Fixed income markets are experiencing a significant amount of change. Though challenging in the short term, the combined effect of shifts in regulation, liquidity and market structure will create opportunities for institutional investment firms to provide new or enhanced services for their clients. These factors are also putting additional focus on transparency, trading efficiency and best execution. Such developments are driven by regulatory reform, but are also highly aligned to the evolving requirements of retail buyers of funds, pension funds and other end-investors, who are increasingly demanding greater assurances on compliance and best practice, in addition to performance. Buy-side firms have had access to tools such as transaction cost analysis (TCA) in the equities markets for years, and are now looking for similar data and metrics in other asset classes.
An improvement in data availability creates an opportunity for fixed income execution desks to offer a differentiated trading and reporting service. By using TCA to monitor the cost effectiveness of their trading activities, bond traders can identify areas where improvements can be made, and take appropriate action when necessary. Once buy-side trading functions are able to quantify their performance, they can also provide a more transparent and comprehensive reporting service to their clients. This provides greater scope for proof of differentiation, allowing traders to demonstrate where and how they are best placed to add value.
Alongside the business case for greater use of TCA in fixed income markets, there is a regulatory dynamic. Europe’s new Markets in Financial Instruments Directive (MiFID II) and Regulation (MiFIR) will become effective in January 2017, applying to bonds, exchange-traded derivatives and other non-equity instruments that weren’t covered in the original MiFID legislation. In addition, although buy-side firms have been focused on best execution for some years, the new rules will place greater emphasis on asset managers to demonstrate they are meeting this requirement.
Trading desks that position themselves to go above and beyond the minimum requirements will be best placed, in what will become an increasingly competitive marketplace.
Unique market characteristics
The TCA methodology honed in the equity markets analyses a relatively small number of instruments that are typically very liquid and with well-established pricing sources. Fixed income markets are substantially different in nature – with a much larger number of instruments, particularly in the corporate bond segment, and a broad range of liquidity profiles for these securities. Transactions are typically carried out in much larger size and less frequently than would be usual for equity trades. The sheer number of bonds available in the secondary market means that timely matching of buying and selling interests is much less likely to occur, resulting in a prevalence of over-the-counter trading. This has meant that the kind of data needed for a robust analysis of execution performance and transaction costs has been less readily available, limiting the availability of analytical solutions such as TCA.
That’s not to say that there have been no tools in the fixed income markets to date. The data that has been available has been used to provide buy-side firms with post-trade, compliance and best execution reporting. Historically, however, best execution policies in fixed income markets have necessarily been limited – often being a matter of proving that a minimum number of quotes have been received for each enquiry.
More recently, this has started to change because electronic trading has reached critical mass in certain fixed income markets. Current estimates in the dealer-to-institutional-client market are that approximately 55% of European government bond and 50% of US treasuries volume, along with 40% of activity in European credit, is traded on electronic platforms.
Because electronic trading, by its nature, makes it easier and faster to capture trade execution data, the potential for more data availability in the bond markets is greater than ever before. Combined with rising demand for more comprehensive information from execution desks, this availability is fuelling increased depth of analysis and reporting tools. But while fixed income traders would welcome the levels of data available in the equity markets, effective TCA in the fixed income market is not simply a matter of extending the more-established equities model to other asset classes.
Developing an appropriate TCA methodology
The unique characteristics of the bond market substantially increase the difficulty of developing a TCA solution. Given this, a deep knowledge of market structure and the complexity of how these products trade are essential ingredients for a strong methodology. Just as importantly, it’s necessary to have access to sufficient depth, accuracy and cleanliness of volume, price and other data. Since execution platforms like Tradeweb centralise fixed income trading activity, and have both the required market expertise and quality of data, they are extremely well-positioned to provide bond market TCA solutions.
Another key success factor is an understanding of how the transaction cost data would be used by institutional investors. Tradeweb has worked closely with buy-side firms to define the key determinants for a successful solution, namely:
The ability to quantify and monitor ongoing trading performance and execution costs;
Analysis that can be used to design new trading strategies to reduce costs; and
A more comprehensive solution to help prove best execution.
These are the key objectives that would underpin the development of an accepted methodology, which would also need to be independent, tailored to each specific market, and instructive as to how transaction costs can be specifically reduced.
An effective TCA solution needs both a precise, time-stamped reference price and a comprehensive dataset of executed trades in order to accurately measure the cost of execution. Tradeweb uses its long-established proprietary trading composites as the basis for transaction cost comparison, separate versions of which are available for each asset class covered by its solution, including European government bonds, US treasuries, Japanese government bonds, European credit, covered bonds and supranational agencies and sovereigns.
Analysis can be then carried out directly by the trading desk, which can view comprehensive data reports detailing its transactions, and look at metrics that quantify execution performance over a period of time. Trades can be assessed by looking at key aspects of the transaction, such as time of day, trade size, sector, and number of counterparties in competition. This provides specific direction for traders, who can then adapt their trading behaviour to, for example, put into competition the number of dealers that is right for the profile of the transaction.
These tools also have broader appeal to buy-side institutions. TCA reports can also be used by sales teams when pitching their trading desk’s performance, and by compliance to determine whether their best execution policies need strengthening in any area.
The future of TCA
As fixed income markets continue to become more electronic, more transparent and more efficient, we will see even more depth to the availability of fixed income trade data, enabling the enrichment of existing fixed income TCA offerings. Upcoming regulations are certainly a driver. Given the broad nature of the asset classes covered by incoming European rules, it’s certainly possible that TCA offerings could be extended to other asset classes such as derivatives. For now, we’re expecting that, even ahead of regulatory requirements, demand for more detailed transaction cost and trade execution data will continue to increase as investment managers seek to monitor and quantify their ability to provide optimum service and performance levels for their clients.
This article was written by Simon Maisey, managing director, finance and business development, Tradeweb as part of The TRADE's 2015 Fixed Income Handbook.