Banks Eye ETFs As Bond Trading Stalls

(Reuters) – Wall Street banks are ramping up businesses that trade exchange-traded funds full of bonds, a bright spot of growth at an otherwise-bleak time for trading, but one that may carry unappreciated risk.

Barclays, Credit Suisse Group and Goldman Sachs Group have all created special teams to make markets in bond ETFs. The teams include staff across stock and bond markets, since the ETFs trade like stocks on stock exchanges, but their underlying securities are bonds.

All told, 12 to 15 banks now have a presence in the business, whereas a few years ago, almost none did, says Anthony Perrotta, global head of research and consulting at TABB Group.

"There are a lot of institutions that, even though they might be retrenching in fixed-income trading, are looking at ETFs as a way to galvanize their business," said Martin Small, who oversees U.S. operations for BlackRock's iShares unit, which is the largest ETF issuer.

Won’t Replace Bond Trading Profits

Although these businesses are sprouting up across Wall Street, they are unlikely to make up for huge profits banks earned during the glory days of bond trading, at least not anytime soon.

Investors pay banks 0.01% to 0.03% to trade a bond ETF, according to TABB Group, compared with 1.03% for an individual bond. Traders say they are hoping to make up for piddling margins by selling more of the product, since the ETF business is a bulk-volume one that is rapidly growing.

Related Article: How Illiquid Are Bond ETFs, Really?

The sales push comes after years of pressure from leading ETF creators like BlackRock and State Street to make markets for the bond ETFs. Those firms rake in billions of dollars' worth of revenue from ETFs each year, and view bond ETFs as a way to grow their own businesses.

Firms that create ETFs need banks to act as intermediaries for sales, and also to ensure that prices are in sync with underlying securities. Before banks entered the market, trades were handled by market makers like KCG Holdings, Cantor Fitzgerald and Susquehanna Capital Group, who have been in the business for years.

ETFs Not Without Risk

As Wall Street has warmed to bond ETFs, the market has quickly grown. Assets under management in the U.S. rose 44% to $372 billion at the end of January, from $258 billion a year earlier, according to fund research service Lipper. That represents about 19% of the broader $2 trillion U.S. ETF market.

While the bond-ETF boom may be good for Wall Street, it is not without risk.

This comes at a time when liquidity in the corporate bond market has shriveled due to new rules that require banks to hold significant capital against those securities. As a result, banks avoid buying bonds from investors unless they can resell them quickly, and do not maintain much inventory for interested buyers.

Despite their holdings, bond ETFs trade more like stocks, on stock exchanges, so they are not facing the same type of liquidity issue. But it is unclear how they will perform if investors rush for the exits all at once, or if markets come under serious stress. During the Aug. 24 "flash crash," for instance, some ETFs failed to trade properly.

"I think ETFs can be great products," said Gershon Distenfeld, director of high yield at AllianceBernstein. "They just don't work where there's an illiquid market."

Building ETF Businesses

Despite those concerns, bankers seem happy to be building up a business that is in high demand.

Barclays' foray into bond ETFs began several years ago, but the bank has recently increased its marketing of the products to clients who are unfamiliar with them. The bank's head of ETF trading, B.J. Prager, said the business relies on staff who have expertise across stock and bond markets.

Credit Suisse launched a similar effort about a year ago. The bank's credit team finds bonds for money managers to include in the products, and its equity desk provides technology to trade and value them. Credit Suisse sells bond ETFs through both channels, and includes them on Nitro, its ETF trading platform, so that clients can trade more easily.

"It's a serious initiative at the firm," said Rob Bernstone, a managing director in equity trading at Credit Suisse.

Goldman Sachs has spent the last six months building up its bond ETF business. Brian Levine, a co-head of equity trading who is leading the effort, said it involves "close collaboration" between stock and bond traders.

Banks have also forged close ties with firms creating bond ETFs.

BlackRock and other ETF issuers allow banks to sweep bonds that might have otherwise hogged space on their balance sheets into ETFs. And each week, representatives from BlackRock's iShares business speak to bond traders at all the major banks about the business.