European Fixed Income Advent of the Platforms

European Fixed Income Advent of the Platforms

Contents Introduction 3 Impact of Basel III 3 The View from Europe The Impact of MiFID II 3 Evolution is Necessary but What is the Right Model? 4 New Models, New Risks 5 Conclusion 5

Introduction The fixed income business is in a state of transition. Issuance is soaring but liquidity is withering as banks withdraw due to Basel III s stringent capital adequacy ratios. Existing electronic venues as well as a plethora of new platforms are trying to get a foothold but moving a traditionally relationship-driven and voice-executed market to a new forum is no easy task. Platforms not only have to offer the right functionality to suit different products but also ensure robust pre and post trade systems are in place to meet impending regulations such as the Markets in Financial Instruments Directive (MiFID) II. Impact of Basel III Market participants have no choice but to develop new options as the liquidity crunch is only set to worsen. The past couple of years have already seen some of the world s largest banks shifting their strategies, scaling back their fixed income business or exiting altogether due to the high costs imposed by the new banking legislation. For example, the leverage capital ratio (LCR) requires banks to hold high-quality liquid assets to cover 30-day stressed outflows while the net stable funding ratio obliges them to hold more long-term debt or equity capital against hard-to-finance assets. Profitability and market share of the main fixed income dealers has been further eroded by Basel III s long and uneven implementation timeframe. The final deadline is 2019 but regulators in different regions have been moving at various paces. This has exacerbated price moves in many bond markets particularly in the corporate space where liquidity is often lower than other segments. One reason is that the market has a high number of debt instruments issued by a multitude of firms and has often relied on banks to facilitate trading. However, it has been difficult to match buy and sell orders as banks retreat more and more from the provision of liquidity in favour of using inventory to bolster their own balance sheets. The numbers speak for themselves. The corporate bond market in the US has almost doubled to $4.5 trillion since the start of the crisis, yet banks today hold just $50 billion of bonds compared with $300 billion pre-crisis. Even the most liquid markets such as index linked and government bonds are experiencing problems with trading volumes dropping in US Treasuries dropping by 10% according to research from Deutsche Bank 1. The View from Europe The Impact of MiFID II The same trends are expected to play out in Europe although sell and buy-side firms will face the additional challenges posed by MiFID II (an updated and expanded version on securities trading rules imposed through the original iteration of MiFID in 2007 that focused on equity markets). The new directive which will take effect from January 2017 covers a wider breadth of asset classes and introduces pre- and post-trade transparency for fixed income instruments. Amongst some in the bond trading community there is a growing concern that too much information on trades could make it difficult for dealers to hedge and unwind their positions over time. 3

Buy-side firms will also have to contend with tougher best execution obligations under MiFID II such as requirements for increased information for their end investors around both costs and execution quality. The latter will require a revision of existing best execution policies and the downstream operational changes that require enhancements such as trade transparency processes and transaction reporting. The number of data fields in transaction reports is expected to grow from 23 to 65, which will have a significant impact on systems. Although the large players are reconfiguring their models as evidenced by a research from Greenwich Associates 2 in the summer, which found that despite the drop in liquidity and volumes, those investment banks with scale will remain formidable competitors. However, the breadth and complexity of fixed income opens the field to a greater viability of models. Smaller players with niche areas of expertise will continue to carve out a role and fill a gap for asset managers who feel they are being neglected by the bigger banks. There are also opportunities for new trading platforms although the landscape is becoming overcrowded according to research from consultancy Greyspark 3 showing there are over 30 participants vying for attention with nine more in the pipeline. They range from new entrants to exiting equity players moving into the fixed income space including established stock exchanges investing in the burgeoning platform new market start-up or simply creating their own all of which is headline grabbing and fueling the argument for alternative sources of liquidity. Earlier in the year, Liquidnet, a buyside only venue, acquired electronic bond platform Vega-Chi while SIX, the Swiss national bourse operator, plans to open its corporate bond platform later in the year. Evolution is Necessary but What is the Right Model? As with any evolution, not all will succeed and consolidation is inevitable in the long run. The initial interest followed by subsequent shortcomings of recent bond platform start-ups have done much to highlight the pitfalls of creating new trading venues in the $8 trillion market. However, these early experiences were essential in navigating the path of a successful evolution, demonstrating what the market is missing: a highly transparent, all-to-all platform that connects anonymous indications of interest from asset managers and investors with banks and brokers. Whilst the attraction of such a model is not in doubt, it is yet to be seen if the model will gain a following from the right investors. If not, we will likely see a number of false starts. Liquidity was not the problem as matches were made but old habits die hard and fund managers do not want to negotiate with each other; they prefer their traditional pricetaker role which involves getting competing prices from dealers. 4

The challenge in finding the right formula has not deterred newcomers. Some new ventures look beyond the provision of platform-based liquidity and instead seek to solve the problem by creating private networks connecting market participants through a more social media route. Instead of pricing and executing trades which has yet to gain traction, the new platforms would facilitate trades. Once a match is found, the platform would manage the negotiation process between the counterparties while banks using the software can white-label it to connect to other dealers to help expand the range of possible counterparties to a trade. There are success stories: well-established players such as MarketAxess, Tradeweb and BrokerTec, all of whom launched in the early 2000s, which can prove valuable to fledgling venues. Their staying power can be attributed to innovation and the ability to offer access to different protocols and products under one roof. In addition, a request for quote (RFQ) option is also attractive to a community who is not ready to make the move to pure electronic trading. For example one of them introduced an electronic RFQ system that enables the buy-side to manage increasingly arduous workflow issues more efficiently by automating manually intensive processes. A critical and diversified mass of clients should also not be underestimated. The theory is that new platforms will not gain traction or attract liquidity if they have the same clients pursuing similar strategies. One way to achieve this is having access to different types of order management systems. At the moment, though there are a variety of approaches: all-toall platform, taking orders from both dealers and buyside firms or an equity model, targeting a buy-side only audience. Niche firms can also set an example. One of the platforms which came to the market in 2012, Algomi, started by building a social network for the corporate bond market but has since expanded its client base and added fund managers to its Honeycomb network. This enables them to interrogate the data provided by banks to determine who is likely to be the best counterparty for an individual trade, as well as providing a record of why a broker has been chosen. New Models, New Risks As the fixed income business evolves to a more equity-like model, some of the same characteristics are likely to emerge. Platforms will see orders being sliced to improve likelihood of execution. It means that there will be more trades with ticket size becomes smaller, leading to an increase in overall transaction costs. The whole post-trade model will need to be rethought as the cost of settlement is currently on a per trade basis. If we look at how the equity markets evolved via order book trading post MiFID, the number of trades required to complete a single order has increased as has the number of market counterparties to trade with. This increase of settlement volume, in turn puts pressure on costs for the broker to pay the clearer and equal pressure on the clearer to offer volume-weighted discounts. The same impact is to be expected to eventually play out for fixed income market. Moreover, downstream the effect on settlement efficiency will also be impacted: replacing one settlement counterparty with many will place greater emphasis on pre-settlement transparency. 5

On top of additional costs, the question of risk also arises. With an increased number of trades executed on-exchange, who will clear them? If the answer is the central counterparties (CCPs), their model will have to evolve. Either existing CCPs will expand their product offering to embrace the new fixed income instruments, which will inevitably lead to the concerns around concentration of risk and the downstream impacts on recovery and resolution models, or new CCPs will emerge as specialist clearers in that space to spread the risk across a wider risk structure. One thing is certain, platforms will not operate in the same way as broker-dealers. They will not take principal risk or run a matched book, in fact the new rules under MiFID II explicitly forbid it. This means that in the drive to provide liquidity to markets there will be a heavy reliance on a clearing and settlement post platform execution. If CCPs cannot or will not fill that void, then established clearers will likely become the bilateral clearing party to the platforms and assume the counterparty risk direct with the platforms members. However, if clearers are to take on new risks to support the model, it is likely that they will put a price on it. This puts clearers at odds with the volume discount mentioned previously. Conclusion The development of electronic trading in fixed income markets will be more of an evolution than a revolution. The relationship with the sellside should not be undervalued as it still remains an important part of the fixed income ecosystem. This is especially true in times of market stress where brokers will be contacted based on the services and liquidity they can provide. However, success will not happen overnight, but will be found in the midst of lessons learnt from the almost made it models. While there is room for competing models, the ingredients of success should not only include innovation and a strong, diversified product offering but also offer robust pre and post trade frameworks backed-up by solid risk management processes in order to meet existing and impending regulation. While no regulation has specifically been designed to focus solely on fixed income, once the establishment of a definitive shift from OTC-traded to on-exchange or on-platform traded is complete, then the focus will likely be on all things related to transparency, so the discussion of a consolidated tape and TCA for fixed income should be expected. 1 Deutsche Bank note on the corporate bond market May 2015 2 Access to Liquidity a Top Concern Among U.S. Fixed Income Investors, Greenwich Associates 3 Rebooting the Corporate Bond Market, Greyspark 6

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