May 2011

TRADING: More electronic users get switched on

ElectricityInstitutional investors are likely to increase e-trading in the near future, says Rupert Warmington of Tradeweb, as vanilla products prevail and regulators push for price transparency New issuance of all European credit in 2010, while down on the record levels seen in 2009, was still healthy. The European credit high-yield segment, for instance, saw record levels of new issuance. Indeed, in an environment of historically low-fixed income returns, institutional investors have remained focused on the corporate bond markets – particularly the high-yield segment – to improve portfolio yields. Driving this trend is a broad structural change in the debt markets away from bank lending and towards financing via the capital markets as a result of constraints on bank balance sheets following the onset of the financial crisis in 2008. At the same time, the market is embarking on a permanent shift in the way institutions trade European credit as a result of upcoming regulatory changes and the adoption of MiFID II (see page 30 for more on the Markets in Financial Instruments Directive). In anticipation of these new regulatory requirements for improved transparency and minimised counterparty risk, electronic trading platforms – which also deliver the right tools and efficiencies required by institutional investors – have enjoyed very significant growth. For instance, over the past two years there has been a sustained increase in the volume of electronic trading of European credit, with three-and-a-half times the pure cash credit business trading on Tradeweb in 2010 compared to 2009. Supranational, sovereigns and agencies (SAS) and covered bonds also saw a substantial increase in trading volumes during the year. On the one hand, the increase in electronic trading of European credit reflects a widespread change in the trading patterns and workflows of “real-money” institutions. In Europe, dealers are increasingly focused on servicing their flow business in vanilla products, where there is greater liquidity on electronic marketplaces. This growth in electronic trading of flow business has boosted e-trading volumes overall, which are estimated to now represent 25-30% of the entire European credit market. Alternatively, this trend is being supported by the anticipated direction of new regulations. The exact rules under which the market will operate in future are yet to be finalised, but it is already apparent that the broad sweep of legislation will push trading further towards electronic platforms, which offer improved price transparency and regulatory oversight. Furthermore – and perhaps most important – institutional investors are also attracted to the improved operational efficiencies and access to liquidity on e-platforms. Buy side
However, not only has there been a significant increase in the number of dealers providing prices on electronic platforms, the liquidity being provided is consistently of high-quality. Measures of the quality of electronic liquidity continually show dramatic improvements, reflecting the sell side’s desire to actively seek flow business from large asset managers through electronic platforms. For buy-side customers, electronic trading platforms provide ready access to more information, bond analytics and price transparency. This applies throughout the entire trading cycle of price discovery, trade execution and post-trade processing. And because they operate as online platforms, electronic marketplaces can be fully integrated into existing workflow systems, both at the institutions on the buy side and the sell side. This workflow automation enables a number of efficiency gains, not least by plugging order management systems on the buy side directly into the relevant trading desk on the sell side (via straight-through processing). Flexibility is also important. On the more significant electronic platforms, end users can tailor tickets to their requirements and make them available to a chosen number of dealers (the “request for quote” model). Market-makers then have a set amount of time in which to respond and subsequently update their bid or offer. Through this automated auction process end users achieve natural and transparent price discovery and in so doing put dealers into competition to offer the best terms. This increased competition typically optimises pricing efficiency and further encourages end users to trade on electronic platforms. Furthermore, the sophisticated electronic trading platforms allow buy-side investors to simultaneously execute multiple trades from a single list of orders across multiple asset classes. This facilitates larger month-end trading flows or other peak flows in activity. Because of the significant efficiencies and real-time saving impact this provides, such functionality is proving an invaluable tool for institutional investors – specifically asset managers. Meanwhile, asset managers who typically see themselves as searching for both efficient execution and price transparency have responded with a marked increase in trading in European spread products – and particularly in cash credit. As a testament to how e-trading continues to develop as an effective and efficient trading tool, a very high proportion of cash credit trades – some 90% – are executed at or better than Tradeweb’s composite prices. What does the future hold?
The latest Market Liquidity Income Survey from the Association for Financial Markets Europe (AFME) also indicated that the shift in favour of electronic trading of credit products continues to gain strength. For the second consecutive year, the survey respondents predicted that more investment-grade credit will be traded electronically in the next twelve months. Market participants also ranked spread products – which comprises SAS, investment grade credit and covered bonds – within the top six (out of 15) in terms of percentage of overall traded volumes that were executed electronically last year. In contrast to 2008 – when the credit crisis severely impacted liquidity in spread products – this increased interest in e-trading from both the buy and sell sides reflects a substantial shift in transparency and liquidity in the credit e-markets. As clients adapt and alter their trading patterns to the new world order, electronic platforms continue to upgrade functionality and expand the number of asset classes that are covered. While the proportion of European credit products traded electronically has not yet reached the levels seen in European government bond markets (where approximately 45% of traded volumes are electronic) e-credit trading will continue to
grow in significance – not least because a “request for quote” model sits well with the stated intentions of the international regulatory bodies to mandate greater transparency and operational integrity in the global bond markets.  Regulation – reinforced by an increasing focus from buy-side firms on efficiency – has established a clear trend towards electronic trading. Rupert Warmington is director of European credit markets ­at Tradeweb ©2011 funds europe

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