FIXED INCOME – A BEST EXECUTION LEGOLAND.
The building blocks needed to achieve best execution depend not only upon qualitative and quantitative analysis of trading behaviour, but on the resources of sellside counterparties. Banca IMI’s Umberto Menconi and Carlo Contino* discuss the importance of partnership in assuring execution quality.
What level of feedback should buyside firms expect from their counterparties on execution quality?
Technological innovation, digital transformation and new regulatory obligations following the global financial crisis are dramatically reshaping the financial markets landscape, affecting every asset-class. Relationship dynamics, the level of engagement and the sellside and buyside roles are shifting from the traditional bilateral workflow to a new paradigm. The buyside is not only taking more ownership of its own trades but also rethinking its role in market transformation. It has also increased its appetite for sellside collaboration and investment in trading and risk management tools.
Changing dynamics have forced the sellside to evolve and adopt flexible models to satisfy the buyside’s liquidity demand requirements. They have to invest huge resources in technology innovation, in order to generate greater efficiencies as well as acquiring and sharing information and analytics in a more complex and fragmented market environment.
The biggest challenges remain efficient multi-market connectivity and real market data across the trade lifecycle: order creation, order placement, trade execution, TCA analysis, clearing, settlement and custody. The execution quality of a trading strategy, employed by buyside execution desks to capture alpha or to limit portfolio risk, strongly depends today on communication networks, collaboration tools, and continuous feedback. This is not only the case with buyside execution desks, brokers and trading venues, but also among other financial ecosystem participants, such as custodian banks, clearing houses and central depositories. This is because best execution is more than just the transaction price. It also needs to embrace the entire trade workflow with a much broader horizon.
How does the execution protocol impact that?
Leverage limits, stricter capital requirements and balance sheet restrictions on proprietary trading are causing many sellsides to rebalance towards agency broker models. They are helping clients to execute trades on trading venues rather than directly assuming portfolio risk. This market evolution had been pursued by Banca IMI from the beginning, with the launch of the Market Hub platform back in 2008. The transformation from a bilateral, voice-execution model towards a new communication and trading model, based on a network of trading platforms, electronic chats, systems connectivity, and sophisticated EMS/OMS tools necessitated a change in trading culture. This did not only include human resource hiring, but the adoption of different communication channels, language formats, trading protocols and a higher level of collaboration.
To better execute orders, there is an increasing array of venues to use. This ranges from the conventional (MTFs, RMs, OTFs and ISs) to the unconventional (dark pools) sources of liquidity, as well as different trading protocols (All-to-All, click-to-trade, CLOB, Auctions, Direct connectivity, RFMs, Portfolio Trade, anonymous RFQs-to-all). However, despite the growth, the traditional electronic RFQ (request for quote) model is still central.
We are still a long way from real market structure changes, and the new market ecosystem integration remains a ‘work-in-progress’. However, there are several drivers for a stronger fixed income trading ecosystem including standardised and integrated market connectivity solutions and communication protocols to reduce complexity. There are also shared technological infrastructures among all participants as well as different trading relationship levels, with respect to the recasting of players’ roles, and putting the different protocols in place. Moreover, there has been broader implementation of machine learning and artificial intelligence solutions for the data ‘tsunami’ created after the introduction of MiFID II. Last but not least is the increasing demand for readable smart data and value analytics.
When supporting high- and low-touch executions, what should dealers be cognizant of in supporting their client’s performance?
In fixed income it is possible for the buyside to fully automate some of their execution, thanks to more data availability, axes and price streaming activity. Buyside execution desks see this as an opportunity as well as a game changer. A high-touch and low-touch execution strategy is increasing automation in execution of small size tickets, while leaving more time for traders to concentrate on larger tickets on a bilateral bespoke basis as well as the design of new investment ideas.
To perform high-touch and low-touch execution, the buyside needs to modify its best execution rules accordingly, based on both a quantitative and qualitative approach. It has to reflect their perception of what is low-touch or high-touch as well as ensure trading decisions are addressed to the right counterparties. It also has to make the best use of low-touch efficiency in small size execution and of high-touch risk trades. Firms have to measure execution performance through new metrics tools, even though we are still in the early stages for TCA in fixed income. TCA is still controversial due to a lack of reliable transparent data compared to some other asset classes.
To support buyside execution performance, the sellside should constantly monitor their execution quality and offer customised and efficient trading solutions for high-touch and low-touch business, market connectivity, readable market data and comprehensive reporting services.
What sort of feedback and interaction can better support an understanding of dealer/client objectives?
On one hand, the sellside has been spending plenty of time focusing on data consumption and, more importantly, wondering how they can transform that data to ensure the buyside can use it and that it adds more value for both sides. On the other hand, the buyside has focused more resources on workflow automation and collaboration enhancement with their sellside partners. What is clear today is the need for collaboration with the goal of establishing a relationship based on value.
In this new and complex environment, a pivotal role can be played by fintech vendors when bridging the gap between buyside and sellside, and better supporting interaction. The key moving forward for both buy- and sellside firms is to have a more open and connected networking infrastructure. The end objective is to create a best-of-breed solution that brings the buyside and sellside together.
What are the challenges in benchmarking performance?
Since market data can address the adverse effects of a more fragmented trading environment, demand for real market data has increased. However, today, the cost of acquiring real market data from the various data sources is expensive and there is also a lack of standards. This results in a significant hidden cost to consume and manage data, and represents one of the main challenges in fixed income performance benchmarking. It reduces the potential of using it as a measure of trading performance, improving execution and applying more complex benchmarking. The equity market can be used as a reference, but fixed income execution needs more caution due its unique characteristics.
How does a bank then optimise performance based on feedback from multiple clients?
The style in which the buyside and sellside interact has changed significantly in the last few months. Investment banks can no longer offer everything to everyone. The buzzwords of today are, network compatibility, partnership, interoperability and execution model flexibility. Therefore, Banca IMI has set up a client service desk, which is fully dedicated to improving the client experience – across asset classes, as well as the full operative process – that is in close proximity to the sales and trading desks.
This service strives to better serve and increase the specialisation of our services for our clients. Customer experience offers a key opportunity to build investor loyalty and to create a competitive advantage for both the buyside and sellside. To achieve an edge in the current financial market, the sellside needs to move forward with an increased reliance on innovative technology in order to deliver returns for the buyside, reduce market complexity and real market data consumption cost. Firms also need to be able to integrate their trading systems and data tools into the client workflow.
By moving from trading-centric towards a customer-centric, unified value proposition, fintech companies are bridging the value chains of various industries to create an ‘ecosystem’ that should reduce customers’ costs, be more user friendly and provide them with new experiences. In this collaborative environment, a data-centric business model and client service feedback are gaining ground as the real new assets and value-adds for the sellside/buyside relationship.
*Umberto Menconi is head of Digital Markets Structures, and Carlo Contino is an analyst in Digital Markets Structures, at Market Hub, Banca IMI, part of the Intesa Sanpaolo Group.