LET THE SCALES FALL…
Paul Reynolds, self-professed electronic trading guru and CEO of new trading platform Bondcube suggests that the solutions to some of the key challenges facing the fixed income market already exist – it’s just a case of knowing where to look.
As a long-term inhabitant of the fixed income realm I do find it challenging that this asset class is so far behind Equity and FX in terms of market structure and technology. Fixed income is of course different in terms of the proliferation of securities and the lack of a central market structure, but the idea that these issues present an insuperable impediment to change is now simply not sustainable.
Any market that feels it can resist the benefits of new technology and ideas is in for a surprise. Whether it is taxi drivers acknowledging the presence of Uber, advertisers comprehending social networks or the military understanding the possibilities of real-time intelligence gathering, no-one can assume an established structure is not improvable.
As the bad boy of the global financial crisis in 2008 the impact of regulatory change is and will be especially profound in fixed income. This factor alone opens up new opportunities, but two other influences deserve consideration. Firstly the increasingly secular change in sellside fixed income profitability and secondly the extraordinary accumulation of fixed income assets amongst the buyside. These two features are closely related and to some extent inter-dependent.
In the context of equity and FX trading infrastructure, fixed income trading infrastructure looks primed to enjoy an era of significant innovation. Fifteen years ago fixed income saw the introduction of electronic trading. Since then the market size has grown, as has the volume of electronic volume. Government bonds, especially US Treasuries, account for most of the growth in secondary volume. Smaller orders and recent liquid issues are largely well catered for by existing platforms. In my view the innovative focus will be on the less liquid securities and larger trades that carry price transparency and market risk challenges.
What’s the problem?
So what are we trying to solve here? Firstly, there is a huge universe of hundreds of thousands of bonds in multiple currencies, maturities, issue sizes and structures. A large majority trade as infrequently as a couple of times per year and liquidity or pricing sponsorship from the sellside can understandably be sparse. Added to that, information about traded volumes is almost impossible to find and any enquiries to buy or sell are lost in a spaghetti bowl of unconnected ends. Furthermore, the market risk of opening ones’ intentions to the wrong person can have profoundly negative implications on any pricing resource that may exist.
Under these circumstances it is hardly surprising that many buyside investors choose to buy and hold rather than face the time consuming and often deleterious consequences of seeking order execution. The buy and hold strategy has however paid investors colossal returns over the last five years as central banks have massaged interest rates to extraordinarily low levels and purchased vast quantities of fixed income securities themselves. The buyside are well aware however that at some point in the not too distant future the five-year accumulation binge will end and underlying investors may wish to change their allocations to other asset classes. This may be caused by a bout of inflation, a change in central bank asset purchases or indeed a continuous hike in interest rates to more normal levels.
As things stand the liquidity sponsored by the sellside could absorb very little selling before prices were abnormally affected. A unique feature of fixed income under these circumstances of price volatility is that unlike any other asset class, traded volume declines in fixed income when volatility rises. This is because liquidity is almost entirely sponsored by the sellside.
In other asset classes like interest rate futures and commodities (that I read of so enviously in this magazine), this problem does not seem to arise in the same way. The central market structure grants all types of participant some level of access to price and volume information and the ability to trade with each other, without risk.
How then to overcome the liquidity challenge in a fragmented, low volume market? Firstly we need a structure that permits all users to trade with each other, or ‘all to all’ as it has become known. Secondly, assiduous gathering and dissemination of all price, volume and enquiry data pre-trade. Finally, a mechanism for posting and matching enquiries that mitigates market risk.
None of that is especially challenging, but in itself it is insufficient to transform the present malaise. One of my other favourite reads is Wired magazine. I am amazed how little of what has been created in Silicon Valley has permeated Wall Street. Trading is after all an intensely social activity. I know from my own experience as a corporate bond trader that the superior quality of my relationships with my sales force, clients, brokers and other traders gave me an advantage over my competitors. That, amongst other things contributed to my intrinsic value. It is no different for sales, buyside execution traders or agency brokers.
How then to introduce the network effect into the new model? Simply put, it is who you are and who you know. If you are a reliable, trustworthy, value-added individual you need a way of displaying that – like a well-known auction site. If you have a vast network then you need a method to communicate with it – like a certain social network site. Finally if you want access to other persons and their trading activities you need to able to request a link to their network.
If you combine these features it is then a question of how well you use them. This means accumulating valuation and negotiation skills beyond the traditional roles of sellside and buyside. Everyone can benefit from improving their skills and network to the point where it can have a profound effect on their trading performance.
This is not thinking outside the box, so much as adopting existing technology that we use every day on our personal devices.