More and More Bond Trading Is Being Done Under the Same Roof

  • Some of world’s biggest investors increasing internal trading
  • Practice raising questions about fair treatment of clients

When Glencore Plc bonds were being whipsawed by dropping commodity prices this year, trader Christoph Hock found two fund managers willing to trade -- one wanting to wager on a recovery and another hoping to dodge a falling knife.

He didn’t have to go far. Both funds are owned by his employer, German asset manager Union Investment, based a stone’s throw away from the euro currency monument in Frankfurt. Internal trades like this are happening more and more at some of the world’s biggest asset managers globally as banks withdraw from market making.

Proponents of internal crossing -- as the practice is known -- say it can reduce costs, while detractors say it’s riddled with potential conflicts of interest and is exacerbating the decline in bond market liquidity. The trades are on the rise at funds including BlackRock Inc. and Legal & General Investment Management, which now trades more with itself than any other firm. The trend is the latest sign of a shift of assets and influence to the buy side from the sell side.

“Asset managers are getting bigger, so they are increasingly crossing internally,” said Elizabeth Callaghan, London-based director in the secondary markets group at the International Capital Market Association. “Where is all the liquidity? It’s sitting in their back garden.”

Fire Sale

When investors pulled more than $100 billion from a Pacific Investment Management Co. bond fund after Bill Gross quit in 2014, traders were expecting the firm to dump holdings at fire-sale prices. A hint of why that never happened came the following year in a regulatory filing: the firm had sold about $18 billion of assets from that fund to other Pimco accounts.

Internal trades occur when two funds of the same asset manager want to do opposite trades. They usually take place when funds that track indexes, such as exchange-traded funds, add or remove securities to better reflect benchmarks, or when funds receive inflows or need to meet redemptions, according to investors who have conducted the deals.

Volumes are increasing at Legal & General Investment Management and at BlackRock, the world’s largest asset manager, according to people familiar with the matter, who asked not to be identified because they’re not authorized to speak about it. Standard Life Investments, the 269 billion-pound ($331 billion) Edinburgh-based fund manager, and Union Investment say they’re also increasingly trading this way.

Nicolette Botbol, a spokeswoman for LGIM in London, declined to comment on the amount of internal trading at the company, saying it’s commercially sensitive information. BlackRock said the practice reduces costs incurred in trading and that’s beneficial to their clients.

Internal Trading

Internal trading at LGIM has grown to account for about 20 percent of the firm’s fixed-income trades, according to a person familiar with the matter. At Standard Life Investments it’s increased to about 8 percent of deals, said head of trading Steven Swann. At Union Investment it’s risen to more than 10 percent, said Hock.

The growth of the practice is a product of the increased might of the buyside in the $100 trillion global bond market as well as a recognition it’s becoming more difficult to trade as dealers pull back.

“If we sell a bond to the market and try and buy it back, the cost will be higher and we’re not sure we can get hold of it again,” said Yann Couellan, Paris-based head of trade execution for fixed income at AXA Investment Managers, which oversees 679 billion euros ($755 billion) of assets. “It makes sense for us to keep the bond internally.”

Sellside Decline

Investment banks once dominated debt trading by maintaining large warehouses of securities and providing the other side of trades when investors wanted to add or offload securities. Tougher rules since the financial crisis have encouraged them to pull back and downsize, while asset managers have amassed ever greater holdings and become more proactive in seeking out alternative ways of shifting positions.

BlackRock saw it’s assets swell to $5.1 trillion from $1.1 trillion in 2006, while LGIM’s assets increased to 853 billion pounds from 233 billion pounds during the same period. Even though Pimco’s assets have declined since Gross’s departure, its current $1.6 trillion hoard is more than double the $640 billion it held 10 years earlier.

At Vanguard Group, the proportion of bond trades crossed internally has remained steady between 10 percent to 20 percent over the past decade, it’s assets under management have ballooned to $3.5 trillion from $1 trillion in 2006. Matching buyers and sellers internally can cut costs and benefit both parties to a trade, said Paul Malloy, head of European fixed income at Vanguard in London.

Fair Price

Others are steering clear of the practice because their clients may not like it. Brandywine Global Investment Management, a $70 billion Philadelphia-based asset manager, has made it policy not to cross trades between its own funds, according to Regina Borromeo, a London-based money manager at the firm. That’s because the practice can give the appearance of unfair treatment of investors, she said.

“Firms that cross bonds may open themselves up to questions on best execution, transparency and fair prices for clients,” said Borromeo. “Cross trading can present a conflict of interest since it can favor one client to the detriment of the other.”

For Hock, who is head of multi-asset trading at Union Investment, internal crossing is beneficial and can be justified so long as traders can prove they transacted at a fair price.

“You have to be able to know the fair price so that both funds benefit,” said Hock, who is responsible for matching buyers and sellers -- in-house or externally -- for government and corporate bonds, equities, currencies and derivatives. “You need to have a proper pricing mechanism.”

Winners, Losers

Lack of trading in corporate bond markets makes it hard to establish the fair price, according to Tamara Nefedova, assistant professor of finance at the University Paris-Dauphine, who co-authored a report on cross trading in equity markets for the Bank for International Settlements earlier this year.

“For each transaction at the wrong price, there will be a winner and a loser party since every cross-trade is a zero-sum game,” she said. “The risk that the price is arbitrarily set to benefit the most expensive or valuable fund at the expense of the cheap fund is particularly high.”

Union Investment and Standard Life use third-party price providers, while AXA Investment Managers and BlackRock uses their own systems.

An official for BlackRock declined to comment on what percentage of fixed income trades are executed internally or how it processes the trades.

While internal crossing helped Pimco navigate the shock from Gross’ departure, its success will not be replicated if there’s a market-wide sell off, according to Brian Scott-Quinn, the non-executive chairman of the ICMA Centre, part of Henley Business School at the University of Reading in England. If investors stampede for the exit an internal network of funds will be of no help, he said.

“If there’s a shock, internal trading doesn’t solve anything,” said Scott-Quinn. “What happened at Pimco was not a systemic crisis. In a systemic crisis all funds will want to sell and prices will go down regardless, and at that point there may be no internal buyer.”

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