TBA MBS trades and Tradeweb Direct (retail) market data available to customers.
How can Dealerweb help?
Dealerweb is the largest TBA MBS interdealer broker, and has enjoyed a dominant market share for over a decade. The electronic marketplace produces dynamic Primary Dealer Top of Book real-time prices sought after by the top trading institutions globally.
The left panel in Figure 2 shows the indicative pricing that is currently available through Tradeweb. But as noted above, these prices are indicative — i.e. they are not necessarily tradable — and there is no indication of the depth available at the posted price.
The right panel shows the Dealerweb data that will now be available to our clients. The prices shown here are actual trades that can serve as a filter on whether the indicative prices are becoming stale. It can also provide clearer information on where the market is trading or has most recently traded when bid/ask spreads widen out.
Less opaque price discovery
Price discovery is inherently less transparent in an OTC market where there are multiple sources of pricing and a request for quote is required to get prices that are executable. The lack of information on trading volumes also makes it more difficult to assess the relative liquidity of different instruments.
These shortcomings of a RFQ market become much more acute in the current highly volatile market environment, which forces dealers to post wider bid/ask spreads and causes posted prices to quickly become stale.
We believe that access to Dealerweb real-time market trade data will complement the current offering of Tradeweb indicative pricing, and make the task of price discovery for our clients less opaque in these unprecedented times of COVID-19 triggered market upheavals.