A brave new world for fixed income?
• Although e-trading mechanisms in fixed income and equities have always been different, practices in the two markets are increasingly converging
• These trends, coupled with an acceleration of demand for passive investment strategies, will have important implications in 2018 for exchange-traded funds (ETFs) in general and for fixed income ETFs in particular managing its assets and encouraging the corporate sector to engage more actively in the battle against climate change
Head of ETFs, HSBC
A number of market participants believe that a prominent theme of 2018 may be the accelerated convergence of trading and reporting mechanisms across the global fixed income and equity markets.
One notable driver of this convergence process will be MiFID II, which comes into force in January 2018. While the first MiFID, implemented in 2007, focused principally on promoting transparency in equity markets, MiFID II shines its spotlight firmly on bonds. ICMA is explicit about this, advising that MiFID II will bring “much of the transparency traditional in equity markets to bond trading”. It adds that “Europe will go further with bond transparency rules than just about anywhere in the world, including the US ”.
Specifically, says Mehmet Mazi, Managing Director and Head of Credit Trading at HSBC, historical precedent suggests that requirements under MiFID II for pre and post-trade reporting in the fixed income market could have a positive impact on liquidity. “After the TRACE [Trade Reporting and Compliance Engine] reporting requirements were implemented in the US in 2002, the fixed income market became more observable and margins decreased, reducing total buy-side dealing costs,” he says. “We welcome the opportunities that will be created by MiFID II, we believe we will see a similar development in Europe.”
HSBC, Mazi adds, is committed to helping its buy-side clients meet their reporting requirements in the MiFID II environment by acting as a Systematic Internaliser (SI), maintaining client access to liquidity to clients on and off the trading venues.
It is not just falling dealing costs that will benefit fixed income investors following the entry into force of MiFID II in January. Mazi identifies the potential introduction of a consolidated tape system (CTS) for fixed income – an updated version of the ticker tape – as another future positive element of MiFID II. “The availability of more data feeds will help the sell-side as well as the buy-side become more efficient at price discovery,” he says. “It will also control execution costs by encouraging the application of transaction cost analysis [TCA] across the fixed income market.”
TECHNOLOGY’S ROLE IN ENHANCING EFFICIENCIES IN FIXED INCOME
The role that will be played by consolidated tape providers in facilitating TCA by collecting and aggregating post-trade data is an important example of how technology is supporting enhanced efficiencies in the fixed income market. More generally, it has been the influence of technological innovation, independent of regulatory change, that is revolutionizing the global fixed income space and bringing trading practices increasingly into line with those in equities, says Paul Henry Bacher, Global Head of Fixed Income Electronic Trading at HSBC.
The most visible evidence of the impact that technology is having on fixed income markets, he says, is the dramatic increase in electronic pricing and trading volumes. HSBC’s investment in smart pricing engines and connectivity, he says, now allows it to price many European and US bonds with no manual interference. The bank is aiming to add Asian issues to its electronic repertoire in the first quarter of next year, which will mean that it offers electronic trading in over 4,000 bonds globally.
Market-wide, meanwhile, Bacher believes that within the next two years as much as 60% to 70% of bonds will trade electronically at the secondary market level. This is still below the 90% rate of electronification that has been achieved in equities, but is a significant advance on today’s level, where in some fixed income markets no more than 15% or 20% of total trading volumes are executed electronically.
It is improbable that the global fixed income market will trade exactly like equities any time soon. Mazi says that the relative lack of homogenization across global fixed income means that certain pockets of the market are bound to take more time to match equities for liquidity and transparency.
It may be some time, indeed, before the fixed income market graduates to electronic pricing. “The next level of efficiency will be full auto-quoting,” says Bacher. “In the first instance we could have a situation where 70% of trading is electronic but only 10% of the market is priced on a completely low-touch basis. The question then will be, how quickly can we bring about a complete structural change in which everything is firm-priced electronically and front-to-back efficiencies have been maximised? We’ll be better positioned to answer this question two years from now.”
A WATERSHED MOMENT FOR ETFS?
In the meantime, one notable area of growth is the market for fixed income exchange-traded funds (ETFs). According to data published by the independent research and consultancy firm, ETFGI, net inflows to European ETFs reached a record $63.8 billion in the first half of 2017, bringing total industry assets under management (AUM) to $686 billion. In spite of this healthy increase, underpinned by record inflows into both equity and fixed income funds, total AUM in European ETFs remain dwarfed by those in the US, which were just shy of $3 trillion at the end of the first half of 2017.
Demand for fixed income ETFs is being driven by a number of factors. One of these, says Mazi, is the growing preference among investors for passive rather than actively managed strategies. Another is the continued compression in costs between ETFs and other products. According to ETFGI, the asset-weighted average annual cost for ETFs/ETPs is just 27 basis points, or less than one-third of 1%. This contrasts favourably with the 2+20 fee structure traditionally commonplace in the hedge fund industry.
One of the most striking recent trends in the ETF market, says Steve Palmer, Director and ETF Champion at HSBC, is that they are capturing the attention of institutional fixed income investors and, importantly, the fixed income divisions at the investment banks. “Traditional fixed income traders at the big investment banks can no longer afford to ignore ETFs,” he says. “As a result of the banks involvement, and the application of their balance sheets, underlying bond price discovery and market access, fixed income ETF liquidity is increasing and spreads in the ETFs are narrowing. At the same time, ETFs have become cheaper and cheaper to hold through phenomenal economies of scale, which all combined is a watershed moment for the industry.”
MIFID II: DRIVING THE INDUSTRY?
Palmer says that one factor inhibiting the expansion of ETFs in Europe was their exclusion from MiFID I. In Europe, it is estimated that around 70% of trading is over-the-counter (OTC). “The ETF market in Europe has suffered because clients and end-users are unaware of existing or potential trading volumes,” says Palmer.
“However, because of the post trade transparency requirement that MiFID II will usher in, I’m hopeful that it will mean a light will be shined on the industry,” says Palmer. “This would be to everybody’s benefit because it would provide a much clearer picture of true trading volumes.”
He cautions that “clients are likely to continue to trade ETFs away from the lit venues, via the Request for Quote (RFQ) MTFs, in order for them to avoid any post-trade transparency responsibility and to evidence some form of best execution.”
ENHANCED TRADING EFFICIENCIES
Palmer says that trading via the RFQs can lead to an over-reliance on dealing on a risk basis, which can be sub-optimal, expensive and non-transparent. “We feel that there is a lack of options for clients when it comes to how they go about executing ETFs in Europe.” A key component of HSBC’s preparations for MiFID II has been the development of mechanisms to help clients execute ETFs more effectively and in a more transparent way. “Next year we will be able to deploy the strength of our balance sheet, combined with our market access and the quality of our low-touch capability, to help our clients trade the ETF not on a risk only basis, but in the same way they trade the underlying instruments.”
This leaves Palmer upbeat about the prospects for ETFs in the new MiFID II environment. “In the MiFID II world, there will be much more ETF volume transparency as well as on the true costs of investment vehicles; ETFs will stack up well against competing products such as mutual funds,” he says.
Mazi says that he is encouraged by HSBC’s rising market share in the ETF market. “The product is straightforward, but given that fixed income and equities have traditionally been managed by banks like HSBC as separate asset classes, we have needed to build up systems for risk managing ETFs like bonds but settling them like equities,” he says. “We have also developed pricing engines to electronify and accelerate ETF net asset value [NAV] calculations and automate creation of new fund units”
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