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An interesting report (well worth reading), published in January by The BIS (Bank of international settlements), looks at the impact of ‘electronification’ of the fixed income markets. The report was based on structured interviews with market participants,  and a survey of electronic trading platforms.

It argues that advances in technology and regulatory changes have significantly affected the economics of intermediation in fixed income markets and that electronification is changing the behaviour of investors. The rise of electronic trading is creating efficiencies for many market participants, improving market quality in normal times, lowering transaction costs and reducing market segmentation, while at the same time posing challenges to some participants.

Electronic trading, in particular automated and high-frequency trading, also poses a number of challenges to policymakers, including the need to monitor its effect on market liquidity and functioning and to ensure appropriate governance of automated trading. The report identifies a number of core areas for further policy assessment.

This report highlights two specific areas of rapid evolution in fixed income markets.

• Trading is becoming more automated in the most liquid and standardised parts of fixed income markets, as a result:
  • Dealers are able to better monitor the trading behaviour of their customers and how their order flow changes in response to news.
  • Dealers are also internalising flows more efficiently across trading desks, providing greater economies of scale for trading in securities where volumes are particularly high.
  • Whilst non-bank liquidity providers are searching for ways to trade directly with end investors using direct electronic connections.
• Electronic trading platforms are experimenting with new protocols to bring together buyers and sellers, as a result:
  • Changing the behaviour of buy-side investors. They are deepening their use of execution strategies, in particular complex algorithms.
  • Large asset managers are further internalising flows within their fund family, whilst a number of asset managers are supporting different competing platform initiatives that are attempting to source pools of liquidity using new trading protocols.

Changing fixed income market structure

Electronic trading tends to have a positive impact in terms of market quality, but there are exceptions. Electronic platforms are not the appropriate solution for all securities, particularly for illiquid securities for which the risks from information leakage are high. For these securities, there is still a role for bilateral dealer-client relationships.

The impact of automated and high-frequency trading is a matter of considerable debate. Studies suggest that automation results in faster price discovery and an overall drop in transaction costs (at least for small trade sizes). The entrance of principal trading firms with lower marginal costs than traditional market-makers has intensified competition.

It remains to be seen whether the benefits of automation observed in normal trading periods also prevail during periods of stress, when the benefits of immediacy are particularly high.

Competition over speed might displace traditional broker-dealers who may be more willing to bear risks over longer horizons. There is a risk that liquidity may have become less robust and prices more sensitive to order flow imbalances.

Fixed Income trading styles, platforms and protocols

Electronic trading, and in particular automated trading, poses a number of challenges to policymakers.

The report identifies four core areas for further policy assessment:

1. Advance of electronic trading needs to be appropriately monitored.
2. Further investigation is required to gauge the impact of automated trading on market quality. Liquidity may have become more fragile during stress episodes.
3. Electronification has created additional challenges for risk management at market-makers, platform providers and end investors. Algorithm developers should follow guidelines for best practices.
4. Regulation and best practice guidelines should be living documents. They should be repeatedly reviewed and adapted as markets evolve

State of electronification in various asset classes
Source: Greenwich Associates (2014); McKinsey & Company and Greenwich Associates (2013)

Today’s fixed income futures markets are highly electronic. Similarly to the modern equity and spot FX markets, around 90% of transactions in fixed income futures occur electronically (see graph above). A variety of end investors and market-makers use automation and electronic means of execution. Principal trading firms (PTFs) are the main providers of (short-term) liquidity and account for the majority of the trading volume. They are financially incentivised to do so by exchanges. Banks rarely act as market-makers on exchanges, but will take principal risk as market-makers for large trades conducted off-exchange and subject to delayed reporting (known as block trades).

The report also carries results of a survey of electronic trading platforms and usage of trading protocols, which highlights some interesting trends.

Survey of electronic trading platforms and usage of trading protocols

Findings of the survey showed that:

• pickup in the use of electronic trading platforms in fixed income markets. Recipients reported that trading volumes (excluding repos and futures) rose significantly between 2010 and 2014 Over the period, there was rapid growth in trading activity judged by the number of transactions on the surveyed platforms
• The majority of electronic platforms included in the survey are geared towards dealer-to-dealer markets (above graph-left hand panel). Only around a third of surveyed platforms facilitate all-to-all trading or dealer-client trading.
  • A closer look at the data suggests, however, that the pickup in the aggregate trading volume on electronic platforms is largely due to a rise in trading volumes via all-to-all platforms, albeit from a lower base. A key factor could have been greater use of electronic trading methods for interest rate derivatives.
  • Trading on dealer-to-client platforms has also picked up, but less so than trading via all-to-all platforms. As a result, inter-dealer trading volume, which grew slowly over the period, now accounts for only a third of trading volumes on the platforms surveyed, down from around half of the volume in 2010 (inline with decline in FX inter-dealer share of market).
  • Most of the platforms allow for API connectivity – a prerequisite for automated trading. API connectivity is notably less prevalent on multi-dealer platforms geared towards dealer-customer markets, but is a common feature of all-to-all platforms and inter-dealer platforms.

Full report Electronic trading in fixed income markets

A second report from The BIS, looks at Fixed income market liquidity

The findings of the report highlight:

• Fixed income markets are in a state of transition, as dealers have continued to cut back their market-making capacity in many jurisdictions.
• Demand for market-making services, in turn, continues to grow.
• The effects of these diverging trends have, thus far, not manifested themselves in the price of immediacy services, but rather they are reflected in possibly increasingly fragile liquidity conditions.
• Key drivers of current trends in liquidity include the expansion of electronic trading, dealer deleveraging, arguably reinforced by regulatory reform, and unconventional monetary policies.
• Given the transitional state of fixed income markets, regulators appear to be facing a short-term trade-off between less risk-taking by banks and more resilient market liquidity.
• Yet, in the medium term, measures to bolster market intermediaries’ risk-absorption capacity will strengthen systemic stability, including through a more sustainable supply of immediacy services. To help ensure a smooth transition, the report argues for a close monitoring of liquidity conditions as well as an ongoing assessment of how new liquidity providers and trading platforms are affecting the distribution of risks among market participants.

1. Tensions between reduced supply of and rising demand for liquidity
   • Reduced supply vs rising demand
   • Liquidity increasingly fragile in benchmark bond markets?
   • Liquidity bifurcation continues.
   • Adjustment mainly through quantities, not prices.
2. Market liquidity trends driven by more than one driver
   • Technology and competition are shaping adjustments in trading and business models
   • De-risking continues amid tighter regulation
   • Monetary policies: supporting liquidity, but at the risk of increased fragility
3. Transition to a new regime?
   • Strengthening the resilience of market-makers
   • Resilient market-makers and resilient liquidity – a trade-off
   • Adapting policy to the new market environment

Full report on Fixed Income market liquidity

Filed under: Corporate Bonds, OTC, Regulation, Single-Dealer Platforms, Survey Results |