Fixed Income Electronic Trading – Let There Be Light
First Published Saturday, 22nd October 2011 02:27 pm from Xand : pcurley
The opinions expressed by this blogger and those providing comments are theirs alone, this does not reflect the opinion of Automated Trader or any employee thereof. Automated Trader is not responsible for the accuracy of any of the information supplied by this article.
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The Last Hold-Out
The fixed income
trading world has been the last hold-out in the broad shift
towards electronic trading and more transparent centralized
trading venues. We've already witnessed the other popular
financial instruments including equities, options, futures, and
currencies, succumb to the inevitable, but fixed income is still
dominated by the murky business of OTC trading. There are signs,
however, that even this asset class has finally reached a
tipping-point, and that we are now on the verge of a new world
where the buy-side's demands for transparency will finally be
realized.
To understand what this future may
look like we must first understand how fixed income trading got
to where it is today.
When Two Sides
Collide
The fixed income trading world has
always been defined by the opposing interests of the buy-side and
the sell-side.
The buy-side has almost
uniformly expressed dissatisfaction at the whole fixed income
trading process. Complaints include a complete lack of
transparency, an inability to obtain reliable price discovery and
market data, the high-cost, and the general inefficiency when
compared to the electronic trading of other asset classes. More
recently there has been intense pressure to include fixed income
in electronic multi-asset trading class strategies.
The sell-side on the other-hand has been highly
motivated to keep things status quo. Over the years fixed income
trading has been a cash cow business for the large Wall Street
dealers. For example, fully 52% of Goldman Sachs' $45 billion
revenue in 2009 came from their fixed income trading division.
The sell-side understands that moving fixed income trading away
from the OTC model to more exchange-like platforms and
Alternative Trading Systems (ATS's) will almost
certainly result in greatly reduced profits. The sell-side in
their defense has argued that the sheer volume (3 million
fixed-income securities and counting) and the inherent complexity
of fixed income products does not lend itself to a more
standardized and centralized market.
Innovation around the Edges
That is
not to say that there has not been innovation or change. Over the
years there have been some key developments
that have allowed the fixed income
trading world to creep towards a more electronic and transparent
marketplace:
1998
- Tradeweb introduces an electronic
request-for-quote-driven multi-dealer platform focused on U.S.
treasury bonds.
2000 -
MarketAxcess introduces an electronic request-for-quote-driven
multi-dealer platform focused on corporate bonds.
2000 - FIX, the
widely-used equity-focused electronic trading protocol, is
expanded to include fixed income features.
2002 - NASD
introduces TRACE (Trade Reporting and Compliance Engine) which
captures and disseminates consolidated fixed income transactions
from the secondary bond market.
On the retail
side we've also seen some innovation with more fixed income
market data becoming available on websites like
"Investinginbonds.com" and "Yahoo! Bond Center".
The Credit-Crisis and the Regulatory
Response
The credit crisis and the
yet-to-be-fully understood regulatory response has upset the
status quo of the fixed income trading world and will result in
the demands of the buy-side finally overwhelming the interests of
the sell-side dealers.
The sell-side lost
billions during the crisis and is already accepting that the
writing is on the wall. In some cases they are not waiting for
regulation and are in the process of downsizing their fixed
income trading businesses. We are also seeing them less willing
to risk their own capital in fixed income trading.
On the regulation front there have been a number of
major initiatives including the Dodd-Frank Wall
Street Reform and Consumer Protection Act and
Europe's MiFID II, both of which
force transparency by mandating that swaps and other derivatives
be traded on exchanges and Swap Execution Facilities (SEFs).
The Volcker Rule will further strike
at dealers by outlawing proprietary trading and tactics such as
the highly profitable 'flow trading'.
The
Electronic and Transparent Future
Perhaps the
biggest advantage of this new fixed income electronic trading
world will be the broad availability of fixed income market data.
As we've seen with other asset classes that have gone through
this electronic transition the availability of accurate market
data will result in the buy-side becoming much more focused on
cost and efficiency. There will be increased interest in
best-execution and over time we will see a more efficient
marketplace.
Another key trend that we can
expect is the 'retailization' of fixed income trading. As fixed
income market data becomes ubiquitous we will see the retail
investor want greater direct involvement in electronic fixed
income trading. This will result in more services, websites, and
even mobile apps aimed exclusively at the retail bond
investor.
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