Fixed Income Electronic Trading - Let There Be Light

from Xand : pcurley - 31st December 1969

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LetThereBeLight

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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