There is an information gap in fixed income markets. They lack any legacy of centralized infrastructure, have never distributed consolidated price data, and inevitably regulation does not require orders to be pushed around looking for best bid / offer because there is no consolidated record of a national best bid and offer (NBBO).
Several developments have widened these gaps. Firstly, the low interest rate environment has encouraged bond issuance to reach record levels, increasing the number of instruments available in the primary and secondary markets. The number of non-fungible instruments traded is an inherent problem in fixed income markets.
National government bond markets have one issuer, corporate bonds have an enormous range, as do municipal bond markets. Each of these can issue bonds at any point, with a variety of tenors, resulting in an enormous universe of potentially tradable instruments relative to equities. For investment purposes, these are divided up across investment grade and high yield, based on assessment by credit rating agencies. Their geography constitutes another characteristic, broadly divided between US, European, and emerging market debt.
When many securities are issued by the same entity, as happens with bonds most extensively when interest rates are low, and there is no centralized trading infrastructure, finding a counterparty in the universe of dealers and investors is not easy. That reduces the level of liquidity in the market.
Secondly, the cost of holding risky instruments under capital adequacy rules has led dealers to withdraw from market making activity. That has impacted liquidity across instruments, but due to bond markets’ inherent illiquidity, the impact has been more noticeable. Credit and interest rate derivatives, which provide hedging for cash instruments, have also had their trading costs driven up by the need to centrally clear derivative trades. Overall this has increased the costs of accessing liquidity.
The third and final development is the market structure. Bilateral trading has not been replaced by a central order book, but instead multiple trading venues have developed support for bilateral trading. That arrested development has recently begun to change, with all-to-all models developing in order to provide access to non-dealer liquidity.
Trading venues have launched across fixed income markets in order to fill the void created by the concentration of market makers on the most liquid securities. From rates to credit, cash and derivatives, more than one hundred venues have been created in the last years. Some of these are using genuinely innovative new trading models, particularly all-to-all which has proven successful in the credit space, but no matching mechanism can make up for a lack of buyer / seller to your trade.
Every fixed income instrument set has a cluster of successful – and many less successful – venues with the potential to help connect buyers and sellers. Although there are limits to the amount of non-dealer liquidity that can be provided, this is a positive development for traders.
However, the landscape they are faced with becomes more complex as new venues are added, creating a need for even more effective connectivity to get a complete liquidity picture.
Having come to terms with capital requirements, sell-side firms are starting to try and increase their profitability in these markets. For the sell-side, fitting into this new landscape can create a wealth of execution options and ways to reach new clients.
However, the sheer number is paralyzing. There is not a standard application programming interface (API) or messaging standard, although use of FIX is increasing. For each venue, data feeds need to be analyzed, implemented, and tested by the dealer. Connectivity needs to be set up and legal agreements need to be reviewed and negotiated in order to start engaging with any one venue. Data then needs to feed seamlessly onto the trading desk, whether it is buy- or sell-side, and preferably without occupying too much screen real-estate.
Prices are not displayed on many of the larger markets, which mostly offer bilateral trading via the request-for-quote (RFQ) trading model. This requires buy-side firms to reveal their interest to a certain number of counterparts in order to obtain a price. Understandably keen to avoid information leakage, many buy-side firms are building data feeds that allow them to understand where a price should be on a pre-trade basis. That is an additional cost.
The connectivity process with venues is also a cost and these mounting expenses can inhibit the advantages construed by finding multiple liquidity sources.
From a technical point of view, start-ups will often have constructed platforms using the latest technology while incumbent venues are built on older systems – there is no standard interface. To ensure each trading desk can benefit from these new innovative venues, it is crucial that firms assess their ability to normalize data feeds and trading connectivity early on in the process.
Reaching every platform might seem too great a challenge on a technical level. Overcoming that burden demands the use of technology that can normalize data, and the use case for supporting that investment.
Dealers have a compelling business case for connectivity. If a bank can connect with 40 platforms it substantially increases its capacity to support clients. The ability to aggregate pricing data from those venues by standardizing the data and pushing it out to clients adds greater value to the client relationship.
For buy-side firms, there is a strong case but the risk of connecting to several platforms for a single instrument can potentially outweigh the benefits they offer. Some platforms have already fallen by the wayside. For an asset manager, increased connectivity can spell a reduction of the costs of liquidity, price formations, and trade execution. The risks of investing in connectivity to a failing venue can impede those business goals.
As a result, it is widely expected that mid- to large-sized buy-side firms will see some investment in their own technology build-out, but smaller firms may need to access service-based data and market access to gain the same advantages without excessive costs. Dealers making an investment in pricing technology can seize the moment and deliver a superior service to their clients while they are most in need.
For a heavily voice-traded market, the introduction of electronic trading channels is still relatively fresh. Buy- and sell-side firms seeking a route to access liquidity more easily will have to start with the nuts and bolts; working out how to get low-cost connectivity first, will make the economics of the wider market work and find real opportunity in the expanding ecosystem of fixed income trading.
However, in Europe, best execution responsibilities are increasing under MiFID II from January 3, 2018, impacting debt trading just as they did equity markets under MiFID I in 2007. Best execution must be demonstrated and quantified where possible, so firms will have to show engagement with multiple venues and build the book across all of those different sources. In October, equity analysts from UBS reported in a note entitled ‘MiFID II's domino effect’ that they expect “competitive pressure will lead asset managers to fund research internally in markets beyond Europe.”
With a bifurcation between research and execution extending into other markets, the pressure to prove best execution can be expected to spread. Consequently, better connectivity for data and trading engines will prove an asset for buy- and sell-side firms across fixed income markets, globally.