Using electronic trading tools to source liquidity across a number of counterparties in the fixed income markets can significantly reduce trading costs, according to new research from the University of California, Berkeley.
Cal academics Terrence Hendershott and Ananth Madhavan found that competition among dealers and increased auction participation sharply reduced costs.
“The results confirm the value to traders and investors from sourcing liquidity widely and using tools to optimally select a venue. These gains are significant and can materially influence realised investment returns,” said Hendershott, who also found technology was continuing to reduce search costs and that even traditional bastions of over-the-counter trading will face strong competition from auction type markets.
The Cal study supports additional findings from fixed income electronic trading platform operator MarketAxess. The firm found significant cost savings for buy-siders who used electronic trading across all trade size buckets and maturities in the fixed income credit markets.
Alex Sedgwick, head of MarketAxess Research, said the average cost savings of electronic execution for all trades during the period analysed was 5.2 basis points, compared to the calculated volume weighted average spread.
MarketAxess Research looked at the embedded costs of trading, consisting of the dealer mark-up plus any fee associated with executing the trade. It was therefore possible to determine the cost of execution by comparing the electronically executed trade to a ‘prevailing market price’ using post-trade corporate bond market data reported to Financial Industry Regulatory Authority’s Trade Reporting and Compliance Engine (TRACE).
MarketAxess sampled 900,000 TRACE-reported trades over a 24-month period from January 2009 through December 2010. From these, MarketAxess identified 150,000 trades where it could establish a prevailing market price and compare electronic trades with a sufficient number of TRACE prints.
“The advent of FINRA’s TRACE reporting combined with greater adoption of electronic trading for fixed income has allowed us to develop an objective approach to examine trading costs in new and compelling ways,” Sedgwick. “Using this data, MarketAxess Research developed new methodology for demonstrable transaction cost analysis (TCA), formalising the value of fixed income TCA in support of best execution.”
Based on this proprietary approach to analysing trading costs in the fixed-income markets, MarketAxess has launched a new service dubbed REXIQ.
“Forthcoming regulatory changes are placing increased scrutiny on transparency of execution in the over the counter markets. Electronic trading helps address the stated goals of this regulation – to create more open, transparent and competitive OTC markets – and drive trading efficiencies,” said Rick McVey, chairman and CEO of MarketAxess, adding he believed REXIQ can deliver insight into the corporate bond market to help fund managers meet fiduciary responsibilities. “Our research validates the value of e-trading as a tool in achieving transaction cost savings and improved portfolio returns. Using this methodology, we are providing our institutional investor clients with regular, robust analysis of their execution costs to support their best execution requirements.”