At last, the electronification of Fixed Income! And what it takes to adapt.
Still trading bonds by phone, email, or fax? That’s about to change.
In the same way a first-time home buyer needs a realtor to find and buy the right house, an investor needs a trader to price and find the right security, especially if it’s a bond.
Decades ago, back before the equity markets were electronified, firms were connected through pink sheets. If you wanted to know the price of a stock, you would get a copy of the pink sheet, open it up to an alphabetical listing of the stock, and see a list of the market makers who traded in that stock. You would pick up the telephone, call up any of the market makers, and ask them about the said stock.
Yet there was no incentive to call up every market maker to get the best price. It didn’t matter if there were ten market makers who covered the stock. As long as you made calls to, say, at least three market makers before executing for a client, you had done your due diligence and could execute. So the guy at the desk executing on behalf of a client would make his obligatory phone calls, and execute with one of them (usually his buddy) every time. And they were traded with a point (or half point) spread, with a huge bid and offer, and the profits from these spreads went to the brokers, not you, the investor.
When you think of the modern marketplace (aka the trading floor) for equities, what comes to mind? People, specifically MBAs and Quants from top schools, sitting around multiple computer terminals, using the best software to analyze and monitor trading data, all the while relying on computers and algorithms to make investment decisions and execute trades on their behalf. With electronic trading today, volumes have increased and margins have collapsed, and brokers make profits on fractions of a penny, resulting in a higher return for the investor.
However, the fixed income market (or bond market), is one — extremely large — market that has traditionally resisted all attempts to modernize. It is not dissimilar to how I just described equities from decades ago. Trades are executed over the telephone, instant message, and even fax! It’s insane if you think about how advanced the equities markets are now. Since many trades aren’t executing through an exchange, prices in many fixed income instruments aren’t disclosed, and there can be huge bid and offer spreads. In my prior days working on the sell-side, I’ve witnessed on many occasions brokers making six and even seven figure commission on a single fixed income trade.
Why is it that stocks are traded on electronic exchanges in the blink of an eye (milliseconds), but bonds are still traded by phone, email, or fax?
To date, many attempts to electronify the Fixed Income market have failed. This is due, in large part, to a lack of strong foundational market structure or level of standardization, especially when it comes to the ability to organize pre-trade quote information. APPL stock, for example, can trade in any number of electronic marketplaces — all of which are traceable. For APPL bonds, however, a bond issued today is different from one issued last year. They trade over the counter or through various newly-developed electronic platforms that aren’t e-connected, and with varying issuing dates and sizes, coupons, and maturity dates.
However, thanks to advances in technology, changes in regulation, and changes to the structure and liquidity characteristics of the markets, the Fixed Income market is at last becoming electronified! The very recent and rapid electronification of the Fixed Income markets has brought complexity and new competitive dynamics. Similar to highly electronic markets, Fixed Income has now become an arms race. You need to know your performance, verify everything, and have the best insight and information.
Although there are multiple electronic trading platforms for investment-grade and high-yield corporate bonds, there isn’t the same level of pre-trade transparency as in the equities market. In fact, Anthony J. Perrotta, CEO and Head of Fixed Income Research at Tabb Group said, “With electronification and market-making renaissances underway across bond markets, firms that effectively leverage technology to gain insight from trade flows and optimize their system performance will gain better access to liquidity and will be appropriately positioned to satisfy future regulatory transparency requirements.”
Both price makers and price takers should take note. Price makers and price takers alike often don’t have complete and unbiased information to help them assess their trading performance as it relates to network performance, counterparty/liquidity venue behavior, and pricing/execution algo efficiency.
This new normal favors market participants who know how to extract meaningful insight from their trading flows. It requires a deep understanding of an asset class market’s micro-structure, the trading business’s objectives, and the desk’s technical architecture. Those who have mastered this capability will continue to outperform those who lack transparency into their pre-trade and trade lifecycle.
If you work in Fixed Income and would like to better understand how Corvil can improve visibility and transparency into the performance of trading systems, the markets, and the behavior and effectiveness of client and customer order flow, please reach out to me at email@example.com