Although there are several parallels that can be drawn between the 2008 credit crunch and the infamous Black Monday slide of 1987 – the 25th anniversary of which is later this week – no two crashes are alike. The major similarities between the aforementioned events lie in the regulatory response and the market participant-driven need for increased transparency. It's important to note that following each crash, it was market participants who collectively called for greater visibility – leading the regulators' call for transparency.
To recap, the 2008 crisis was credit-driven, while equities trading – and specifically portfolio insurance – was at the root of the Black Monday plummet. Still, in both cases, the capitulation came in the form of increased regulatory oversight that led to mandated post-trade transparency. Both events left quite an impression on the financial services industry – and aftershocks from both reverberated for years.
Learning the Hard Way in '87
There was a time when equity prices were available only end-of-day and high frequency trading was unimaginable due to limitations in technology. Following the 1987 crash, a slew of regulatory reforms – driven in no small part by Regulation NMS – allowed for a new standard of price transparency and consistency, while leveling the playing field for market participants. In addition, new electronic and all-to-all equity venues rose from the capital market ruins, giving birth to algorithmic trading, driving further electronification and improved liquidity.
Looking back on the regulatory fallout from Black Monday, one can't ignore the good that came from the bad. Through new rules and refreshed best practices, the industry gained better risk management and oversight for the buy side and the sell side, alike. In particular, the buy side gained greater access to information, breaking down the data wall separating them from the sell side. Although the crash caused a lot of financial woes upfront, the resulting shift in the marketplace brought many positive changes, even trickling down to retail investors by giving them more power.
Waking the Sleeping Giants
If you look carefully, the equities evolution spurred by the crash of '87 is currently playing out in the fixed income space. Up until the credit crunch, and through today, the over-the-counter market remained largely opaque – remembered the limited price availability in the equities space? However, there has been significant regulatory pressure in the form of Dodd-Frank, Basel III and MiFID II, which has unsurprisingly led to mandated post-trade transparency.
Just like the crash of 1987, the fallout from the 2008 crisis is significantly shaping the existing market structure. The changing role of the sell-side and buy-side fixed income market participants is becoming clear, as is the need for a renewed market structure and new trading protocols. Learning from the equities transformation experienced 25 years ago, it stands to reason that we will see a proliferation of new venues in the coming years.
Regardless of the specific protocols that emerge, there is, without question, a need for pre-trade transparency to level the playing field for all market participants in fixed income. The credit crunch was the catalyst for change in the market structure, which for decades concentrated power on the sell side. With increased risk management and vigilance brought on by the new regulations, the sell side no longer has the same balance sheet and isn't capable of holding significant inventories of corporate bonds. Decreasing the chance of execution for the buy side, makes it harder to find the right liquidity.
However, the bond market is not going away any time soon. With approximately $7.6 trillion in total outstanding value, the USD corporate bond universe is an expansive market, and with approximately $11 trillion in pension assets to be invested in over the next five years, we can expect the market to grow substantially. How can the market access that liquidity? By waking the sleeping buy-side giants. sOne way or another, the buy side needs to go from playing the role of price-takers to becoming the price-makers in order to reestablish efficient trading practices.
The final shakeout for the fixed income market is still uncertain. However, it's very likely that the ultimate venue model will adopt a hybrid approach, much like that of the equities market in 1987. There has to be new technology and protocols that combine voice trading, pure central limit order books, grey pools, as well as dark pools. However, in order for any of the venues that have recently emerged to gain traction, the buy side needs to broadly and proudly adopt its new role.
Bracing for the Future If there's one thing the industry can count on, it's more crashes. We will never be immune. Although the increased vigilance helps the overall market, the next crisis will come in a dissimilar format and likely won't be caused by the same elements. The lesson we learned from Black Monday is the same lesson that we learned from the credit crunch – it is difficult to control and manage risk in complex instruments. These kinds of crashes can happen as a result. However, further transparency will help.
Tim Grant is the Managing Director of Benchmark Solutions, an independent provider of fixed income and derivatives market pricing, where he oversees all sales and marketing activities, including the development of the company's client solutions business. Prior to joining Benchmark, Tim had been a Managing Director at UBS where he latterly was drafted by the Executive Board to assist in managing fall-out from the ongoing financial crisis, reporting directly into the UBS Group Chief Risk Officer.