Brave new world of electronic bond markets; Single-dealer bond trading venues are falling out of favour

March 21, 2014 1:04 pm
Brave new world of electronic bond markets
By Michael Chuang
Single-dealer bond trading venues are falling out of favour
As bond markets continue the march towards greater electronic execution, there are increasing signs that bond trading venues owned by single dealers will not have much of a role in the new world.They are falling out of favour as corporate bond market participants seek platforms to which several brokers contribute, as these venues meet the needs for best execution, provide diversity in liquidity and seek a more efficient marketplace. The recent purchases of Bonds.com by the London Stock Exchange Group and Vega-Chi by Liquidnet highlight this trend.
Banks and brokers are finding it difficult to replicate in corporate bond markets the success of foreign exchange markets, where single dealer platforms are prolific.
This is mainly because the bulk of foreign exchange market liquidity is concentrated in a handful of currency crosses whereas corporate bonds are a fragmented marketplace with tens of thousands of unique securities.
This makes it virtually impossible for any single dealer to consistently make competitive markets through their platform. With institutional investors under a fiduciary responsibility to seek best execution for client trades, this lack of competition makes corporate bond execution via a single dealer platform model a tough proposition.
What exactly is best execution and how does it impact the asset management industry? Although the duty to seek the best price has long been known to be an important responsibility of the asset manager, the term “best execution” is not defined in US Federal security laws, nor consistently defined by the industry participants or regulators.
Asset management firms use their own interpretation to implement SEC’s guidance from 1986. An asset manager must “execute securities transactions for clients in such a manner that the client’s total cost or proceeds in each transaction is the most favourable under the circumstances,” the SEC said.
Under this definition it seems fairly obvious that managers can’t comply with “best execution” by simply routing orders to a single broker’s platform. The fragmented marketplace and need to provide best execution means the dealers – the former proponents of the single dealer platform model – are innovating. There is now a greater chance they will join to contribute in efforts under way in the multi-dealer arena.
Why will this drive success in electronic trading? The first reason is diversity in liquidity. When it comes to finding liquidity or trading counterparties, more is always better. Multi-dealer venues build an interconnected fixed income marketplace; providing both buyside and sellside participants opportunities to access each other and form a valuable ecosystem for transactions.
Multi-dealer venues build an interconnected fixed income marketplace; providing both buyside and sellside participants opportunities
The second reason is data. To maximise liquidity and minimise execution costs, market participants need to leverage the plethora of data available in the market to make more intelligent portfolio and trading decisions.
Finally, trading is a sophisticated business process for institutional investors, and therefore increasing efficiency is critical to make any business generate greater returns. This also means higher alpha for shareholders without taking on any additional risk.
Dealers also benefit from a multi-dealer model. With fresh pressures on balance sheets, bond dealers can no longer hold large inventories without either regulatory or capital penalty.
Successful dealer business models post-Dodd Frank and Basel III will enable clients to execute trades without a heavy dose of the dealer’s balance sheet. Dealers will now be rewarded to help clients access liquidity on behalf of a client and not necessarily trading against the client.
This is an opportunity for all market participants to align themselves and move to multi-dealer platforms, where both the buyside and sellside can continue to interact in the new environment for fixed income trading.
The buyside will need help to access liquidity that resides on the fragmented electronic markets and the sellside will have the expertise and technology infrastructure to help their clients do that.
This will overcome the greatest barrier towards greater electronic trading of corporate bonds: the lack of homogeneous efforts by the marketplace.
As the great innovator, Henry Ford, once said, “If everyone is moving forward together, then success takes care of itself.”
Michael Chuang is the chief executive of iTB, a fixed income trading technology provider