The rise of electronification in Fixed income markets

The electronification in fixed income markets is steadily growing and the adoption of electronic trading has been uneven across fixed income asset classes with greater adoption in the order of government, investment grade, high yield, municipal, and emerging market bonds. This article delves into the electronic trading and market trends in the bond market, and implications for sell-side firms.

Electronic trading

The drivers for embracing electronic trading include access to the broad and deep liquidity pool, improved price discovery, and regulatory requirement for best execution. The rise in electronic trading contributed to proliferation of electronic trading platforms offering central limit order book (CLOB) and automated request for quote (RFQ) execution protocols.

The benefits of electronic trading include cheaper and faster execution, expanded liquidity, improved transparency and automation, regulatory compliance with accurate timestamp capture and audit trail. Electronic trading comes with its own challenges, which include market fragmentation, illiquidity in certain instruments, and access to quality market data.

Voice trading

Amid the growing electronic trading, voice trading is here to stay and will continue to be pivotal in the fixed income market. Voice trading brings in human touch and allows handling of large and complex deals with nuanced negotiations. The coexistence of voice trading and electronic trading will play a vital role in shaping a flexible and efficient bond market, especially during periods of high volatility.

Market Trends

• Growth of non-bank liquidity providers in market making and providing liquidity in the bond market. High frequency trading firms garnered a significant market share in market making of more liquid markets and buy-side firms increasingly engaging non-bank liquidity providers for trade execution.
• Growing exchange-traded fund (ETF) and portfolio trading in the bond market and increasing demand for low-touch portfolio trading. ETF and portfolio trading improve liquidity and enable price discovery of less liquid instruments. The gradual electronification of credit markets enabled the growth of portfolio trading in corporate bonds.
• Increasing adoption of execution management system (EMS) by the market participants to streamline and improve workflows. The rise of electronic trading contributed to more electronic liquidity and increased volumes of data with multitude of trading venues and protocols. EMS provides a centralized view of liquidity across sources, enables superior trade execution and improved decision making, and minimizes the need for traders to log into multitude of platforms.
• TRACE reporting in the US enables the aggregation of bond price data and the availability of aggregated bond price data aided the automated pricing of greater proportion of bonds, especially corporate bonds. The forthcoming launch of consolidated tape (CT) in Europe and UK will offer comprehensive, accurate, and timely bond data in a cost-effective way to the market participants and improve transparency. CT will enable the automated pricing of more bonds in Europe and aid in acceleration of electronic trading in Europe.
• Growing electronification and shift towards the shortening of settlement cycle require automation of post-trade to cater to increased volumes and compressed time for post-trade processing.

Implications for sell-side firms

As electronic trading surges in the bond market, firms must enhance electronic trading offering to meet their clients’ needs. Key client demands include liquidity provision, automated pricing, streaming of two-way firm prices, instant response to RFQs, and application programming interfaces (APIs) for automation of workflows. Firms must invest to build the following key capabilities to expand their electronic trading capabilities in fixed income.

Pricing: Pricing would be a key competitive differentiator, and firms need to build the algorithms for automated pricing of bonds and provide instant quotes to their clients’ requests. Algorithms need to support the automated pricing of odd lots, and portfolio trades, which require pricing a chunk of bonds of varying quality in one go. Quality market data is pivotal for automated pricing and firms need to focus on sourcing market data and building market data analytical capabilities.

Streaming: Trading protocol streaming is gaining prominence and clients are increasingly looking for dealers to stream two-way firm prices than indicative prices on a variety of bond instruments. Firms as liquidity providers need to offer streaming two-way firm prices with the ability to click to trade.

Application programming interfaces (APIs): APIs enable access to real-time data and automate the workflows. Firms need to offer access to their data, analytics, and algos through APIs to clients, who can call these APIs directly or through EMS.

Post-trade automation: Post-trade automation is essential with increasing electronification and shift towards shortening of settlement cycle. Focus should be on straight-through processing with no or minimal trade exceptions. Trade exceptions include trade breaks, missing allocations, and incomplete or incorrect standard settlement instructions (SSIs). Firms need to implement technological solutions to increase automation and reduce friction.

Conclusion

Electronic trading in fixed income is expanding and gaining momentum in asset classes with low adoption. Amid the growing challenge from non-bank liquidity providers, it is imperative for sell-side firms to invest in expanding their fixed income electronic trading capabilities to meet the demands of evolving market and gain a competitive edge.