Bonds have been traded over the phone for decades so why should the buy-side now need to invest in systems for executing them electronically?
Many regulators and market participants want to push the bond market into the 21st century. If the end goal is greater transparency, the means is wider use of technology to price, trade and report fixed-income transactions. The big question is whether the order-driven, exchange-traded future predicted for the market really will deliver better outcomes than existing request-for-quote mechanisms.
Today, fixed income trading is generally considered to be an opaque, dealer-led market, often resulting in wide spreads that are passed through to the buy-side.
To source liquidity, buy-side traders and – unlike equities – portfolio managers call up a number of broking counterparts to compare indicative prices for a particular instrument.
But the process is far from ideal. By definition, indicative Prices are subject to change at short notice.
Furthermore, European bond markets have little to no pre- or post-trade transparency, making quote validation a matter of best efforts not best execution..
As such, money managers are eagerly anticipating the introduction of new rules that will help to improve the investment and execution process. However, there are concerns that the changes do not fully appreciate the nature of bond trading today, with asset managers worried that less liquid bond issues may become harder to trade if transacted on-exchange.
Where are we at with the new rules that will overhaul the fixed income market?
The European Parliament was supposed to finalise its amendments to MiFID II – the key piece of legislation that will reform European fixed income trading – early this week. However, the sheer amount of changes tabled by individual MEPs meant the Parliament needs more time to consider its position.
Given the transformational impact of the directive, most market participants agree taking more time will be better that rushing regulation.
MEPs will now meet in September to finalise their version of MiFID, with the final legislation expected to become law by 2014, after the Council of the European Union has also had its say.
The overall aim is to apply the same model of pre-trade transparency to fixed income as the first version of MiFID did to equities, requiring public display of quotes in bond instruments. While the European Commission’s first draft of MiFID last October stated that thresholds for applying pre-trade transparency would be determined by instrument, there is no specific detail on how this could be applied.
European policy makers also want to establish a post-trade transparency regime for bonds, with the ultimate aim of creating a consolidated tape once a successful mechanism is introduced for equities.
The US already has post-trade transparency for bond trading via the TRACE system set up by the Financial Industry Regulatory Authority, but the Commodity Futures Trading Commission, which oversees US derivatives markets, is keen to apply pre-trade transparency as well.
The buy-side is worried that an improper calibration of transparency rules could increase market impact and dissuade brokers from quoting in size – but the plus side is greater certainty on how much they will pay for a bond and benchmarking of execution performance against the wider market.
Does electronification of fixed income mean exchange-based trading?
Very possibly. At present buyers and sellers can meet on third-party electronic platforms, mainly regulated in Europe as multilateral trading facilities, which effectively bring greater transparency to an existing process. MiFID II is likely to introduce the organised trading facility (OTF), a new category of trading venue designed to encompass different styles of matching, i.e. continuous trading and request-for-quote platforms, across asset classes.
There is also expected to be wider use of the systematic internaliser, which, unlike the current proposal for OTFs, can include proprietary trading activity.
The new venue types will largely be a solution to the problem posed by Basel III.
The latest attempt to ensure banks are adequately capitalised, Basel III will require dealers to hold risk-weighted capital against the assets they hold on their books. This means it will be more expensive for brokers to provide liquidity using their own balance sheets, with some expected to exit the market altogether. This is a particular concern for instruments that are only traded infrequently.
It’s too early to say where liquidity will migrate to but at present there is no shortage of models vying for attention.
BlackRock is close to launching Aladdin, its internal fixed income platform that will be open to other buy-side investors. NYSE Euronext and TradingScreen announced an initiative last week to improve pre-trade transparency across the bonds they offer on their respective platforms. Brokers are also shifting their value proposition: UBS, for example, is encouraging the buy-side to become price-makers as well as price-takers on its PIN platform.
Although reforms are still a few years off from becoming reality, the industry is already moving ahead in anticipation. Buy-side trading desks must ensure that they have the systems in place to source fixed income liquidity, wherever it coalesces.