MAKING READY TO FACE TECHNOLOGICAL AND STRATEGIC CHALLENGES.
By Umberto Menconi, Market HUB E-Commerce Distribution Banca IMI.
The European fixed income market has been recently facing unprecedented changes and will continue to do so for several years, mostly driven by technological innovation and regulation. The old‑style bond trading models, such as RFQ and OTC high touch, are the focus of much discussion and while there are signs of new models/protocols emerging, no clear view has so far emerged on how the secondary bond market will look in coming years.
The consultancy firm McKinsey issued a working paper on corporate & investment banking on the 28th October 2015, forecasting a near-future Wall Street dominated by the use of “machines” and financial institutions forced to heavily invest in “digital” technology (from electronic trading, to blockchain, big data management and algo-trading). The paper also highlighted a decrease in human intervention across the STP chain from front to back office functionalities. At the same time, an increasing number of industry reports has highlighted that regulatory changes have led to a 70% drop in bond inventories, yet the stock of fixed income assets outstanding has doubled on the back of years of low interest rates. All in all, this has led to major liquidity shortages as fixed income traders have had to become accustomed to an era of trading in an environment with a dearth of liquidity.
Basel III and other post-crisis legislation (the Dodd Frank Act in the USA and MiFID II/MiFIR in Europe) have brought about structural changes in the way credit institutions have had to reduce their asset inventories, and the capacity to hold, finance, or hedge trading positions, and pare back their long-held intermediary roles as principal. The reduction in balance sheet due to Basel III, combined with investors’ reluctance to trade, has led to a diffusion of liquidity across platforms.
This is particularly the case in corporate bonds where it is often heard that liquidity is “a mile wide and an inch deep”. Sourcing and aggregating liquidity is paramount for sellside and buyside traders. Technology is the only way to enable these participants to uncover the liquidity available. As a consequence, the traditional bond trading model, mostly reliant on market makers and voice broking is being reshaped.
The principal-to-principal model still remains central on the dealer side, but with more weight being placed on agency brokers and on new trading protocols (e.g. all-to-all trading, central limit order book, anonymous auctions, indication of interest). In Italy in particular, due to its particular market structure, solutions that put together price provider specialists and fixed income trading venues in a sort of virtual book, with a combination of different market protocols and commission fee models, have been available since 2007.
The role of sales and market maker will change heavily due to tighter spreads and lack of liquidity, hence low touch will improve, and high touch will only be reserved for very highly profitable tickets. This change will be a gradual shift from a one-stop-shop (supported by strong bilateral relations) towards a multilateral trading solution. We believe that the specialisation of market makers around the world can recreate liquidity through some type of ‘hub of hubs’ or ‘web net’, comprising regional specialised liquidity providers, authorised as systematic internaliser (SIs).
A SIFMA report in 2015 on new US electronic bond trading platforms released the results of a survey of more than 20 electronic bond trading platforms for US corporate and municipal securities, while an ICMA electronic trading platform mapping study in 2016 analysed more than 24 European trading platforms.
Both results highlighted that the fragmented environment will lead to a concentration process in the near future. In Europe, trading venues will compete to harmonise the pre- and post-trade regimes, evaluating the threshold effects and impact on on-venue trade size, with transparency and electronification/STP processes as a key competitive advantage.
In this new marketplace, the role of the buyside and the sellside is being reshaped at many levels. The bigger buysides in particular need to take on a greater responsibility, playing an enhanced role in the new market environment, and in the market infrastructure evolution from a trading process based on RFQ and ‘polling’ the market to more standardised practices.
The new transparency regime may also impact issuers behaviour and the size of issuance (‘threshold effects’), as well as promoting more automated practices in new issues distribution. A good balance between transparency and liquidity thresholds may avoid the possible negative impact on SMEs (small and medium-sized enterprises). The considerations over the possible impact on market liquidity of a wrong calibration of transparency obligations, together with the need to complete MiFID II level III requirements are among the reasons for the delay requested by the European Authority on MiFID II implementation.
Paramount in this phase is the role of vendors in supporting market players still wondering whether to use in-house or external solutions in order to to fulfil pre and post trade transparency, trade reporting, best execution and SI obligations.
Technology is the key and also the ‘passport’ to this change. Innovation is vital in supporting the radical changes across the scope of financial asset classes, from those where more traditional trading behaviour is still central (with particular reference to corporate bonds), to others that are leveraging changes already in place in other asset classes.
Firms are re-directing their business strategies to adapt to the changes in fixed income. The requirements will of course need huge technological investment and this might constitute an entry barrier to new players and reduce their number due to the high levels of competition.
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