But can firms like iShares really take up the slack and take over the role of the big investment banks, who face higher capital requirements for their trading activities, as well as a crackdown on proprietary risk-taking?
In its marketing literature, iShares makes a virtue of the fact that its parent company’s size allows it to match many buy and sell orders internally, bypassing external liquidity providers.
“Given BlackRock’s leading market position, iShares has plenty of opportunities to cross bonds both internally between its own funds and externally with other institutional investors,” the firm says in a recent publication, “Managing iShares Fixed Income ETFs”.
It’s clear that BlackRock has major ambitions for its bond trading activities. In an April Wall Street Journal article, BlackRock’s head of global trading, Richard Prager, said that the firm can offer significant cost reductions to investors. "If there's a saving available to clients, we want to give it to them," the WSJ quotes Prager as saying, implying that investment banks have traditionally overcharged for making markets.
Details of BlackRock’s planned bond trading platform are scarce, though it’s supposed to be launched by the end of 2012. But some fundamental questions remain. Crossing trades between willing buyers and willing sellers and adding a fee on top for doing the matching is one thing.
Providing capital to ensure that buyers and sellers can enter and exit markets at any time is quite another.
For investors in ETFs, such questions matter. Since ETFs effectively promise instant tradeability, and that tradeability depends on the ability to buy and sell the bonds or shares in the index, a corporate bond tracker relies on there being deep-pocketed, steady providers of liquidity at the end of a chain of transactions.
If BlackRock’s bond trading venture turns out to be more a crossing platform than anything else, the claims that the firm’s ETF promoters are making about the transformational role of their funds in the corporate bond markets appear to rely on a dangerous circularity.
The recent compression in bid-offer spreads in corporate bond ETFs may be more the result of increased investor demand than of any fundamental change in the liquidity of the asset class, in other words.
Perhaps BlackRock has larger-scale ambitions, aiming to provide some of the traditional “warehousing” functions of investment bank dealers. While this would be an opportunistic attempt to capitalise on the current difficulties of banks, such a move would raise difficult questions about capital requirements and potential conflicts of interest.
In the meantime, if you’re an investor in corporate bond ETFs, it must be puzzling to hear the managers of actively managed bond funds worrying about liquidity, while you’re hearing only optimistic noises.
It’s worth following this debate closely. While interest rates remain near zero and investors chase yield by buying bond funds en masse, questions about the tradeability of bond funds may seem moot. But eventually we’ll see the iShares hypothesis tested.