By Bob Holland, Senior Product Manager, Linedata
This time the stars really are aligned for a major leap forward in the automation of bond trading, according to Bob Holland, senior product manager, Linedata.
Sometimes we’re taken by surprise by the most obvious changes, especially if they’re a long time coming. Just like the frog that jumps out of hot water, but doesn’t recognize the danger when the heat is gradually turned up to boiling point, we can be complacent about shifts in our environment that take longer to have an effect that we anticipated.
Take electronic trading in the bond market. At the turn of the century, many wise heads expected electronic trading of stocks and bonds to take off with equal vigour. A study from Dartmouth College’s Tuck School of Business counted around 90 fixes income trading platforms in 2001. Some have flourished and evolved but many failed. Few would argue that the stock trading world left bonds trailing in its wake in the race to automate. Always more fragmented, more esoteric and therefore more in need of market-making support from the sell-side, the automation of the bond markets has been a long-drawnout affair.
Call it electronification. Call it equitification. Call it moditisation. Just don’t ignore it
But the place of change has accelerated significantly. We may have been waiting for a long time, and the change may have been obscured by the sheer number of macro-economic market structure and regulatory changes since 2008. But be in no doubt. Call it electronification. Call it equitification. Call it moditisation. Just don’t ignore it.
Just as a squeeze on margins and commissions drove the equity markets to adopt execution algorithms in the early 2000s, a multi-faceted attack on sell-side revenues from bond trading is a major factor in today’s trends toward automation. Whether one points to the unprecedented, sustained period of low interest rates or the impact of the Volcker Rule and Basel III on the banks’ ability to hold inventory or make markets, there is a thinning out of margins and therefore a thinning out of sell-side firms’ balance sheet availability to serve institutional investors’ bond trading needs.
According to an analysis by Citi based on European Central Bank data, european banks reduced their bond holdings by 800 billion between Q1 2010 and Q1 2014, suggesting that the liquidity cushion traditionally provided by banks to investors is being gradually eaten away. And alongside Volcker and Basel stand the G-20 reforms to OTC derivatives markets. The desire of global political leaders, central banks and regulators to move major swaps markets onto central clearing is the most high-profile evidence of a wider trend: the need to post collateral to support an ever greater proportion of financial markets transactions. As with other post-crisis reforms, this will lead market participants to prioritise transparency, certainty and simplification of their exposures.
Regulatory change is only part of the picture of course. In parallel with reforms market structure and process, technology and innovation also drive the market forward in search of alpha. One of the biggest growth stories in the financial markets in the past 20 years has been the growth of exchange-traded funds (ETFs), first in equities, now in bonds. There are almost 150 bond ETFs listed on the London Stock Exchange alone and the rapid growth in the number of ‘authorised participants’ which arbitrage the price of the underlying constituent bonds against these ETFs is good for spreads in benign conditions, but bad for sell side margins and no guarantee perhaps of liquidity in volatile times.
Simpler and more transparent markets are required if the buy-side are to become price makers and takers
In response to all these trends, we are now seeing a second wave of electronic bond platform that match large block trades in the equity markets – such as Liquidnet and ITG – have announced plans to enter to bond markets. They face competition not only from the evolving offerings of established players TradeWeb and MarketAxess, but also a host of new offerings some backed by both the sell-side and the buy side.
The bond markets are still more fragmented and esoteric than the equity markets, but there is a renewed will from participants on both sides of the market to ensure that does not get in the way of efficiency. The bound markets may or may not be following the lead of the equity markets, but there is no doubt the differences are disappearing. Simpler and more transparent markets are required if the buy-side are to become price makers and takers, as many feel they must to support liquidity levels.
The reality of today’s buy-side trading desk is that fewer staff are expected to cover more ground, which inevitably means specialisms will die out. More institutional investors will move to an exposure-based approach whereby traders secure the exposure their portfolio managers are seeking through the most effective available strategy, market and instruments.
Where does this leave us? Should we stop clinging to the past and accept that the case for electronification of the bond markets is coming to the boil? Balance sheet pressure? Check. Regulatory pressure? Check. Lack of liquidity pressure? Check. Most importantly, do both the buy- and sell-side agree something has to change? Check. Like the frog, it’s time to jump!