By Tommaso Di Grazia, Head of Fixed Income Product Development at ION Markets.
In recent years, the credit market has become increasingly complex and fragmented, making it harder for firms to find liquidity and offer customers fast and accurate services. However, simultaneously, the market has seen a growth in electronic trading; according to industry analysts Coalition Greenwich, in October 2020, 37% of high-grade US corporate bond trading happened electronically, up from 21% in early 2019. In Europe more specifically, MiFID II alongside other regulatory requirements have mandated extensive data collection duties for voice trades, which to a great extent catalysed bond markets’ transition towards electronification.
The pandemic only accelerated this shift – prompted by periods of high volatility and dislocation to working patterns. In other words, many processes became automatic – for instance, voice trades were replaced with a higher number of small electronic trades. Amidst this changing landscape, the industry introduced standardised inventory contributions, and put a greater focus on ensuring the consistency and reliability of data – two things electronification was apt to provide.
Traders realised the need for automated, computer-driven trading, based on algorithms. As a result, the industry has seen an uptake of technological advancements and the creation of new methods of matching buyers and sellers. This has been enabled by several recent improvements, including, new trading models being implemented to enhance liquidity and trading opportunities, an increase in the number of inquiries due to the introduction of broadcast RFQs in all-to-markets, and large trades and small trades becoming fragmented, resulting in an overall increase in the number of tickets.
Now, traders are able to access live prices and spreads from all markets, aggregated alongside firms’ own prices and quotes. Additionally, they can see new issue corporate bonds on the day they are priced and ‘free to trade’ in secondary markets. We’ve seen the launch of trading protocols focused on trading entire portfolios, an increasingly blurred distinction between buy-side and sell-side participants and the availability of multiple trading workflows, from bilateral RFQ workflows to intraday auctions and dark pools.
With the broad adoption of inventory distribution models across multiple venues and a gradual migration to live updates, it’s clear that the industry is beginning to realise the associated benefits automation offers. However, the question is, why has the credit market only now started to harness electronification?
The challenges facing this uptake of electronification
Despite the recent uptake, fixed income trading still happens manually in many cases. The corporate bond market still tends to follow a more analogue workflow, and while algorithmic and electronic trading is becoming widely adopted for smaller trades, larger trades are still being negotiated over the phone. This hesitation is for several reasons.
There are a large number of issues that make it difficult to maintain certain prices on a vast inventory, leading to a model where traders can delegate less to automation tools. The high value of information received requires careful selection to understand which information on position and prices to distribute – and to whom. While electronic trading of US investment grade bonds grew 111% between 2017 and 2020, in Europe, most trading is done via traditional RFQs to five dealers. This is a protocol that makes it hard for the buy-side to express interest without showing their hand. As such, there’s less of an appetite for electronification because competitive RFQ workflow is still the dominant offering as it provides a limited degree of anonymity on transactions to buy-side firms. This workflow does not fit with larger trades due to the issues related to information leakage. Ultimately, the market will take far longer to become fully automated as relationships still play a key role when executing and searching for liquidity, and sales remain an essential component for trading workflow.
The competitive advantage available
Despite these obstacles, we are witnessing an increasing push for electronification in the credit markets. Firms that choose to automate will see vast standardised connectivity coverage, allowing easy addition of new venues and trading protocols to keep up with market trends. These new robust and scalable electronic trading solutions will be capable of coping with large number of markets, securities and RFQs. By leveraging multiple distribution channels they will have the ability to offer and maintain axes and run simultaneously on multiple venues.
Innovative market data aggregation tools are able to blend and enrich pricing information from various sources (spreads, prices and transparency data) and firms will be able to analyse customer flows to identify patterns and trends in their trading activity. Given the numerous advantages of electronification, it’s clear that the firms failing to implement such will inevitability struggle to keep up with the increasing competition.
The trends likely to take shape as a result
As we look to the future, credit markets will continue to see a gradual increase in the percentage of electronically traded tickets and automation as a whole, as traders will delegate decisions to algos, initially on smaller and easier trades and evolve to fulfil larger ones. This will be enabled by the broadening of the transparency reporting requirements beyond TRACE in the United States, making MiFID II reporting more effective.
Further automation tools will mean firms can access a larger number of venues and trading protocols, blend multiple sources of market data, and dealers will be able to handle a vast number of negotiation events. As a result, the market will see an increase in reliable data on transactions and the value of inhouse data analysis tools.
There will also be a transition to robust cross-market solutions that are able to cope with the large volumes of RFQ activity and a shift from traders’ “market feel” to objective data-driven models in pricing. Due to the changing landscape, traders will increase their attention in blending pre-trade pricing information from multiple sources including brokers prices, axes and historical trades.
While the credit markets may be playing catch-up to equities and foreign exchange, electronification is most definitely a key component for any firms looking to the future.
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