Paving the way for European regulatory reform: an evolution in electronic fixed income

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1 Paving the way for European regulatory reform: an evolution in electronic fixed income By Roger Barton, Founder, Financial Reform Consultancy Summary Market participants are moving towards e-trading in their fixed income operations as a better way of doing business ahead of regulatory decisions When selecting a platform, participants are focusing on access to liquidity, better price discovery, more certainty, post-trade transparency and full STP Traders that were once specialised in specific markets are now taking a more holistic view of the EGB space and seeking platforms that offer access to the entire spectrum of European government bond issues New regulations such as MiFID II are having strong emphasis on best execution, and therefore accurate and reliable market data is assuming a more critical role than ever before On both the buy- and sell-side, participants are looking to electronic platform providers to aggregate and concentrate liquidity while the European downturn plays out and regulations are finalised Fixed income markets in Europe are about to change. The MiFID reforms being formulated in Brussels will have a profound impact on all market participants, buy-side and sell-side, execution venues and infrastructure providers. But while the policymakers have been debating the final calibrations, a paradigm shift has been taking place in the market itself. Three years of crisis in the eurozone have thrust the government debt market into the public spotlight and transformed the way bonds are viewed, valued and traded. Slowly but surely, fixed income market participants have taken it upon themselves to instil their trading operations with the transparency that has formed the basis of the regulators discussions thereby setting best practice for the new market landscape before the authorities had even put pen to paper. And the levels of transparency required in today s riskadverse and compliancy-sensitive environment can only be achieved through one method electronic trading. While the new regulations are unlikely to actually make electronic trading mandatory, the European Commission has stated that they do not see that the regulatory objectives can be achieved through the use of pure voice trading. Although the specific details are still being thrashed out, there are a number of clear intentions in MiFID II including a significant focus on increasing levels of pre- and post-trade transparency, which regulators believe can be achieved largely by shifting more participants towards trading on electronic platforms. Amongst its major updates, MiFID II is expected to propose a large extension in the regulation of all trading venues that are not already regulated venues. This will create two new categories of regulated platforms 1

2 Organised Trading Facilities (OTF) 1 for multilateral platforms, and Systemic Internalisers (SI) 2 for bilateral platforms. The effect will be a move towards electronic platforms for a wider range of fixed income products, with Celent estimating a 45% rise in electronic trading amongst the sell-side by 2015, and a 50% rise amongst the buy-side. 3 The path to electronification Nowhere has the migration towards e-trading been more pronounced in recent years than in the fixed income markets. Electronic platforms are able to increase the available market transparency, and in many cases use transparency as a central characteristic of the trading arrangements. For example, electronic order-matching systems show the exact, immediate position of the market at any time. When selecting a platform, participants must focus on the key criteria necessary to stay ahead in today s competitive markets namely access to liquidity, better price discovery with a higher quality trading experience, more certainty, post-trade transparency and straight through processing. However, for traders, measuring the functionality and benefits of one electronic platform over another comes secondary to recognising why they should move to such a platform in the first place. One key reason for the shift from voice to electronic is speed. Using an electronic platform allows traders to find out within seconds whether they have done their deal as soon as the trade matches, it s done. The trader gets an immediate confirmation and is able to view the trade details on-screen and data is fed directly to the back office, without the need to write a ticket. This greatly enhances efficiency for both market makers and takers. In the B2C space, e-trading dramatically cuts latency between a fund manager and the counterparty on the trading platform. It used to take a phone call, or fax for execution, then the trader on the execution desk would run the trade through over the phone a process which involves a high cost and could sometimes take hours. Anything can happen in the markets during that time. Flow of data through an organisation is also an important consideration. Electronic platforms offer straight through processing (STP), a highly efficient process that strips out much of the operational risk associated with a trade. STP routes every trade directly to the middle office, back office and to the clearing and settlement functions. The trade is also integrated into the risk management system, so the trader is updated in real-time on their position and that day s profit and loss, and the risk management department can update the company s risk profile. This is essential insight in today s volatile fixed income markets. The generation of an automatic audit trail also ensures that the back office benefits from enhanced compliance and best execution. 1 An Organized Trading Facility (OTF) is any facility or system designed to bring together buying and selling interests or orders related to financial instruments. 2 A Systematic Internaliser (SI) is an investment firm which, on an organised, frequent and systematic basis, deals on its own account by executing customer order flow in liquid shares outside a regulated market or a multi-lateral trading facility. 3 Fixed income in Europe read for the tornado? Celent,

3 In today s cost-sensitive environment, another key factor to note is that switching to electronic trading also reduces the overall cost associated with the trading process. Electronic trading creates a self-contained environment where the trader is able to initiate an order, execute it and clear and settle it without ever writing a ticket. This high level of efficiency, combined with full integration between all the bank s systems, significantly reduces spend on IT resources and any costs associated with operational errors. An appropriate solution for today s markets Banks fixed income operations continue to face the double challenge of staying abreast of market developments and addressing demands for increasingly precious liquidity. The eurozone crisis has dramatically changed the way in which institutions trade and manage fixed income products. Against this backdrop, the benefits of trading fixed income electronically have come into sharp focus. Bond traders at investment banks that were once specialised in particular markets or product types now need much broader knowledge of both the countries on which they concentrate and the European government bond marketplace as a whole. Electronic markets such as MTS offer traders access to the entire spectrum of European government bond issues on one platform, delivering a level of efficiency that simply would not be possible when trading in a wide range of bond markets via traditional voice channels, and various tools to enable banks to serve their customers more efficiently and effectively. To avoid moving prices in less liquid markets, traders have also started to break up big single trades into smaller amounts that will be bought or sold gradually during the course of a whole day. Executing a large number of trades over the phone introduces a range of unnecessary inefficiencies, costs and risks electronic trading is the perfect solution to this new market dynamic. Traders also need to be plugged into day-to-day political developments, economic analysis and market news like never before gone are the days when they could switch off and head home a couple of minutes after the market closed. Prices are now more sensitive to political announcements at any time of day or night than to the scheduled economic data which once chiefly moved the market. Traders are now looking to new technologies such as mobile apps to give them access to the market news and data they need when they are away from their desk. In response, MTS developed MTS Mobile an app that offers access to a European government bond market news feed, live bond yields and spreads and a government bond auction calendar via an iphone, Blackberry, ipad or Android device, thereby connecting traders to the markets when they are on the move. 3

4 Figure 1: Average Number of Trades Executed Daily by IDB Platforms in Europe in 2012 (Celent) Market data and the battle against latency Irrespective of asset class, informed trading and management decisions rely on access to optimal market data. However in fixed income, before the crisis erupted, money was made or lost on moves of one hundredth of a percentage point - one basis point - or less. Now, much larger swings happen daily and so price discovery, verification and validation are more important than ever before. MTS Data delivers real-time tradable never indicative prices across the entire European government, quasi-government and covered bond market, allowing fixed income dealers to set best practice in this field. New regulations such as MiFID II will have a strong emphasis on best execution, and therefore accurate and reliable market data will assume an even more critical role than currently. Inevitably all platforms offering best execution will need connectivity to sources of reliable market data. While the influx of electronic trading volumes will introduce new data sourcing and management challenges, the idea is that eventually the introduction of a consolidated tape and best execution will protect the market. The mechanisms and timing of such a system are still under discussion, but again it will depend crucially on the wide distribution and use of accurate market data. On the back of both regulations and client demands, banks have also started to move from end-of-day valuations to intra-day or even real-time checks to drive accurate analysis, pricing and risk management decisions. This requires very rich market data, delivered with minimal latency. MTS has always put client demand at the forefront of its technology development and innovation, and with the market asking for low latency fixed income data, the company has developed MTS Live, a new ultra-low latency data distribution facility, offering participants a comprehensive un-aggregated order information for the most liquid bonds traded on the MTS Cash market. Data is based on the constant tradable pricing for the bonds traded on the platform, giving participants access to the full range of information in between ticks. This 4

5 kind of service is likely to see significant uptake in the near future as market participants require everincreasing levels of data granularity to be as transparent as possible. The liquidity challenge Liquidity is scarce and needs to be concentrated, aggregated and managed carefully. Whether buy- or sellside, the liquidity squeeze has affected participants across the European fixed income markets in recent years and dramatically changed the way bonds are traded. Forward-thinking market players have looked to new solutions to overcome this issue, and electronic platform providers are leading the way forward with efforts to aggregate and concentrate liquidity while the cyclical European downturn plays out and new regulations are finalised. As Europe s premier facilitator to the fixed income market, MTS takes its role in regards to liquidity very seriously and has developed the technology and functionality to enable participants to maximise trading opportunities in today s challenging market conditions. For over 20 years MTS has been working closely with DMOs, primary dealers, regulators and central banks across Europe and beyond to facilitate highly liquid primary and secondary bond markets. The company's strategy of enabling participants to combat the liquidity squeeze includes offering a variety of order types for fixed income products, therefore making the market more accessible and optimising liquidity. MTS Cash, the interdealer platform for European government bonds, offers access to either an order-driven market or a quote-driven market, with both being based on the same technology, maximising liquidity amongst market making banks. The MTS EBM order-driven market allows primary dealers to display their positions clearly and transparently to investors, while the quote-driven market displays the bids and asks of these market makers for a specific security. Liquidity is shared between the two markets. In addition, MTS supports the B2C bond market through its BondVision platform, which is built on the same technology as MTS Cash. Market makers on MTS Cash also provide prices on BondVision, so liquidity is maximised across the two platforms. MTS also recently developed the MTS Prime technology to further enhance liquidity in the secondary nongovernment bond markets. MTS Prime enables buy-side participants to trade fixed income products, including corporate bonds, covered bonds and SSAs via their chosen prime bank in a transparent orderdriven marketplace. This has stimulated trading in the secondary credit markets and continues to be a key focus for MTS in its aim to improve liquidity through the development of innovative technology that facilitates multiple order types. Conclusion 5

6 There is no doubt that MiFID II will change the way European market participants trade fixed income. There will be much work needed to prepare for clearing and trade reporting requirements, and certainly a move towards electronic trading. In terms of execution, it is likely that even a number of electronic trading venues themselves will not meet the requirements and will require substantial changes. Participants will need to examine their execution, clearing and reporting arrangements, evaluate which providers are compliant and which are not, and get ready for change. On the other hand, the more transparent, regulated electronic markets and the forward-thinking market participants that have adopted them in advance of any firm rules being set by the policymakers are likely to require less change. For example, MTS has been operating regulated and transparent electronic markets for fixed income products since 1988, and will require very little change. Its efforts to optimise liquidity and equip traders with the technology and market data they require to prosper in today s markets have already positioned the company for the new regulatory landscape. While in principle there is no debate as to whether the increase in transparency proposed by MiFID II will be beneficial to the fixed income market overall, the danger of course is that the regulators overcook the transparency requirements, which could impact liquidity in a very negative way. The proof will be in the final calibrations, but the indications are, so far, that they are being careful about this and that they recognise that the bond markets work in a different way to the hyper-regulated equities markets, so there is hope that the worst excesses will be avoided. It is only once the final rulebook has been published that participants will know what kind of an impact it will have on their specific day-to-day trading activities, but until that time they could do a lot worse than to embrace the electronic revolution. About the author Roger Barton, Founder, Financial Reform Consultancy Roger Barton is the Founder and Managing Director of Financial Reform Consultancy, specialising in the strategic and practical implications of financial regulatory reform. Previously, Barton was a Managing Director at Tradeweb, where he served as head of the company's European and Asian business, and latterly Tradeweb's expert on the European regulatory landscape and pending financial reform of OTC derivatives trading. 6

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