Next level: the changing securities markets

“Western capital markets are clearly approaching their long-predicted suicide at a rapid clip …” read one comment on a recent post on the Tabb Forum site by analyst Rebecca Healey.

To be fair, the tone matched Healey’s: commenting on the latest iteration of the European Commission’s Markets in Financial Instruments regulation, she wrote, “The death knell has just been sounded for European cash markets … European regulators have re-introduced a volume cap mechanism that will have a draconian effect on dark trading in Europe.”

Suicide and death? Have we come to this? Perhaps not, but there is hardly an area of the securities industry that is not reeling from the effects of regulation or economic conditions – or more usually a combination of both.

In Europe, and potentially elsewhere, the equities markets face uncertainties such as the Financial Transaction Tax – currently the subject of furious back-pedalling in Europe’s corridors of power – though exchange indices are pushing ever higher.

Meanwhile, MiFID II is hovering, and Dodd-Frank looms.

But by far the most rapidly changing market is fixed income, which is being particularly affected by changes in the shifting balance between collateral management and capital adequacy (The Gathering Storm, page 26).

Says Bradley Wood, partner, GreySpark Partners: “In general it is probably the asset class that is undergoing the most market structure change, not least because of regulation like Dodd Frank but there is still, and will continue to be, growth and evolution. The market is not going to die – just look at the amount of debt that governments are issuing to realise that there is going to be a fixed income market.”

But while he says that it is not going to disappear, he adds that it will most definitely change. “In a sense it will follow the path that the equities market has already taken,” he says. “It has moved to a more electronic all-to-all type of market structure, and with the advent of MiFID there was a fragmentation of liquidity. There is an analogous thing happening in fixed income with the emergence of SEFs – Swap Execution Facilities – liquidity is fragmented. That poses both challenges and opportunities for trading. As an asset class, sourcing liquidity becomes more difficult, but the opportunity to take directional views or to arbitrage those fragmented markets potentially increases – when different markets are perhaps not pricing things optimally, opportunities present themselves.”

Mark Hepsworth, president, pricing and reference data, Interactive Data says agrees about the shifts, stressing the illiquidity as the main challenge. “The big issues with fixed income are, one it is an OTC asset class and two, it’s huge and relatively illiquid  – we estimate that less than 2% of the bond universe trades on a daily basis. There are some bonds out there that may not trade for months or trade by appointment only,” he says.

“There is a lot happening in this space, but the main thing is the lack of liquidity in fixed income trading. What is happening is that the sell side is dramatically pulling back on inventory. The drivers for that are capital adequacy requirements. The old paradigm was that the sell side was willing to buy bonds back or hold onto them if they couldn’t find an immediate seller. They are much less willing to do that now. The buy side still may want to get into bonds, but the real issue is how will they get out of them when they want to?”

Hespworth is less convinced about the move to electronic trading. “Will this market go, completely electronic? Our view is that this isn’t going to happen any time soon,” he says. “I think what we see is people trying hard to leverage technology as much as possible, trying hard to automate as much of the process as possible, and to serve up as much information as possible to a human trader and let them focus on where they add real value. We still think that human contact is going to be very important particularly when you get the more illiquid end of the spectrum. There are still going to be conversations taking place between buyers and sellers.”

“The fixed income capital markets are going through an evolution in terms of how things are going to get done in future,” says Hepsworth. “The market is looking for a new way of doing things. The ECNs have definitely a role to play – MarketAxess is developing strongly because of that – but it’s not a simple case that this is going to look like equities and everything is going to go electronic. Liquidity is the main thing. We don’t think this is an asset class that you can just automate by transferring technology, it’s more a question of automating as much as possible.”

Bob Fuller, a director at trading systems specialist Fixnetix, says that as well as the issue of illiquidity, the fixed income market straddles a wider field than simple equities or FX.

“Fixed income is going through big changes, but it is still largely a voice market that is not going to change in the short term – 95% of the business is high-touch,” says Bob Fuller, director of trading systems specialist Fixnetix. “The real problem is determining where fixed income starts and stops, and when it becomes the derivatives and futures market. That’s not an easy distinction to make – it’s like deciding when politics takes over from regulation.”

GreySpark’s Wood says that a shift is already happening. “We’re beginning to see, with ‘electronification’ and the push towards electronic trading generally, a change in the way banks are structured,” he says. “Voice-based salespersons will decrease in number, but they are expensive people to keep on the payroll. If you can get rid of them and replace them with a clever piece of software, It is not necessarily a bad thing.”

A traditional argument for keeping voice traders is that some fixed income instruments are notoriously illiquid and voice traders can create markets for them. Brad disagrees: “That’s true up to a point. I think we’ll see different banks morph into different kinds of organisation – there will be the big flow monsters where it’s all about volume and the per ticket profit they make is small but the cost per trade is managed down through the use of technology. Those flow guys will minimise on the number of voice traders they have. On the other side you will see more specialisation with niche operators who work in specific sectors, or specific types of bond, or have a strong research element – these are areas where you might see a bit of innovation and you might see less of a focus on electronic and more on human relationships. Those types of relationships will still exist, but only a certain niche type of bank and certainly only for a certain type of client.”

A recent Tabb Group report says that there is a shift in the market, with new liquidity pools emerging. Electronic volumes are now 22% of the cash market, it observes, but points out that “electronic is no longer a voice equivalent on the screen. Innovative protocols and new order flow networks have a place in the new fixed income universe. Many asset managers and exchange traded fund market makers find it more efficient to execute odd-lot sized trades across alternative trading systems”.

Because of this, “the line between institutional and retail blurs as comingled flows make for attractive pools of liquidity for many participants”.

Driving all of this is the way in which assets on the balance sheet are treated from a capital adequacy perspective. “Basel III and all of the new regulations around capital are going to make capital requirements more punitive if you are holding a large inventory of debt. Banks are going to be loath to warehouse as much of this stuff on the balance sheets as they previously would have been,” says Wood. “Previously, their risk appetites would have been larger: they would have sat on large amounts of inventory and they would have risk managed that inventory by trading on the market and hedging appropriately. The the cost of doing that is more punitive under Basel three than it was previously so the ability to make money in that warehousing model is going to be diminished and will become more of a flow or agency based mode of operation – again, not dissimilar to what we see in equities today.”

The scale of the change is quite staggering. Figures from the US Federal Reserve show that the aggregate bond inventories at the larger US investment banks have dropped more than 75% since 2008, when they peaked above $200 billion. Currently the figure is some $45 billion.

He says that this will change the role of traders. “That will mean that traders in banks will need to be able to source liquidity for clients and pass it through in the most cost efficient manner, rather than relying on their in-house inventory. The nature of their work will become more about finding liquidity than hedging risk, which will have an impact on the way they trade – it will become easier because the risk management side is where the challenge is,” he says. “If all you’re doing is finding liquidity, then the way you make money is by trying to predict what type of position or which way your client might want go so you can earn a few basis points off a particular trade.”

This means that some other trading strategies from other asset classes will migrate to fixed income. “Certainly this means you will see some buy-side interest in this asset class from a statistical arbitrage perspective, and you might see things like algo trading and HFT which are normally the preserve of equities and FX. We may see a bit of that starting to happen in the sector as well, which is interesting. It may create some moneymaking opportunities and it will certainly have an impact on the way trading operates and the way banks work,” says Wood. “Those kinds of trading technologies and trading approaches we are beginning to see more of in the fixed income space – things like smart order routing or what some equities houses refer to as direct strategy access, which is effectively algo trading where people want to take a position but don’t want to move the market or they want to use some VWAP algorithm.”

For the most part, “fixed income products almost always rely on a quote based mechanism whereas equities trading hardly ever does, it is almost always order book trading,” says Wood. The shift from quote-based trading to order-based trading is going to affect the way instruments are priced, which is reflected in the shift that information providers like Interactive Data are making towards intraday pricing, though that is as much being driven by the effects of regulation as anything else.

But in a market where instruments, or at least some instruments, are traded only occasionally – “by appointment”, as Hepworth put it – how do you price them in any meaningful way?

“It’s the same issues in doing it at the end of day, says Hepsworth. “There are three key components that we need to create fixed income pricing: technology and models we have developed, and which we are honing on a regular basis. Secondly, is essential to collect as much market colour as possible. We are receiving information from sell-side pricelists and our buy-side clients give us a lot of market information because it’s in their interest to help us – we currently have about four million data points coming in on a daily basis, which is a significant amount of the market. The third part is the human evaluators: we have about 200 fixed income professionals around the world who help us filter through the market, and help to verify and create our price.”

The bulk of evaluators are based in New York City “which is the fixed income centre of the universe” says Hepsworth, but local nuances and local relationships are important. There are also teams in London, Frankfurt, Hong Kong, Tokyo and Melbourne. “It is important to get as much local colour as possible – a lot of people are focused on Dim Sum bonds at the moment, for instance,” he says.

There remains a potential issue with this says Wood. “In the same way that you have a danger with rating agencies who have a conflict of interest and every bond they are rating, there will be some bonds that are not traded frequently that are not easy to price,” he says.

In general though, he says “having more information on balance is going to be better than less”. It will also allow firms to develop more sophisticated approaches to customer tiering – separating different clients into layers that get different treatment depending on their value to the business. “If you look at Dodd Frank, for instance, one of the mandates is to provide a mid-price for SEF-traded products. The mid-price is designed to be un-tiered so if you have gold, silver, bronze tiered clients, you can give them a different spread but the mid-price needs to be fixed,” says Wood. “Banks are investing a large amount in CRM and customer behaviour analytics for client segmentation to get a better understanding of who their clients are, where the profit pools are in the buy-side and who they should be targeting. Previously that has been down to individual relationships and one sales guy moving from Bank A to Bank B could have a significant impact.”

“I think this is a good thing: you put more control in the hands of clients. Clients are becoming better informed and some of them maybe would make good use of this data, others less so. But on balance, it has to be better to give them more data than they hitherto have had; it will make them more sophisticated in selecting with whom they do business, which has to be good for competition and that has to be good for the evolution of the market.”

Interactive Data’s Hepsworth says that there are some other issues that better pricing information is going affect more flow moves to platforms. “With ECNs, such as Blackrock’s Aladdin folding in with MarketAxess, there are issues around areas like best execution – people will need to demonstrate that it was a fair price they were trading at,” he says. “The buy side and the sell side are both looking for a new paradigm. When you add those dynamics the reason we are going to bring real-time fixed income prices into the market is in reaction to two use cases: one is in the pre-trade world, where the feedback from the market is that they will find it helpful to have an additional independent reference point on the value of the bond before they trade; it would help them to automate the process around RFQ more and be helpful in getting the conversation going. We are also seeing our core back-office clients are looking to move more towards continuous pricing more intraday snapping of data to have more of a real-time view of the value of portfolios. Provided that what you give is an accurate price, more is better.”

Other information providers are also rising to the challenge of improving information in the sector. Following MarketAxess’ acquisition of Xtrakter in February, end-of-data pricing data for Eurobonds is now also available to premium subscribers to its BondTicker service, which provides market data on a wide range of credit instruments including US high-grade, high yield, emerging markets, CDS and Eurobonds, including 144As, underwritten instruments that have become more popular in recent years as they have become more liquid.

Given the importance of the debt markets to the real economy, there has been concern that regulation might kill things stone dead and that would have dire repercussions throughout the rest of the economy. The signs are, however, that the market is adapting to a new way of operating, and the regulators are starting to recognise the links. “What we have clearly seen was an initial surge of regulation, but they are dampening things down,” says Hepsworth. “As it comes to implementation they have realised it is not as straightforward as they thought: Main Street and economies need fuelling through capital markets, and let’s not throw the baby out with the bathwater.”