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Carl James   00:00:00

Hello, and welcome to the Capital Markets conversation. I'm here today with Chris Fensky. My name is Carl James. Today, we're going to be discussing the emergence, implementation and the rise of portfolio trading. Chris, I wanted to turn and say, set things off, set the stage, why portfolio trading?

Chris Fenske   00:00:22

I mean, first and foremost, we've talked about this in the past, liquidity is everything. And this is one way of providing liquidity very quickly, which obviously keeps the markets running very efficiently and also enables reinvestment into different asset classes and repositioning portfolios. It's been a long road to get here. I think electronification of the markets, electronic trading was the foundation that actually put us where we are today. For instance, back in 2013, only about 8% of U.S. IG bonds were actually traded electronically. Now it's up to about 49%. Then you fast forward to 2019, only about 2% of all trading volume for U.S. corporate bonds is done through portfolio trading. Now that's up to about almost 12% year-to-date. And this is actually data from Coalition and Greenwich.

Carl James   00:01:17

Got it. I mean within the investment-grade world, it's quite interesting to see how it's emerged because if you think in the equity world, program trading or portfolio trading has been around for a while. And I think that's the rise of electronic trading within the equity world has emerged far earlier. And I do agree with you that the emergence of e-trading has allowed for portfolio trading to emerge in investment grade or in the fixed income world.

Chris Fenske   00:01:47

E-trading, but then even before e-trading, you needed evaluated pricing services, basically bond pricing services. These are all OTC markets. You mentioned equity portfolio trading. Equity is exchange traded. So this prices every single second of the day that are real accurate prices. Bond market didn't have that 25 years ago. The technology exists now where there's actually real-time pricing of fixed income instruments. S&P Market Intelligence actually does this and offers this to clients right now. you need that pricing component first, then you need some sort of credit scoring model because if you have 100 line items in your portfolio trade, you can't have an analyst looking through every single one and doing the credit work. There's going to be some sort of automated credit work there to actually figure out how you're going to internally rate each of those bonds, and that's going to determine what type of price levels you're going to use plus the guidance you're getting from multiple evaluated pricing services.

Carl James   00:02:40

So if I understand you correctly, you've had the foundational steps of e-trading. You've had the foundational steps of the ability to price risk and you've had the ability for computing power to capture all of that and therefore, be able to offer a price in a quick way to the portfolio manager or whoever it is that is asking to trade that basket of bonds.

Carl James   00:03:10

Got it. Okay. When we think of the innovations that have happened in capital markets, one that I'd like you to talk about a little bit more is the innovations that enabled portfolio trading to come to the fore.

Chris Fenske   00:03:25

Okay. So portfolio trading for the bond market 20 years ago, especially when you're talking credit, was an Excel spreadsheet and basically a trader or an analyst going line item by line item, putting an individual price, then eventually, of course, rolling that up into one price. This could take hours, could take days. The other part of it, too, is that you don't necessarily have the distribution network to offload all that risk. So that's a factor too. That's obviously going to impact the liquidity in and of itself. We've come a long way since those days of spreadsheets and manually pricing bonds.

Carl James   00:04:01

And in terms of -- you've got the spreadsheet, and we've moved on from that. But I assume the availability of data and its accuracy has been a big step change as well.

Chris Fenske   00:04:15

Yes. So I mean, every investor gets quote runs every single day all day long from different asset classes, different markets where they basically -- these quotes through messages, various messaging services can be immediately parsed into data and actually used as a pricing, evaluated pricing services use this, trading desks can use this. And you use this to create almost like a mosaic to determine what you think is a valid price in a given point in time. So data is the key. regulatory reporting like trace, things like that, where you have data of real trades that becomes an input. So all these different inputs with the right technology and the right algorithms gets you that much closer to what the actual market value of that security is.

Carl James   00:05:00

So that created more certainty into the outcome of the risk they were taking on for that portfolio. I assume built into that would be credit analysis because that's become much more sophisticated over time.

Chris Fenske   00:05:14

Yes. The availability of financial data in a streaming perspective, real time where possible, gets pumped into a system. It gets normalized. The financial data has to be normalized. It's not always apples and oranges. So that can be actually put into your algorithm and you can create a screening or credit scoring model relatively quickly that identifies what your methodology is in which you rate that particular security from a trading perspective.

Carl James   00:05:43

So that for me is the front office element, the analysts and the portfolio managers and they're referring to their portfolios and they want to take some risks, so they take a slice of that portfolio. Then you have the banks that are pricing that risk for them on behalf. So that talked all through the front office. Is there any impact from a settlement perspective that you think has made a difference?

Chris Fenske   00:06:10

Yes. I mean there's been major improvements over the past 20, 30 years through more like straight-through processing. You don't have a back-office person going to through hundreds of tickets a day, manually going through reports and manually moving wiring money for delivery of money for some securities. So that particular part of the market or that particular part of the infrastructure has improved significantly over the years as well.

Carl James   00:06:35

So we're seeing these incremental efficiencies from front to back that create the opportunity for portfolio trades being priced more effectively and efficiently. Exactly. And that is to the benefit of the end client, I'm assuming, because they are then -- if they went to release cash, so they sell a slice of the portfolio. First of all, the people realizing that are selling all of the portfolio or the slice of it, but also the people want to stay in the portfolio, you haven't got bits of the portfolio being cherry picked. It's now fair for all clients.

Chris Fenske   00:07:14

Yes. And the beneficiaries of this are the end-to-end investors, people that are investing in mutual funds, their 401(k)s, pensions, -- so they're benefiting from the improved liquidity of this technology.

Carl James   00:07:27

Now that leads also to -- I wanted to talk about the velocity of trading. So trading platforms proliferated over many years, and they've sort of become -- I think it was 150 at one point. Now it's kind of coalesced between 4 and 5. That has allowed a higher velocity of secondary trading. To me, that has to have been a positive effect that allowed portfolio trading because that offloading of risk.

Chris Fenske   00:07:59

Well, the distribution was the biggest challenge back in the day. So you're buying 100 bonds, some of which are extremely liquid, you could sell within minutes. But then you're left with the bottom tranche where it's more difficult, it takes more time to shop a bond, try to market it, sell it. That's where electronic trading platforms actually took center stage and provide another very good outlet for liquidity that didn't exist 20 years ago.

Carl James   00:08:26

You quoted earlier that you have over 10% of investment-grade trades are now done as a portfolio trade. So to me, it's not going anywhere. So if anything, it will become even more embedded into trading.

Chris Fenske   00:08:46

And that's been mostly single asset over the years, but what's to stop you from doing multi-asset portfolio trades, mix in some municipal bonds, some corporate bonds, securitized. And then the plumbing exists now, technologies exists where this could get routed to all the different trading desks within an organization and still rolled up to that one bid for that one item for the portfolio.

Carl James   00:09:09

So if I get you correctly, conceptually, what you're saying is because we're able to price investment grade. You're able then to actually go, well, there could be some equity portion of that portfolio. There could be some muni part of that portfolio or there could be high yield or investment grade or emerging market, and then it's priced for that basket.

Chris Fenske   00:09:32

You get one line item dollar price for the whole portfolio, weighted average price for the portfolio, and it gets redistributed to each specialist desk and then to clients.

Carl James   00:09:42

And how far away do you think that is? Do you think it's already happening? Or do you think it's a little bit a way to actually happening?

Chris Fenske   00:09:48

I believe it's already happening in a small scale. I don't believe it's happening in large-scale portfolios, but in a small scale, I believe it's already happening.

Carl James   00:09:56

And if we think about the future state of portfolio trading, I mean, where do you think it can go? Because it's a very efficient way of executing. It's good for the portfolio manager. It's good for their clients. I think the transference of risk is now done at an efficient price. So the banks seem happy with that, and they seem to be putting more investment into creating these teams to trade this type of trading. Where do you think you can go in the future?

Chris Fenske   00:10:29

So I mentioned before, multi-asset. That's probably the first place it would go. Multicurrency, which obviously has its own challenges in many different ways, Multicurrency maybe is a possibility one day. Maybe one day gets to a scale where you trade a whole fund as a portfolio. whole fund, you transfer out of one particular asset class into another simultaneously on a large scale. And then your platforms, I mean, you run syndicate platforms where new issue bonds are going through every single day. Maybe potentially syndicates all the different syndicate activity for a particular bank is rolled up into one place. So you have your asset-backed security syndicate orders being intermingled with your corporate bond orders. And then basically, as all the syndicate desk figure out the priorities based on participation across all the different asset classes in the desk. So you determine who -- what type of allocation somebody gets because they're very active in maybe your asset-backed deal and maybe that could actually eventually determine how much allocation they get for their corporate bond request. And as an investor, you could just start putting in just the profile of what you're looking in new issue. And the profile could -- that algorithm -- the characteristics and could zero in on which bond issuances in the market fit the profile, agnostic of asset class. for the portfolio manage the flag and to potentially act on and invest upon. That's the future state. Whether it happens or not, TBD. It's too early to tell if that will happen, but there's definitely an efficiency of approaching the market that way and the new issue market that way.

Carl James   00:12:10

Can I also touch on accelerating new issue investment decisions. I think it's quite interesting where you've taken us there.

Chris Fenske   00:12:18

Yes. I mean there are some days where there's so much activity across all the different asset classes globally. So being able to actually efficiently analyze everything that's potentially out there for sale from a new issue perspective, you could more quickly identify where you want to invest your capital, where you want to put your orders. versus decentralized investment groups, each trying to find investments within a given sector, a lot of overlap potentially across the firm based on how they're structured across funds. So being able to centralize that and be able to basically just focus on where it makes the most sense without missing any deals, too. There's always the potential to miss deals that are out there just because there's only so much time in the day.

Carl James   00:13:07

So essentially, investors can identify certain opportunities by utilizing conceptually some of the logic around portfolio trading. So I think what you're telling is that at the moment, it's in its simplistic format of being able to trade a single asset class, investment grade, for example. But actually, there is the opportunity for innovation to come along so that actually stretches the logic or the conceptual, the logic of what it can do to an even greater degree to make markets more efficient.

Chris Fenske   00:13:42

Exactly. So the same way as portfolio trading, you're credit scoring every new issue out there with your internal credit scoring model. You're using a collection of evaluated bond prices from the secondary market prices to determine what's a reasonable execution level for this deal? Is it in line with where it's being offered? And then you make a quicker decision and maybe a potentially more rational decision than trying to do it one by one. A better informed decision.

Carl James   00:14:07

Yes, I like that. So actually, I think what we've said here is that portfolio trading with the investment-grade world has allowed for innovation to thrive because the market has become more efficient. But actually, I think what you've been able to articulate, Chris, is that, that innovation will continue so that actually capital markets will become even more efficient and the velocity of capital will increase as well as time goes on. Is that correct?

Chris Fenske   00:14:37

Every new technology is a stepping stone to improve it that much further. Where portfolio trading takes us today, it's hard to know right now, but where we're going to be 10 years from now, the type of things we're going to be doing by using portfolio trading as a foundation for improving liquidity.

Carl James   00:14:53

I really like that. Chris, thank you so much for putting us through what you see as portfolio trading today and where it will go in the future. Everyone, thank you so much for taking the time to tune in.

Chris Fenske   00:15:06

Always a pleasure joining you, Carl. Always enjoy talking about the capital markets with you.