Simon Linwood, Head of Credit Markets and Data, MTS
Automation of fixed income trading offers numerous opportunities and advantages to all participants. The removal of manual processes and paper significantly reduces frictional costs, which in turn also lowers the entry barrier to wider participation, in terms of both participant size and diversity. This consequently begets better liquidity and more efficient price discovery, which deliver more predictable trading outcomes for all.
However, attractive as this sounds, whether or not these various benefits are realised in practice depends heavily upon the way in which the market concerned handles the automation process. As has been seen in some of the less successful examples of automation in equities and foreign exchange, mistakes made in structuring a particular trading platform and its associated processes can have negative consequences. Toxic order flow, spoofing, activity skewed in favour of one participant group, to name but some. The key here is to ensure that automation of bond trading results in an orderly market in which all participants enjoy equal advantages on a level playing field.
The Scope of Automated Trading
Automated trading covers a number of areas of activity, some more applicable to the buyside, some more to the sellside and some to both. The recent BIS report - "Electronic Trading in Fixed Income Markets1" - identified three principal areas of automated trading activity applicable to fixed income. In all three of these areas, given a suitably orderly and well-managed market place, all participants could potentially achieve appreciable and tangible benefits.
The use of order execution algorithms that split trades into smaller 'child' orders has become commonplace among the buyside in equity and FX markets and is also now present in fixed income, increasingly in the context of multi asset trading. By reducing market impact and by also being able to take advantage of price improvement opportunities on each order slice, significant cost saving and additional alpha capture become possible.
The problem for the sellside is that as buyside fixed income algorithmic order execution continues to grow in popularity, the costs in a non-electronic, non-automated environment become exorbitant. Having to deal with multiple buyside child orders in such an environment creates a major cost and efficiency issue for the sellside in terms of manual and paper processes. By contrast, in an automated environment, sellside participants can manage and optimise the incoming flow electronically and use their own execution algorithms to manage any resulting net exposure.
However, much depends upon the availability of a suitable electronic trading environment to facilitate this process flow. The ideal is for the sellside to have access to a carefully managed, regulatorily compliant, electronic trading platform that incorporates sellside and buyside environments. On the one hand, this allows the sellside to interact efficiently with buyside order flow, so costs are kept to the minimum and the buyside trading experience is optimised. On the other, sellside participants can facilitate buyside business secure in the knowledge that they can also count on an orderly interdealer market that offers similar certainty of execution. They can then deploy their own execution algorithms in this interdealer market to lay off risk in the most efficient manner possible.
However, the successful development of both buyside and sellside execution algorithms obviously depends upon the availability of historical data. Furthermore, such data needs to be available for a substantive date range and, of course, be clean if it is to facilitate the building and realistic testing of algorithms.
Andy Webb, Founder, Automated Trader
Regulation has had a major impact on fixed income market making. For instance, it is now no longer permissible to cross-subsidise market making with other activities, such as proprietary trading, so market making now has to operate profitably as a business in its own right. This, coupled with the capital cost of maintaining inventory, has already caused some banks to switch to an agency-only business model and/or turn away certain buyside clients.
Automated trading has the potential to reverse this situation. The cost of technology with which to access suitable electronic fixed income venues has fallen, so Tier 2 banks now have a real opportunity to participate and service their buyside clients directly. Buyside clients that might have become non-viable, may again become viable due to lower frictional costs and a reduced need to maintain capital-intensive inventory.
However, for this automated business model to work successfully, banks also need to have access to suitable electronic platforms offering orderly markets that will allow them to lay off any exposures resulting from buyside business with certainty. And (as with algorithmic execution) a source of clean and reliable historical data is also needed to facilitate building and realistic testing of market making strategies. Finally, there is the need for any trading platform to be able to deliver the type of information required for regulatory compliance automatically - for instance, best execution and transaction cost analysis.
The need for this combination of market making facilities is becoming increasingly apparent. Market making in fixed income has been steadily moving away from being a manual to an automated activity for some time now. This is clearly reflected in the migration of personnel with automated market making expertise in FX and equities into fixed income to handle large volume vanilla activity. This automation of less challenging flow improves efficiency by freeing up human traders to focus on instruments/situations that are more demanding from a market making perspective.
However, achieving this desirable situation depends on not just the right trading venue, but also on the quality of real time data the associated platform can deliver.
Banks making markets in fixed income securities can benefit from significant additional efficiencies if they have access to a platform that can provide both interdealer and dealer-to-client markets. The technological and cost barriers are lower, particularly if the platform supports industry standards, such as FIX, for both markets. Banks can thus connect a broad range of tools that automate the trading and hedging processes, as well as downstream and upstream activities - such as managing positions and trading activity with clients.
Although a suitable platform is essential to facilitate profitable market making, so too are tools that deliver certainty of execution and price. One example might be a 'mid-price' facility, which could enable participants to leverage automation and take advantage of narrow spreads by trading on an average of the bid and offer rates in a range of fixed income securities. This would mean that buyside business could be transacted secure in the knowledge that any resulting risk exposure could be reliably and quickly hedged.
Directional, relative value and arbitrage strategies
The buyside business of capturing fixed income alpha has recently undergone a fundamental change. In the past, some of the largest asset managers automatically benefited from price improvement, as their banks were prepared to offer advantageous pricing through cross-subsidy. However, activities such as crossing the spread to oblige a major client are no longer possible as they are forbidden by regulation. In addition, as buyside firms' trading strategies become more sophisticated (e.g. multi asset trading), their need for trade automation becomes ever more pressing.
This combination of buyside needs and changes driven by regulation has seen some banks completely withdrawing from acting as principal and only being prepared to act on an agency basis. Some buyside clients - who have become accustomed to banks taking the execution risks by acting as principal - are uncomfortable with this, as they are unwilling to assume this risk themselves.
Elsewhere, some of the largest buyside firms have responded to this change by looking for ways to trade directly amongst themselves. However, this isn't a straightforward matter because of the interconnectivity needed, though some peer-to-peer fixed income venues have already emerged. Another response from some trading venues has been to allow a mixture of buyside and sellside participants in a single combined environment on a relatively unmanaged basis2. However, in some cases this has resulted in a sharp decline in average trade and quote sizes, top of book quote sizes and quote lifetimes.
A carefully managed electronic environment, that incorporates both sellside and buyside activity in a precisely controlled fashion, addresses these potential issues. Access to liquidity for the larger asset managers would be improved, while still leaving the door open to price improvement. By the same token, smaller asset managers would enjoy a relatively low cost of entry in terms of technology. In both cases, strategic flexibility for the development of more sophisticated multi asset strategies would be enhanced.
The fixed income market currently has several pressing needs that automated trading, combined with the right electronic venue, could address. Certainty of execution and reduced costs for both buyside and sellside are clearly major priorities. In particular, regulatory changes have substantially increased the capital costs to the sellside of holding inventory. Automation adds value in the general sense here, but also in more specific ways, such as enabling mid tier dealers to participate fully and by doing so fill any gaps in coverage for the buyside.
Satisfying these needs also brings wider benefits to the market as whole. Broader participation, plus the opportunity to transact more business in a predictable manner, will also enhance overall liquidity - both in terms of immediate sellside to buyside opportunities and by facilitating a wider range of trading strategies. Nevertheless, the key requirement to ensure all this becomes a reality is a trading platform that can offer the right combination of markets, tools and data.
1Bank for International Settlements January 2016
2 i.e. little or no constraint on "low-latency strategies, predatory in nature, that do not appear to improve liquidity or raise the efficiency of prices", BIS paper, page 25.