For decades, fixed income market structure essentially consisted of a wholesale inter-dealer market alongside a complex network of dealer-to-client relationships.
This model has delivered a certain measure of security and certainty for investment managers about where to go to trade in or out of a position, while at the same time providing a mechanism for dealers to hedge their positions through inter-dealer brokers, especially in the more liquid sectors, such as government bonds.
Today, this market construct is under scrutiny, and not just by regulators. Increased capital pressures on dealers have necessitated slimming down bond inventory and a shift towards an agency (rather than principal) trading model.
That has created a partial liquidity vacuum, and encouraged many large buy-side firms to more actively work their immense bond portfolios to capture performance alpha, either through reduced bid/offer spreads or – more pro-actively – by providing liquidity to the marketplace.
This opens the door to potentially multiple styles of electronic trading solutions, including models that facilitate a more active role for buy-side traders. In light of market structure and regulatory changes, fixed income clients are looking for technology to help reduce trading costs, closely followed by OMS/EMS connectivity and aggregation solutions as they strive towards more efficient/faster trading.
The opportunity for different flavours of trading or communications platform is new. During the first technology boom of the late-1990s, various approaches attempted to leverage newly emerged internet technology.
At the time, business was booming in the last years of the Clinton Administration, the first two-term Democratic President since Franklin D. Roosevelt. Less than half of the U.S. population was using the internet, and the adoption of e-commerce in the financial markets was nascent.
In those early days, it wasn’t always clear that there was a need for a new business model. As a result, it wasn’t surprising that the successful platforms all took a similar approach – to replicate telephone-based trading but on a more efficient electronic marketplace.
At the time, the buy-side had limited input to the direction of electronic trading, although the desire for single sign-on and an aversion to logging on to multiple dealer websites was a factor in the development of the first request-for-quote (RFQ) based systems.
Today the situation is very different. Not only is there a desire to embrace technology to create more efficient solutions, but more importantly there is a growing recognition that the rules have changed, most likely for years to come.
This has created an opportunity for the buy-side to review their role in the marketplace and the degree to which, and how, they engage with existing electronic platforms.
Into this vacuum has emerged an array of potential new electronic solutions, most of which are targeting the credit markets, which are arguably the most diverse and liquidity-starved of the fixed income products due to the sheer number of individual securities traded.
Current efforts to modernize the bond markets undoubtedly face a more receptive audience than in the late-1990s, as the benefits for both capital-constrained banks and alpha-seeking buy-side participants are clearer than in the first wave of trading platforms nearly two decades ago.
|Key e-traded benefits|
• Pre-trade price transparency to investors
• More efficient processing
• Compliance and audit trails
• More competitive markets
Change in protocol?
The early fixed income trading platforms relied on the RFQ trading protocol, which replicates the traditional telephone enquiries of the buy-side trader. In fact, RFQ still remains the approach of choice, although there is evidence of a move towards more open trading protocols in the corporate bond markets.
Aside from the fact that asset managers are not legally allowed to trade directly with each other (without a broker-dealer license), the resilience of the dealer-to-client trading paradigm has, in the past, partially been because of insufficient buy-side liquidity to entertain an alternative trading approach.
The emerging trend towards more open trading, in which asset managers actively seek to face off against other buy-side trading counterparties, is indicative of the shift in the balance of power in the industry.
Until the last two or three years, it would not have been conceivable that dealers would participate in a trading platform that allowed buy-side firms to request bids from other asset managers on an established e-marketplace. But things are changing.
The result of the shift has been a refocus by the larger banks on their biggest customers, and a laser-like focus on profitability. Larger accounts tend to trade in larger size, which is still predominantly conducted on the telephone.
While the average size of electronic trades is increasing, there is still a concern among dealers about information leakage and potential revenue erosion from a higher level of transparency.
This may be about to change in Europe with the pending arrival of MiFID II, which strikes at the heart of transparency and – unlike in current U.S. regulations – will directly impact the fixed income markets.
And while post-trade transparency has been present in the U.S. but with little pre-trade information, the opposite has been the case in Europe. MiFID II will change this, but as always there are concerns about too much transparency in any marketplace, as it can hamper liquidity.
The buy-side has an historic opportunity to shape its future role in the trading ecosystem, holding a much higher share of inventory than in years past. It is now up to the leadership of buy-side firms to take the reins and determine how they want to engage in the electronic markets of the future. Once fixed income markets transform, they’ll never be the same again!
While history suggests that it is unlikely that radical new trading protocols will be invented, there is a real and meaningful opportunity to share information more quickly, increasing the velocity of the markets and enabling larger-sized trades to be executed more efficiently.
By leveraging technologies, the buy-side can reduce the costs of trading to their investors and take a much more pro-active role in their destiny than they have chosen to historically. It’s also good news for banks, which are looking to more efficiently manage their capital and relationships.
That’s a convergence of interests that the market hasn’t seen before.
Jamie Grant manages the global proposition for Rates & Credit Fixed Income at Thomson Reuters. Prior to Thomson Reuters, Jamie held senior positions within government bond and derivatives trading, over a 15 year career in international debt capital markets.