How will you be trading in the fixed income markets in five years’ time? Not sure? You’re not alone! For many buy-side trading desks, the only certainty is that their current trading technology infrastructure will be insufficient to handle the challenges ahead.
In a market undergoing unprecedented levels of change, there are perhaps two primary sources of uncertainty that will shape the future of fixed income trading in Europe. First, as major banks and brokers respond to post-crisis balance sheet constraints by withdrawing from market-making across a wide range of fixed income instruments, where will liquidity reside? Will peer-to-peer platforms predominate? Will agency trading re-take market share from principal-based trading services? Will a new breed of market-makers arise, similar to the high-frequency traders in equity markets? Second, how will the European fixed income markets respond to the greater transparency that policy-makers are trying to impose via MiFID II? Will liquidity dry up as pre- and post-trade transparency rules are introduced in January 2017? How will traditional sell-side trading and liquidity provision capabilities adapt to electronic trading platforms, such as systematic internalisers and organised trading facilities?
We don’t yet know how these regulatory-driven market structure changes will play out or when the some semblance of stability will reassert itself. Macro-economic developments may be crucial: if, as many predict, US and UK interest rates rise in the near to medium term, the change in monetary policy could stem the flow of primary issuance, with asset managers looking to offload some of their credit portfolios in favour of high-rate investments. This could strain the pared-down market-making capacity of the sell-side beyond breaking point, providing alternative models with both an opportunity and a test.
With so many ‘known unknowns’ in play, market participants, service providers and market structure providers are all reviewing their current capabilities and positioning themselves as best they can. For buy-side trading desks, the priority is achieving the flexibility necessary to access fixed income liquidity across multiple counterparts and trading platforms.
And although many of the current variables may take time to resolve, some things are more certain. Whether the pressure comes primarily through regulatory or client scrutiny, buy-side trading desks are being held to increasingly high standards of performance and transparency. As such, they must take full ownership and responsibility for best execution and demonstrate the effectiveness of their trading decisions in support of client interests. Cost-effective investment in trading technology will be critical in meeting this challenge, and nowhere is this task more complex than in the fragmented and fast-evolving fixed income markets.
Another rare certainty is that price discovery via phone-based requests-for-quote is as outmoded and inefficient as ordering a book via snail mail. It may still have place, but only in specific circumstances: for the vast majority of fixed income transactions, the future is overwhelmingly electronic. As such, this chapter will provide a short guide to the key elements that we believe buy-side trading desks require to automate and ‘digitise’ their fixed income trading operations, based on our extensive experience of working with market participants across the buy- and sell-side spectrum and specific feedback drawn from our client base.
Making connections
At the core of any fixed income trading platform for the buy-side trading desk is a global connectivity layer that can provide normalised access to all the markets and instruments covered by firms’ investment strategies and client mandates. This layer should serve as a hub for the desk’s trading communications with external parties and should be as low-latency as possible. Many fixed income instruments may trade infrequently at present, but in others – such as US Treasuries – competition for liquidity is only going to increase, so speed will be increasingly important. Moreover, the connectivity layer should also incorporate access to listed derivatives markets, to facilitate trading in futures and options, both for hedging purposes and as an alternative means of gaining fixed income exposures. As well as being the channel through which the trading desks places orders – ideally supporting as wide a range of order types as possible – it should also serve as the point of entry for pricing and other market data.
Next, the aggregation layer provides the trader with two key sets of functionality: a global view of liquidity; and access to a range of trading protocols and execution mechanisms from which to select, depending on the nature of the order and the market. The trader uses this layer to obtain an accurate, timely view of available liquidity across markets then chooses the most suitable execution option – ideally including a robust algo engine and smart order routing capability for fully electronic markets – driven initially by whether the market in question is order or quote driven. The aggregation layer sources data from the connectivity layer not only to identify the best prices and quotes across markets, but also to track where and how orders have been executed for best execution, reporting and compliance purposes. Both to demonstrate best execution to clients and to help traders use past executions to improve future decision-making, this layer should also include a full range of trading analytics.
Historically more relevant to sell-side firms, the quotation / pricing layer is likely to become increasingly interesting to a wider range of market participants, including asset managers, many of which are gearing up to take a more pro-active role toward liquidity provision in the fixed income markets. A quotation layer should support market-making by enabling the trader to add their pricing – firm or indicative – to a range of electronic platforms, specifying different spreads in different markets if necessary. In addition, the module should protect the user by allowing traders to ‘sanity’ check prices to ensure they are consistent with prevailing market conditions before permitting them to go live on the relevant platforms; manual intervention by dealers may also be needed. Following on from the growing involvement of buy-side firms in the provision of liquidity, some trading desks could require a ‘negotiation module’ to finalise transactions with trading counterparts, supporting multiple workflows across the transaction lifecycle. When negotiating the details of a trade – which can be conducted via varying levels of automation – the trader should be able to access historical transactions with the same counterpart. Moreover, firms that operate multiple trading desks, perhaps across different time-zones or subsidiaries, may require the ability to internalise order flow, executing trades in-house to save brokerage fees and reduce time.
The final element of the multi-functional fixed income trading technology platform is its APIs, its connections to the other internal systems across the institution. The critical rule here is: don’t automate without context. Priorities for smooth, efficient, seamless integration will typically include risk management systems, credit checking systems and position management systems, primarily to ensure trades are in line with risk limits and client mandates. APIs will also be needed, of course, to provide connectivity within elements of the fixed income trading platform, for example between the pricing engine and the negotiating module to ensure full pricing control and reporting. Finally, to enable dealers to send out orders, distribute liquidity to platforms and interact with the trading infrastructures of other market participants, externally-facing APIs must by FIX compliant. To support the level of connectivity and integration required by a flexible fixed income trading platform, APIs must be monitored, tweaked and upgraded on a continuous basis, which requires a sophisticated API management system. While FIX compliance is pre-requisite, this system must support multiple protocols to be able to handle various interactions with other participants and counterparts, such as RFQs, streaming indicative prices, various matching modes including work-ups which differentiate fixed income from the purely principal-based FX market or the agency-based equity market.
The bigger picture
The level of connectivity and functionality required to reach all the liquidity fragmented across the fixed income universe may be such that asset managers increasingly consider alternatives to managing all aspects of their trading technology infrastructure in-house. Whether simply to reduce cost, reduce the burden on in-house technology resources or to ensure optimal connectivity across multiple fixed income platforms, firms may consider outsourcing elements of their trading platform to a data centre of managed service provider. Such options may become even more appealing if one looks at the bigger picture.
The forces that are changing the structure of the fixed income markets are having a profound effect across the full gamut of financial markets. In all Group of 20 countries, OTC derivatives are migrating to central clearing and electronic trading platforms, all European markets are subject to a raft of reforms aimed at increasing transparency and best execution via MiFID II. Many other recent regulatory initiatives – such as those on market abuse of financial crime – apply to all market participants. At a time when the buy-side is being required by regulators to improve transparency and accountability throughout the trading process across asset classes, fixed income trading technology requirements cannot be viewed in isolation. In particular, the requirement to demonstrate best execution will only intensify as regulators and clients demand ever greater insight into trading process and execution performance. As such, the ability to access liquidity cost-effectively across all asset classes is assuming greater importance than ever before. Today’s trading platform must deliver the kind of functionality described in this chapter on a scalable and multi-asset basis; firms that maintain different systems for different asset classes may struggle to make the necessary investment to ensure those different platforms provide a consistent quality of liquidity access in market characterised by uncertainty and frequent change.
Different firms will assess their future trading technology needs at varying paces, depending not least on their current fixed income trading turnover and the liquidity of the fixed income instruments in which they invest. Indeed, it may be that gradual change in more obscure markets will require the most technologically savvy trading desk to support both voice-based and electronic trading for some years to come. But there can be little doubt of the need for investment managers to evaluate their current trading technology platform in light of likely future requirements. Already the most diverse of asset classes, the future of fixed income will be both OTC and exchange traded, standardised and esoteric, electronic and voiced traded, global and local, quote- and order-driven, low-liquidity and low-latency. Trading desks should prepare for the unexpected.
This article was written for The TRADE's 2015 Fixed Income Handbook by David Vincent, CEO, smartTrade.