The next 

generation 

bond market 

FOR INSTITUTIONAL USE ONLY - NOT FOR PUBLIC DISTRIBUTION 

ICR0917U-255379-805339 
How changes in market structure, 

liquidity & products are shaping 

tomorrow’s bond markets 

Fixed income markets have undergone signifcant structural 

change since the 2008 fnancial crisis. These seismic shifts are 

forcing investors to adapt to a new market paradigm that will 

challenge not only how they trade fxed income, but what types 

of products they use to build bond portfolios and manage risk. 

In this paper, we examine the evolution of the bond market 

through three interconnected lenses: the liquidity environment, 

market structure and product preferences. All three are 

changing in the post-crisis era with implications for the shape 

of the future bond market and investors. 

Similar to what took place in equities, we believe the coming 

years will be marked by a major transformation in fxed income. 

In this new world, investors may have to think diferently about 

how to build portfolios, how to trade and what to trade. 

ICR0917U-255379-805339 
- -

Table of contents 

Executive 

summary 

04 

The pre crisis 

bond market 

17 

The next generation 

bond market 

The post crisis 

bond market 

06 07 

Conclusion 

18 19 

Appendix 

ICR0917U-255379-805339 
Executive summary 

Investors must now think diferently about how to navigate 

fxed income markets: from trading in a new market 

structure, to re-assessing liquidity, to determining which 

products will best deliver a desired outcome. 

The rise of a modern, networked bond market 

• The traditional principal-based fxed income market is transforming into a hybrid 

principal/agency market. 

• Driving this change are the entrance of new market participants and the emergence 

of all-to-all trading technologies that ofer an alternative means to trade bonds: from 

bilateral and voice-driven to multi-dimensional and electronic. 

• The transition to a hybrid model is a challenge for investors, but may result in a more 

connected, diverse and modern bond market with more trading participants. 

Liquidity needs to be reexamined 

• Challenges post-crisis have forced traditional bond dealers to fundamentally rethink 

their business models. 

• Broker dealer inventories have fallen, although the magnitude of the decline may be 

debated. At the same time, however, the size of the investment grade corporate bond 

market has tripled over the past decade to ~$7.5 trillion in debt outstanding.1 

• Inventories have recovered somewhat recently, but relying solely on the old model 

will likely not sufce. Investors need to think about how best to access liquidity across 

products and asset classes, using a broader, more robust suite of liquidity measures 

and exposure vehicles. 

• Not all investors have the same liquidity needs and the degree of liquidity required in 

part dictates the type of instrument employed for portfolio construction. 

1. Source: Bloomberg, Barclays, as of 6/30/17. 

THE NEXT GENERATION BOND MARKET 

ICR0917U-255379-805339 

4 
 

Index-based products central to portfolio construction 

and risk management 

• Today, the changing market structure means that building fxed income portfolios solely with 

individual securities can be increasingly costly and less efcient than in the past, leading investors to 

employ a range of instruments. 

• Post-crisis, demand for transparent, standardized and bundled exposures has manifested in growth 

among index-based products like credit default index swaps (CDX), total return swaps (TRS) and 

bond exchange traded funds (ETFs). These products are fulflling investor needs for building blocks 

to construct portfolios and manage risk more efciently. 

• Bond ETFs in particular have proven to be a valuable solution in meeting these needs. In the last 

fve years, assets have grown 25% per year while trading volume has more than doubled. Bond ETFs 

are on pace to be a $1.5 trillion market by 2022.2 

The trend towards a networked bond market is likely to accelerate and be more disruptive than many 

market participants currently expect. We believe that those who embrace and adapt to the coming 

changes have the potential to beneft most. 

Authors 

Richie Prager Daniel Veiner 

Head of Trading, Global Head of 

Liquidity and Investments Platform Fixed Income Trading 

Brett Pybus Stephen Laipply 

Head of EMEA iShares Head of U.S. iShares 

Fixed Income Strategy Fixed Income Strategy 

Vasiliki Pachatouridi Hui Sien Koay 

iShares Fixed Income Strategist iShares Fixed Income Strategist 

2. Based on the global AUM of $741 billion and a 20% compound annual growth rate, as of 8/31/17. 

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5 
The pre-crisis bond market 

Over-the-counter and opaque 

Liquidity 

Prior to the 2008/2009 fnancial crisis, broker-dealers 

enjoyed a relatively low cost of balance-sheet funding and 

capital, enabling them to warehouse risk for extended 

periods of time. As a result, dealers were willing to 

make markets in signifcant size in both cash bonds and 

associated derivatives. Volumes were generally robust 

and liquidity was perceived as relatively deep across most 

asset classes. 

As Figure 1 illustrates, as a largely principal trading 

market, the concept of liquidity was highly correlated with 

the inherent riskiness of an asset class. As an example, 

U.S. Treasuries were perceived to have a low degree of 

idiosyncratic risk and therefore considered highly liquid 

relative to speculative grade corporate bonds, which were 

perceived to have a high degree of idiosyncratic risk. 

Liquidity was often represented by the one dimensional 

metric of bid/ask spread, which tended to reasonably 

capture a dealer’s risk appetite and ability to either hedge 

or ofoad risk. 

Market structure 

Bond trading was conducted almost exclusively in 

decentralized, over-the-counter (OTC) markets, where 

investors negotiated directly with broker-dealers. Trading 

was bilateral and voice driven. 

Figure 1: Pre-crisis liquidity framework 

Asset liquidity dependent on perceived riskiness 

Electronic RFQ platforms were just taking root, serving 

predominantly more liquid products such as U.S. 

Treasuries, Agencies and Agency MBS. Even with the 

advent of reporting systems like the Trade Reporting and 

Compliance Engine (TRACE), transparency generally 

remained challenged. 

Products 

In addition to traditional cash bonds, investors traded a 

variety of derivative instruments across interest rates and 

credit. Interest rate futures, swaps and options markets 

were generally robust. In credit, the immediate pre-crisis 

period saw investors able to source or hedge exposure 

to individual companies through bespoke single name 

credit default swaps (CDS). Over time, standards and 

documentation for CDS became harmonized across 

dealers. Counterparty exposure, however, was still 

managed through bespoke, bilateral collateral posting 

arrangements between dealers and individual clients. 

While the move towards standardization in CDS helped 

facilitate growth in the CDX index contract, many other 

derivative exposures were often bespoke, complex 

structures that frequently employed signifcant degrees 

of leverage. 

Investment 

grade Government 

More risk and less liquid Less risk and more liquid 

High 

yield 

For illustrative purposes only. 

THE NEXT GENERATION BOND MARKET 

ICR0917U-255379-805339 

6 
The post-crisis bond market 

Regulation and reorganization 

The global regulatory reforms enacted in the wake of 

the fnancial crisis have catalyzed change in fxed income 

markets. Notwithstanding the current debate around the 

appropriate size and scope of post-crisis regulation, the 

efects have been profound, impacting liquidity, market 

structure and fxed income product availability. 

Liquidity 

The onset of the crisis resulted in a sharp and immediate 

reduction in balance sheet and market liquidity as many 

broker-dealers and other market participants struggled 

with funding and capital adequacy challenges. 

While liquidity recovered somewhat in the immediate 

aftermath of the crisis, the introduction of post-crisis 

regulation (Figure 2) among other things has resulted in 

higher funding and capital costs for banks and regulated 

broker-dealers. 

Fixed income trading, traditionally reliant on bank or 

broker-dealer balance sheets, has been especially 

impacted. Higher funding and capital costs have resulted 

in a reduction in traditional risk warehousing, given 

challenges in attaining ROE targets. Market liquidity 

has also been impacted by a retrenchment in the repo 

fnancing market for individual bonds. 

As a result, cash bond trading has migrated to more of a 

hybrid principal/agency model. Agency trading, in which 

buyers and sellers are located and matched by banks 

and broker-dealers, has played a more prominent role as 

opposed to facilitating trades more through principal 

risk taking. 

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7 
Figure 2: Global regulatory and legislative development overview 

Seismic regulatory shifts affecting all market participants 

Legislation Region Summary Effective date 

Dodd-Frank Wall 

Street Reform 

and Consumer 

Protection Act 

U.S. An unprecedented rulemaking process, ongoing for more 

than eight years with nearly 400 new regulations involving 

at least a dozen regulatory agencies. 

Varies 

Volcker Rule U.S. Part of Dodd-Frank, generally prohibits banking entities 

from engaging in short-term (non market-making related) 

trading of securities, derivatives, commodity futures and 

options on these instruments for their own account. In 

addition, banks are not permitted to own, sponsor, or 

have certain relationships with hedge funds or private 

equity funds. 

April 1, 2014 

Basel III Global In December 2010, the Basel Committee on Banking 

Supervision (BCBS) agreed to new rules outlining global 

regulatory standards on bank capital adequacy and 

liquidity. The new rules require fnancial institutions 

around the globe to hold more and higher-quality capital, 

introduce a global liquidity framework, and establish a 

countercyclical capital bufer. 

January 1, 2019 

Markets In Financial 

Instruments 

Directive (MiFID II) 

Europe Building on the rules already in place since 2007, MIFID II aims 

to bring the majority of non-equity products into a robust 

regulatory regime and move a signifcant part of OTC trading 

onto regulated platforms to boost transparency. 

January 3, 2018 

Source: SEC, SIFMA, ESMA, as of 6/30/17. 

At the same time, corporate bond issuance has increased 

rapidly as companies moved to take advantage of 

historically low interest rates and improve their maturity 

profles. This trend has fooded the market with 

record levels of new issues, but the result has been 

increased fragmentation. 

Figure 3 illustrates the efect that growing issuance has 

had on the liquidity environment. While the amount of 

bonds outstanding has increased, secondary market 

trading volume has not kept pace. In fact, the turnover 

ratio for investment grade bonds has fallen from over 

100% to about 65% since 2005. 

THE NEXT GENERATION BOND MARKET 

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8 
Figure 3: Investment grade & high yield market turnover 

General decline in bond turnover Volume and amount outstanding ($bn)

U.S. investment grade

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 YTD 2017

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 YTD 2017

Volume Amount outstanding Turnover

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

$8,000

0

20

40

60

80

100

120

140% Volume as % of outstanding

Volume and amount outstanding ($bn)

144A volumes 

incorporated

in mid 2014

U.S. high yield

0

500

1,000

1,500

2,000

$2,500

Volume as % of outstanding

200%

160

120

40

80

0

Source: MarketAxess, as of 6/30/17. 

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9 
Figure 4: Barclays liquidity cost score 

Traditional measures of liquidity may be deceiving Bid/ask spread (bps)

Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Jun-15 Jun-16 Jun-17

U.S. high yield corporate U.S. investment grade corporate

0

100

200

300

400

500

600

700

800

Source: Barclays, as of 6/30/17. 

As a result, overall transaction costs and the time to trade 

have increased, yet bid/ask spreads are not necessarily 

wider (Figure 4) and have nearly reverted to pre-crisis 

levels. Importantly for investors, however, bid/ask spreads 

(as measured by Barclays liquidity cost scores) may 

not have the same information content with respect to 

liquidity as they once did. The optical narrowness of bid/ 

ask spreads is in our view partially attributable to the shift 

towards more of an agency trading model for smaller 

trade sizes. While displayed bid/ask spreads do provide 

indicative trading levels, such levels are generally for 

smaller sizes at the “top of the book”. Larger trades usually 

incur signifcantly higher all-in costs. 

Bid-ask spreads used to represent breadth and depth; 

now market depth is perceived to be far more shallow for 

a given quote, and liquidity is highly conditional on a host 

of factors. 

These factors, including immediacy of execution, whether 

the full trade size was completed, or the impact on and 

resiliency of prices are not captured in the bid/ask metric. 

Ultimately, the largest driver of a given bond’s trading 

activity continues to be the amount of time since issuance. 

As time passes, trading activity declines sharply and 

eventually the security moves from being “on-the-run” to 

“of-the-run”. 

Moreover, issuers typically issue new securities rather 

than tapping existing bonds, which further exacerbates 

fragmentation. Figure 5 illustrates the severity of this 

decay in trading. It appears that this dynamic has become 

more pronounced post-crisis. 

One consequence of the changing nature in liquidity has 

been an even greater reliance by investors on the new 

issue market, which in turn has masked challenges in 

secondary market trading. There is a question as to what 

could happen if the robust new issue calendar abates due 

to some market impetus such as rising rates or perhaps 

even a change in the tax code. In that scenario, investor 

preferences may shift further towards index or portfolio 

products as individual issues become even more difcult 

and expensive to source. 

10 THE NEXT GENERATION BOND MARKET 

ICR0917U-255379-805339 
Figure 5: Investment grade bond turnover after issuance 

Secondary market trading support has declined Turnover (%)

Months after issue

70% decline in turnover

after 1st month

0

10

1 2 3 4 5 6 7 8 9 10 11 12

20

30

40

50 %

2005-2007 2014-YTD 2017

Source: JPMorgan, TRACE, as of 6/30/17. 

Interestingly, while market depth may be in question, 

market breadth is actually increasing. This is most 

evident in the high yield bond market as overall turnover 

has stabilized relative to the investment grade market. 

One potential contributing factor to the apparent 

stabilization in high yield turnover is the growing use of 

bond ETFs by institutions, which have become increasingly 

accepted by this investor base as an efcient beta access 

vehicle. The creation/redemption process of a bond ETF 

involves the exchange of a sample of index eligible bonds 

or a "basket" for ETF shares. As ETF volumes and activity 

have increased, so has the underlying activity in bonds 

that they hold. 

Figure 6 shows the tiering in turnover between larger 

bonds that are likely to be ETF constituents due to their 

size (per index inclusion rules, which dictate minimum size 

outstanding) vs. bonds that would not be included due 

to smaller size. Larger, index-eligible bonds have enjoyed 

stabilizing or increasing turnover, while smaller issues have 

continued to see declines. 

Figure 6: Turnover of U.S. investment grade bonds based on size 

Larger bonds have remained relatively liquid Avergae daily turnover (%)

2006 2010 2014 YTD 2017

0.60

0.40

0.20

0.00

%

$300mn-$500mn $500mn-$1bn $1bn-$2bn $2bn+

0.34

0.47

0.50

0.43

0.23

0.33

0.42

0.45

0.18 0.20

0.28

0.32 0.32

0.26

0.32 0.32

Source: JP Morgan, as of 6/30/17. 

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ICR0917U-255379-805339 
Market structure 

The decline in traditional risk warehousing and the 

commensurate increase in all-in execution costs and time 

to execution for larger trade sizes have created demand 

for additional liquidity providers and trading technologies. 

Electronic trading has grown across most asset classes, 

with entities such as non-bank principal trading frms and 

ETF market-makers playing larger roles. The growth in 

electronic trading and participation by these new players 

has been a result of the development of alternative trading 

protocols, an evolution in trading platforms and venues 

as well as the ongoing adaptation of operating models 

to the regulatory environment. Traditional banks and 

broker-dealers are also investing in the technology and 

personnel necessary to position for the continued growth 

in electronic trading. 

According to a study from Greenwich Associates, 83% of 

investors surveyed are now trading bonds electronically. 

Similarly, electronic trading of investment grade bonds in 

the U.S. is now estimated to represent approximately 20% 

of the total investment grade trading volume, a three-fold 

increase from 2013 (Figure 7). As would be expected, this 

growth has been driven primarily by smaller size trades, 

and approximately 70-80% of these trades are now 

electronic. The proliferation of small-lot electronic trading 

may help explain why bid/ask spreads have actually 

contracted, despite a reduction in overall market liquidity. 

Figure 8 illustrates the growth of trading activity on one 

such bond electronic trading platform, MarketAxess. 

As discussed earlier, the presence of bond ETFs are 

contributing to the universe of bonds that are priced and 

traded each day. 

This efect is due to how market-makers and authorized 

participants engage in the arbitrage activities that result in 

creation or redemption fows in bond ETFs. Such arbitrage 

activity has driven the development of more robust 

real-time valuation methods and pricing to complement 

traditional pricing services. 

Finally, over time, TRACE has had a signifcant impact on 

market transparency in the U.S., while European markets 

are looking to MIFID II for the introduction of an equity-like 

consolidated tape. 

Figure 7: Electronic trading of U.S. investment grade bonds 

Corporate bonds are shifting towards electronic trading % e-traded

%

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

% Surveyed e-trading

% surveyed e-trading % of volume e-traded

0.0

5.0

10.0

15.0

20.0

25.0

00.0

30.0

60.0

90.0%

Source: Greenwich Associates 2016 North American Fixed Income Research Study. Based on 115 respondents in 2005, 107 in 2006, 147 in 2007, 132 in 2008, 141 in 2009, 146 in 

2010, 124 in 2011, 121 in 2012, 123 respondents in 2013, 104 in 2014, 105 in 2015 and 102 in 2016. 

12 THE NEXT GENERATION BOND MARKET 

ICR0917U-255379-805339 
Figure 8: MarketAxess trading volume in U.S. investment grade & high yield bonds 

Continued utilization of e-trading platforms Trade volume ($bn)

$800

600

400

200

0

U.S. IG volume

2012 2013 2014 2015 2016

# of firms

1000

800

600

400

200

0

Active clients

U.S. investment grade

50% 5-yr vol. CAGR

30% YoY vol. growth

Source: MarketAxess, as of 12/31/16 

U.S. high yield

Active clients

Trade volume ($bn)

$160

120

80

40

0

U.S. HY volume

2012 2013 2014 2015 2016

# of firms

1000

800

600

400

200

0

18% 5-yr vol. CAGR

26% YoY vol. growth

Products 

Since the crisis, trading in standardized derivatives 

(e.g., interest rate futures and index derivatives such 

as CDX/iTraxx) has remained robust. Although trading 

and liquidity in single-name CDS sharply deteriorated 

(Figure 9), these metrics appear to have stabilized once 

transaction clearing achieved critical mass through broad 

buy side and sell side adoption. For broker-dealers, 

cleared, index derivatives such as CDX generally have a 

broad, active user base and are more balance sheet and 

capital efcient than cash bonds. As a result, volumes in 

these instruments have remained relatively strong. 

Accordingly, some investors have migrated risk exposure 

from the cash bond market to standardized derivatives to 

the extent they have the fexibility to do so from a legal, 

regulatory, operational and investment policy perspective. 

Many OTC derivatives are now centrally cleared, which 

has served to reduce counterparty risks and increase 

capital efciency. 

Other solutions such as single name bonds that are listed 

on exchange have not gained traction. Unlike the equity 

market, in which only one ticker exists for a company’s 

common stock, the same company may have multiple 

bonds outstanding, each with unique identifers. As 

discussed, these bonds rapidly become of-the-run 

securities as the time from issuance lengthens. Listing 

individual CUSIPs on an exchange has not solved this 

problem. The sheer amount and variety of CUSIPs creates 

fragmentation and prevents listed single bonds from 

having an active trading market. 

Interestingly, bond ETFs have been a key benefciary 

of market fragmentation. Bond ETFs efectively bundle 

individual CUSIPs into standardized, rules-based baskets 

that are perpetually “on the run”. This aggregation of 

multiple bonds through the ETF structure can help reduce 

fragmentation and increase liquidity by focusing trading in 

a single line item. 

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ICR0917U-255379-805339 
Figure 9: Credit default swap notional principal 

Single name CDS market has contracted substantially Notional outstanding ($tn)

Single name CDS Multi-name CDS

0

10

20

30

40

50

60

1H20072H20071H20082H20081H20092H20091H20102H20101H20112H20111H20122H20121H20132H20131H20142H20141H20152H20151H20162H2016

$

Source: Bank of International Settlements, as of 12/31/16. 

Pre-crisis, bond ETFs were used primarily as passive 

alternatives to mutual funds by retail wealth managers. 

Growth in recent years refects both further penetration 

in retail channels as well as accelerating adoption by 

institutional investors such as asset managers, insurers, and 

pension funds. Although they now represent over $740 

billion in assets globally (Figure 10), bond ETFs are still less 

than 1% of the overall fxed income market. 

Increasingly, bond ETFs are viewed as building blocks in 

both wealth and institutional portfolios, and as alternatives 

to individual securities and index derivative instruments. 

According to a 2016 Greenwich Associates study, 

institutions use bond ETFs for applications such as 

portfolio completion, tactical adjustments, rebalancing 

and liquidity management. Liquidity, operational simplicity, 

and speed of execution were cited as the top reasons for 

bond ETF adoption. 

14 THE NEXT GENERATION BOND MARKET 

ICR0917U-255379-805339 
Figure 10: Global AUM of bond ETFs 

Post-crisis environment drives growth of bond ETFs AUM ($bn)

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 YTD 2017

0

200

400

600

800$

Broad/aggregate

Emerging markets

Government & municipal

Govt/corp

Others

Mortgage

Investment grade corporate

High yield corporate

Inflation

Source: BlackRock, Bloomberg, as of 6/30/17. 

Figure 11: Characteristics of the exchange traded fund structure 

Fixed income in an equity-like wrapper 

Characteristic Description Implication 

Standardized Pools various types of similar and/or Ability to more efciently trade asset classes where 

exposure diferent fnancial assets into a single it may be difcult or require special resources to 

security type source securities 

Exchange- Centrally listed like a stock on an All the potential benefts of liquid, large cap equity 

listed equity exchange market infrastructure including transparency and 

greater access for all types of investors 

Pricing Priced in real-time, even if underlying Implied pricing when underlying market closed or 

transparency assets do not price as frequently inactive. Potentially improved price discovery even 

when underlying markets closed or stressed 

Incremental Secondary market trading of ETF shares Potential for improved trading costs and execution 

liquidity on exchange, independent from the speeds by trading single security 

underlying securities 

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ICR0917U-255379-805339 
A unique feature of the ETF structure is the ability for 

investors (with the help of banks/broker-dealers) to shift 

exposure between the underlying bond market and 

the ETF through the creation/redemption mechanism. 

End investors and banks/broker-dealers alike are using 

the dual access of exchange and OTC market to more 

efciently trade as well as manage inventory levels. 

In particular, Authorized Participants with fow credit 

businesses are becoming increasingly sophisticated at 

managing inventory levels in the context of end investor 

ETF creation/redemption activity. 

Market participants are realizing that it is possible to improve 

execution and gain operational efciencies by accessing 

cash bond exposure through the ETF structure (Figure 11). 

Figure 12: Volume growth across trading vehicles 

Liquidity of indexed-based vehicles growing 

Indeed, the same drivers of demand for index derivatives 

such as CDX and TRS are also driving demand for bond 

ETFs as well as derivatives on those bond ETFs such as 

swaps and options. Figure 12 illustrates the growth of ETFs, 

CDX and TRS over the past several years. The iShares iBoxx 

$ Investment Grade Corporate Bond ETF (LQD) and iShares 

iBoxx $ High Yield Corporate Bond ETF (HYG) are used to 

represent an investment grade bond ETF and high yield 

bond ETF, respectively. 

YTD 2017 2016 2015 2014

Average daily trading volume ($m)

IG cash

17,542

13,764

15,481

13,035

7,878

9,149

8,139

526 566 346 187

8,517

38 24

$

LQD iBoxx IG TRS

5 yr CDX. IG

0

5,000

1,0000

15,000

20,000

8,297

7,134 6,995

4,295 4,352 3,996

1,137

437 712

141

8,428

3,864

974

167 135

Average daily trading volume ($m)

$

HY cash

HYG iBoxx HY TRS

5 yr CDX. HY

YTD 2017 2016 2015 2014

0

2,000

4,000

6,000

8,000

10,000

Source: Bloomberg, BlackRock, FINRA TRACE, as of 6/30/17. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained. 

16 THE NEXT GENERATION BOND MARKET 

ICR0917U-255379-805339 
The next generation bond market 

An era of technological transformation 

As these trends gather pace, we believe the coming years 

will see a transformation in fxed income similar in many 

respects to that experienced in equities in the 2000s. 

Market structure 

The momentum behind the electronifcation of bond 

markets should continue, with signifcant increases in 

electronic trading, all-to-all networks, alternative trading 

protocols, central limit order books (CLOBs), and dark 

pools, which should impact not only cash bonds, but 

standardized vehicles as well. 

Traditional banks and broker-dealers will likely remain at 

the center of the fxed income market as they continue 

to adapt their business models, investing in trading 

infrastructure and automation (including algorithmic 

trading and artifcial intelligence), and embracing new 

trading practices and venues. However, while principal 

risk taking will remain in some form, it is unlikely to revert 

to pre-crisis levels of activity as the new hybrid agency/ 

principal model becomes entrenched. 

Moreover, advances in technology may allow traditional 

asset managers to play an increasing role as price makers 

with respect to trading through crossing networks, a shift 

requiring changes in behavior as well as the adoption 

of technology. 

Non-bank principal trading frms and ETF marketmakers will likely continue to increase their presence as 

liquidity providers. We believe such entities have become 

increasingly active in bond ETFs and the underlying cash 

bond markets, and will continue to branch into derivative 

markets as well. 

The trend towards transparency on both a pre-trade and 

post-trade basis and the resulting increase in data will 

continue due to regulation and the momentum behind 

electronic trading. This proliferation of trade data will allow 

for greater innovation in automated market making activity 

and liquidity provision analytics. 

Liquidity 

We believe that the liquidity and regulatory environments 

will continue to be interconnected. Depending on the 

political landscape over time, regulatory burdens may 

ebb and fow, but the overall trends towards product 

standardization and transparency are likely to continue. 

In aggregate, liquidity should stabilize for individual cash 

bonds as the ecosystem continues to adapt and evolve. 

However, rules-based instruments which reference market 

benchmarks (i.e., derivatives and ETFs) may see the largest 

gains in trading volume as investors discover the liquidity 

and diversifcation benefts they can ofer. Similarly, the 

derivatives and lending markets that reference bond ETFs 

themselves are likely to deepen as adoption increases, 

potentially ofering further sources of liquidity for investors. 

Most importantly, relying solely on bid/ask spreads may 

no longer be an adequate indicator of liquidity. Investors 

should consider a multi-dimensional approach that 

takes into account volume, immediacy, depth, resiliency, 

vehicle and trading venue. We introduce a stylized, 

conceptual framework designed to highlight these key 

factors in Appendix A. 

We believe that there will be a continued drive towards 

data generation, aggregation, and distribution. Real-time 

pricing of fxed income risk is more important than ever 

BLACKROCK 17 

ICR0917U-255379-805339 
 

given the increase in transparency from electronic trading 

and ETF primary and secondary activity. Enhanced trade 

reporting should be a signifcant driver of this type of 

pricing, particularly for cash bonds, but also for bespoke, 

non-centrally cleared derivatives. 

Finally, scale economies will be key as data infrastructure 

costs will likely be prohibitive, leading to potential 

consolidation among data / pricing / index service 

providers. Data itself will become increasingly important 

with data providers seeking to protect and monetize the 

value of that data. 

Products 

We believe that index/basket exposure vehicles will serve as 

building blocks and play an increasing role in how investors 

construct fxed income portfolios. The trajectory may be 

similar to what was observed in the transition from individual 

equities to indexed equities through futures, swaps and 

ETFs. In the future, the ofering of these vehicles in fxed 

income will likely be much more refned and granular, 

moving from broad indices into constituent sub-indices. This 

will allow investors to access fxed income exposures that are 

highly targeted by sector, industry, size, quality or a number 

of other factors or characteristics. 

The creation/redemption process for bond ETFs could 

become much more sophisticated, robust and fuid due to 

enhancements in technology and widespread acceptance 

of the vehicle. Importantly, the creation/redemption process 

itself could serve as a conduit for bundling and unbundling 

of fxed income risk as well as optimizing liquidity across 

venues. This dynamic would aford investors more fexibility 

to navigate risk and liquidity by actively moving between 

individual cash bond and portfolio ETF exposures. 

The growth in borrow availability and in the liquidity of 

derivatives referencing ETFs can further increase the role of 

bond ETFs in the ecosystem. 

Traditional derivative markets are likely to continue to trend 

towards cleared, benchmark reference products. Most 

derivative structures, even the more bespoke ones, may 

ultimately be electronically traded and cleared. CDX will 

continue to be augmented with more bond-like derivative 

exposures such as index TRS given that such products are 

more closely hewn to the cash bond market. 

Further, we believe that the number and type of paired, 

complimentary derivative and ETF exposures (e.g., 

iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and 

iBoxx $ Liquid High Yield TRS) will continue to grow in order 

to increase fungibility between the cash and synthetic 

markets. Derivatives on bond indexes and on bond ETFs 

themselves could be the dominant link between funded and 

unfunded exposure. Such a dynamic is already starting to 

occur in index TRS and credit ETF options. 

With the growth of new instruments, portfolio managers 

will need to be more agnostic, starting with their desired 

outcome before determining the optimal exposure vehicle 

across cash bonds, derivatives or ETFs. 

Understanding how these instruments are traded and 

behave relative to one another will be key in implementing 

efcient investment strategies. 

Conclusion 

While fxed income markets were already beginning to 

evolve prior to 2008, the fallout from the crisis has catalyzed 

a behavioral shift in the market and has dramatically 

accelerated three trends already underway: 

• increasing transparency; 

• adoption of standardized instruments and trading 

vehicles (e.g., rules-based derivatives and ETFs that 

reference market benchmarks); 

• modernization of trading through clearing and 

electronic platforms. 

In many respects, fxed income markets are evolving along 

a path similar to that of the equity markets. However, the 

structural features of bond markets, such as heterogeneity 

and fragmentation, don’t naturally lend themselves to a pure 

equity market infrastructure. As a result, a more complex 

approach and more robust set of tools will be necessary to 

address the longstanding challenges of the bond market. 

This evolution is likely to be faster and more disruptive than 

many market participants currently expect. We believe that 

those who embrace and adapt to the coming changes have 

the greatest potential to beneft. 

18 THE NEXT GENERATION BOND MARKET 

ICR0917U-255379-805339 
Appendix 

A A multi-dimensional framework for 

evaluating liquidity 

Given today’s shifts in market structure and the rise of new exposure vehicles, the measure of liquidity 

in fxed income should be broadened beyond bid/ask spreads. We introduce a stylized, conceptual 

framework designed to highlight the key factors investors should consider: 

1 Quoted bid/ask spread: The displayed bid/ask spread. 

2 Average daily volume: The observed average daily trading volume as an indicator of historical 

trading capacity. 

3 Market depth: The trade size that can be absorbed without signifcant market disruption. 

4 Immediacy: The speed at which a trade is flled. 

5 Price resilience: The time it takes an asset’s price to recover following a market moving trade. 

Case study: Measuring liquidity for U.S. investment grade bond exposure 

Using this multi-dimensional liquidity framework, we can evaluate the liquidity profles of three 

diferent investment grade corporate bond exposure vehicles. 

The vehicles being evaluated include: 

• Individual cash bonds represented by a sample of actively traded investment grade bonds.3 

• Index derivatives represented by the on-the-run CDX.IG contract. 

• Bond ETFs represented by the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD). 

3. References a basket of Anheuser-Bush Inbev (ABIBB) and Verizon Communications (VZ) bonds traded by BlackRock dealing desks. 

BLACKROCK 19 

ICR0917U-255379-805339 
In Exhibit A, we have scored examples of each vehicle 

in the investment grade market based on the above 

fve dimensions of liquidity with a scale from 1-5, (1 

representing the lowest score and 5 representing the 

highest score). Accordingly, an instrument with a total 

score of 25 would exhibit the greatest estimated overall 

liquidity. For simplicity, the factors are equally weighted 

and may not refect each factor’s actual relevance for a 

particular market or exposure. 

In this instance, CDX.IG would rank the highest, with a 

score of 22, followed by an investment grade bond ETF, 

LQD, with a score of 17, and then fnally the sample cash 

bond at 14. 

Exhibit B shows this liquidity scoring system for each 

instrument over time. Note that the spread between the 

cash bond market and the other two instruments has 

been steadily widening. Overall, liquidity in the cash 

market has declined, while ETF liquidity has improved at 

the greatest rate. 

Exhibit A: Liquidity evaluation for U.S. investment grade bond exposure 

1

2

3

4

5

Not

liquid

Very

liquid

Market depth

Price resilience Immediacy

Bid-ask (width at touch)

Asset level ADV

YTD 2017

0

Measures total quantity of liquidity 

supplied for volume offered at 

bid-ask spread

Measures available 

immediate trade size 

without moving market

Measures how quickly price 

reverts to equilibrium after 

large trades

Measures cost of consuming 

liquidity immediately

Measures speed of execution 

for large trades

U.S. IG bond U.S. IG ETF CDX NA IG

Source: BlackRock, as at 6/30/17. For illustrative purposes only. 

Please refer to the back page of the document for sources and assumptions on the liquidity framework. 

20 THE NEXT GENERATION BOND MARKET 

ICR0917U-255379-805339 
 

 

Exhibit B: Liquidity evaluation for U.S. investment grade bond exposure over time 

2013

1

2

3

4

5

0

Market depth

Price resilience Immediacy

Bid-ask

(width at touch)

Asset level ADV 2014

1

2

3

4

5

0

Market depth

Price resilience Immediacy

Bid-ask

(width at touch)

Bid-ask

(width at touch)

Bid-ask

(width at touch)

Asset level ADV

2015

1

2

3

4

5

0

Market depth

Price resilience Immediacy

Asset level ADV

2016

1

2

3

4

5

0

Market depth

Price resilience Immediacy

Asset level ADV

U.S. IG bond U.S. IG ETF CDX NA IG

Toatl liquidity score

25

15

20

10

5

0

U.S. IG bond U.S. IG ETF

2013

14 14

25

14

16

24

15

17

23

14

17

22

2014 2015 2016

CDX NA IG

Source: BlackRock, as at 12/31/16. For illustrative purposes only 

This framework highlights an important feature of the postcrisis bond market. The liquidity of a particular exposure 

vehicle may difer from the liquidity of the asset class itself. 

As one example, CDX is actually twice removed from the 

underlying cash market (i.e., CDX is an index derivative 

contract on individual default swap contracts on cash 

bonds), yet is vastly more liquid than a given individual cash 

bond. The iShares iBoxx $ Investment Grade Corporate 

Bond ETF (LQD) is another example, trading at tighter bid/ 

ask spreads and higher ADV than the individual investment 

grade bonds that it holds.3 

4. iShares iBoxx $ Investment Grade Corporate Bond ETF trades a bid/ask spread of 1 bps compared to 35 bps for the underlying securities of the fund. Source: Bloomberg, NYSE 

 Arca, as of 6/30/17. 

BLACKROCK 21 

ICR0917U-255379-805339 
What explains the divergence of liquidity between the exposure vehicle and the asset itself? 

We believe that there are four contributing factors: 

• Diversifcation: By aggregating individual exposures 

into a portfolio, idiosyncratic risk is replaced by 

systematic or market risk. 

• Standardization: As an example, both CDX and LQD 

are standardized, rules-based exposures which follow 

reference benchmarks governed by inclusion and 

exclusion criteria. 

• Transparency: Both CDX and LQD exhibit daily 

transparency, with the composition of each product 

available from a variety of sources. 

• Trading / clearing medium: While CDX is traded 

exclusively OTC, LQD may beneft from being traded 

on an exchange, which can provide investors with 

unique trading efciencies compared to the 

OTC market. 

Each of these attributes may be thought of as decreasing 

cost and increasing liquidity. Diversifed exposures are 

more manageable from a risk taking / risk management 

perspective than idiosyncratic exposures. Likewise, 

standardized and transparent exposures are more 

manageable than bespoke exposures due to far greater 

certainty around the nature of the risk. 

In the case of the ETF, exchange trading confers a number 

of potential benefts, including real-time visibility into bid/ 

ask spreads, market depth and trading activity as well 

as elimination of counterparty risk. In the case of CDX, 

mandatory clearing has greatly reduced counterparty risk, 

eliminating a former component of trading cost. 

Taken together, it is not surprising that CDX and LQD tend 

to be more liquid than the underlying individual cash bonds 

that they represent. Similar efects can be observed in 

other markets such as equity and Treasury futures. Exhibit C 

illustrates a stylized representation of the relative potential 

liquidity of exposure vehicles across the U.S. Treasury, high 

yield and investment grade corporate markets. Importantly, 

however, this expanded liquidity of the asset class by new 

vehicles does not represent a “liquidity transformation” as is 

sometimes claimed. Rather, incremental liquidity represents 

a structural transformation that is additive to the markets. 

Exhibit C: Aggregate market liquidity by investment vehicle 

Derivatives and pooled vehicles can add incremental liquidity 

U.S. investment grade

U.S. high yield

U.S. treasuries Futures ETFs Cash treasuries

ETFs Cash bonds

Index CDS ETFs Cash bonds

Index CDS

For illustrative purposes only. Based on reported trading volumes as of September 2017, may not represent actual liquidity for the products shown at any given time. Graphic not 

drawn to scale. 

22 THE NEXT GENERATION BOND MARKET 

ICR0917U-255379-805339 
Appendix 

B Glossary of key terms 

Bond exchange traded funds (ETFs) 

Bond ETFs are typically registered funds under the 1940 

Act consisting of a portfolio of bonds that are traded 

intra-day on an exchange, like an equity security. They are 

generally fully funded, unlevered vehicles that hold cash 

bonds. Most bond ETFs seek to track indices that follow 

specifc segments of the bond market, such as government, 

investment grade corporate, high yield corporate or 

emerging market bonds. Rather than trading individual 

bonds in the over-the-counter (“OTC”) market, investors 

can access these exposures by purchasing an ETF on an 

exchange. The ETF structure can lower the cost of trading 

while providing real-time pricing information. 

ETF creation/redemption 

The process by which shares of ETFs are issued to, and 

redeemed from, Authorized Participants (APs). ETF creations 

and redemptions are typically for large blocks of shares and 

are settled by delivery of the ETF Basket (but may be settled 

for cash when in-kind delivery of assets is impractical, using a 

variety of transaction charges so that costs are borne by APs 

in a manner similar to an in-kind delivery). 

Market makers 

A broker-dealer that regularly provides two-sided (both buy 

and sell) quotations to clients. 

Authorized participant (AP) 

APs are fnancial institutions capable of managing complex 

securities settlements that create and redeem ETF shares in 

the primary market in exchange for underlying securities. Each 

AP has an agreement with an ETF sponsor that gives it the 

right (but not the obligation) to create and redeem ETF shares. 

APs frequently create or redeem shares in order to manage 

inventories of ETF shares sold or bought through trading in the 

secondary market. APs may act either on their own behalf or 

on the behalf of market makers or institutional clients. 

Primary market 

Refers to activities through which securities, including stocks 

and bonds, are issued and redeemed. The primary market 

for ETFs (where ETF shares are typically exchanged for the 

underlying securities) is available only to APs. 

Secondary market 

Refers to the market where securities, including ETF 

shares, are traded and includes trading through regulated 

exchanges (such as NYSE ARCA, NASDAQ and Bats), trading 

through Electronic Communications Networks (ECNs), and 

over-the-counter (OTC) trading among institutions. 

Electronic bond trading 

Typically a computer-based trading technology that displays 

bid and ask quotes from many market participants, and then 

automatically matches and execute trade orders. 

All–to-all network 

A trading platform that allows any platform member to 

negotiate and trade with any other platform member. The 

best known all-to-all platform is the modern stock exchange. 

Principal trading frm 

A trading frm that typically deploys proprietary automated 

trading strategies on trading platforms. Some frms may be 

registered as broker-dealers although they have no clients. 

Central limit order book (CLOB) 

A trading protocol in which outstanding ofers to buy or sell 

are stored in a queue and are flled in a priority sequence, 

usually by price and time of entry. CLOBs are common for 

highly standardized securities and markets in which trade 

sizes can be small. 

BLACKROCK 23 

ICR0917U-255379-805339 
 

 

Important notes and sources: “Asset level ADV” score is determined based on the average daily traded volume (ADV) and turnover ratio of each instrument. Source is Bloomberg. 

“Bid-ask (width at touch)” score is determined using average daily bid-ask spreads. Sources are Barclays Research, TRACE, Bloomberg and BlackRock internal trading analytics. 

“Immediacy” and “Price Resilience” scores are determined using BlackRock trading data and analytics based on all transactions of the iShares iBoxx $ Investment Grade ETF (LQD), 

CDX NA. IG, Anheuser-Bush Inbev (ABIBB) and Verizon Communications bonds (VZ) traded by BlackRock's dealing desks. Each transaction is evaluated based on traded notional 

amount, execution time stamp, order time stamp, execution price, daily closing price, and daily open price. “Market Depth” score is determined based on BlackRock trader and 

portfolio qualitative feedback. All data is measured as of June 2017. 

Want to know more? 

blackrock.com +877-275-1255 (1-877-ASK-1BLK) 

Carefully consider the Funds' investment objectives, risk factors, and charges and expenses before investing. This and 

other information can be found in the Funds' prospectuses or, if available, the summary prospectuses which may be 

obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing. 

Investing involves risk, including possible loss of principal. 

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the 

bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fuctuations, 

risk of default or loss of income and principal than higher-rated securities. Diversifcation and asset allocation may not protect against market risk or loss of principal. 

This material represents an assessment of the market environment as of the date indicated; is subject to change; and is not intended to be a forecast of future events or a 

guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular. 

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any 

investment strategy. There is no guarantee that any strategies discussed will be effective. 

The information presented does not take into consideration commissions, tax implications, or other transactions costs, which may signifcantly affect the economic consequences of 

a given strategy or investment decision. 

Shares of iShares ETFs may be bought and sold throughout the day on the exchange through any brokerage account. Shares are not individually redeemable from the ETF, 

however, shares may be redeemed directly from an ETF by Authorized Participants, in very large creation/redemption units. There can be no assurance that an active trading market 

for shares of an ETF will develop or be maintained. 

Buying and selling shares of ETFs will result in brokerage commissions. When comparing stocks or bonds and iShares Funds, it should be remembered that management fees 

associated with fund investments, like iShares Funds, are not borne by investors in individual stocks or bonds. 

The iShares Funds are distributed by BlackRock Investments, LLC (together with its affliates, “BlackRock”). 

The iShares Funds are not sponsored, endorsed, issued, sold or promoted by Markit Indices Limited, nor does this company make any representation regarding the advisability of 

investing in the Funds. BlackRock is not affliated with Markit Indices Limited. 

This material is not intended to be a recommendation or advice by BlackRock. If this material were construed to be a recommendation by BlackRock, BlackRock would seek to 

rely on Department of Labor Regulation Section 2510.3-21(c)(1). As such, by providing this material to you, a plan fduciary that is independent of BlackRock, BlackRock does not 

undertake to provide impartial investment advice or give advice in a fduciary capacity. Further, BlackRock receives revenue in the form of advisory fees for our mutual funds and 

exchange traded funds and management fees for our collective investment trusts. 

©2017 BlackRock. iSHARES and BLACKROCK are registered trademarks of BlackRock. All other marks are the property of their respective owners. 

FOR INSTITUTIONAL USE ONLY - NOT FOR PUBLIC DISTRIBUTION 

Lit. No. WP-NG-BOND-0917 36252 / 0917 

ICR0917U-255379-805339