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Magazine Issues » February 2011

FIXED INCOME TRADING: the human touch

hand_button_410Fund flows into fixed income have grown markedly in the past two years. Nicholas Pratt examines whether this growth will spark a similar resurgence in trading technology

The fund manager’s asset class of choice for the past two years has been fixed income. The bond market has attracted significant investment from funds since the final quarter of 2008, according to the latest figures.

According to Lipper, the net sales total for European bond mutual funds  was €93.35bn in 2009 and this rose to €133.89bn in 2010, as of October. The previous bumper year for bond funds was in 2005 when net sales totalled €149.11bn. However, the big difference is in the proportion of cross-border funds that make up the respective totals (from 39% in 2005 to 96% in 2010).

“This highlights how the industry has changed since 2005, from one dominated by local and national banks selling domestically, to cross-border groups selling internationally,” says Ed Moisson, head of UK and cross-border research at Lipper. “The likes of Pimco and Franklin Templeton have really dominated activity this year, but others such as Schroders and Pictet have also prospered from flows into their bond ranges.”

Figures from EPFR Global, a data provider, also show significant growth for bond funds, even if the flows have dropped slightly of late for some of the more popular bond sectors. “Emerging market bond funds had an eye-popping year in 2010, with five times the amount of flow than in the previous year. So some loss of momentum was inevitable,” says Cameron Brandt, senior global markets analyst at EPFR.

Despite the slight drop towards the year-end, the numbers for bond funds are still good, particularly for the high-yield bonds which enjoyed a weekly average during 2010 that was twice the average of the previous year, and looks set to continue to grow during 2011.

Given bond funds’ popularity, particularly for cross-border trading, is it time trading technology for the fixed-income market stepped up a level and started to exhibit the same kind of development we have seen in the equities market over recent years – high-speed, low latency algorithms and the like?

“There is certainly some room for more advanced technology,” says Brandt. “But the goals of people in bonds are often different to those in equities. They are typically pension funds and retirees with longer investment timeframes. Were technology to inject the volatility that we saw in the equities market, then it could lead to a backlash.”

Dealer platforms
Unlike the equities market, fixed income is very much a broker-dealer-led business operating on two levels: the primary interdealer market and the secondary dealer to customer market. The past ten years has seen an increase in the electronic execution on the secondary market, where as much as 80% of trades are carried out on electronic platforms, although this percentage accounts as only 45% of the market’s total value.

The majority of these trades are carried out on four multi-dealer platforms – BondVision, Tradeweb, MarketAxess and Bloomberg. These platforms operate on a request for quotes (RFQ) basis where buy-side firms can ask for quotes from a number of dealers, thus satisfying their best execution requirements. Ideally, traders want to see the entire market but the lack of central counterparties means that settlement is multi-featured and firms have to have a multiple secondary agreements in place with each prospective dealer. Therefore the more dealers a firm connects to, the more secondary clearing agreements it has to have in place which creates a cost for achieving best execution.

For the majority of buy-side traders, the latency issue so prevalent in equities is not high on their agendas. Like equities, there are a handful of hedge funds that are keen to break into the interdealer market. For these traders, the price movements can be very rapid and they are therefore more latency-driven. However, the majority of participants are using bonds as long-term investment vehicles, so they are looking to the multi-dealer platforms purely to get access to liquidity and transparency through them.

“The RFQ process is measured in minutes rather than milliseconds. And it is still an OTC [over-the-counter] market, so it is more likely that the fixed income market will follow the path of FX rather than equities when it comes to electronic trading,” says Fred Ponzo, managing partner at consultancy firm GreySpark Partners. 

  This guarded view of electronic trading in fixed income is shared by those fixed income traders who feel that the current level of automated bond trading works very well for the retail and private banking clients, but is unlikely to have the same impact if applied to other investors.

It is a matter of average ticket price, says Simon Campbell, senior emerging markets fixed income trader at Hoare Capital Markets, an agency broker specialising in fixed income. “For small tickets of $500,000 or less then automated trading makes sense and it certainly helps those traders that need to prove best execution,” he says.

However, for bigger trades and for more illiquid assets, Campbell does not think automated trading is of any real help due to the dominance of banks in the fixed income market. He says: “Market makers like to keep their cards close to their chest and not reveal firm prices except to a chosen few clients, so I think they will be unwilling to put firm prices on screen.”

The case for automation is likely to suffer even less overall adoption, thanks to the massive popularity of emerging markets fixed income funds during 2010 says Campbell. “The large volumes of cash moving into managed emerging market fixed income funds will actually undermine the move to automation, since the smaller retail investors are likely to buy a fund instead, meaning that fund managers will be trading bigger tickets and will prefer to trade directly with a market maker rather than  via a multi-dealer platform.”

Nevertheless, the platform providers are still buoyant of further success in fixed income and have introduced new features aimed at fund managers. Tradeweb, for example, has introduced a listing capability for asset managers that trade a large number of small tickets in order to rebalance their portfolios. And for government bonds, it has launched a “click-to-trade” mechanism to enable the buy-side to see price offerings from a particular dealer at any specific time and send trade requests to selected dealers.

The high demand for fixed income has seen the arrival of new participants, many of whom have come from the equity markets where there is a greater affinity for electronic trading. Enrico Bruni, managing director and head of European rates at Tradeweb, is hoping that this influx will make Tradeweb a “natural choice” for these newcomers.

This may yet prove to be the case but for those asset managers with a long history of fixed income trading, the relative lack of standardisation and transparency and the proprietary, bank-driven nature of the fixed income market has had an effect on the technology available. Whereas there is plenty of choice when it comes to selecting execution management systems for equities, this is not the case for fixed income, and has consequently led asset managers to develop their own execution platforms.

Paul Squires, head of trading at Axa Investment Management, says: “We have integrated two multi-dealer platforms [Tradeweb and MarketAxess], and developed our own transaction cost analysis and pricing tools.

“Once you start down the in-house route, I think you have to continue and I think we have a far better system than if we had waited for the market to develop something.”

In the past year, there have been various plans to develop online marketplaces for fixed income instruments, similar to the crossing networks that are common in the equities market. For example, in 2010 BNY Mellon launched the Structured Credit Connection, an online auction marketplace for certain fixed income securities.

“The system automates what is a heavily manual process and put into a centralised marketplace where there is more transparency, greater price discovery and liquidity and minimised market impact through the anonymity of the service,” says Doug Magnolia, director at BNY Mellon. “We see it as an additional service to the traditional method of trading fixed-income securities. We are not looking to supplant the existing broker-dealer and asset manager relationship, but to give managers an additional option when they are looking to change their portfolio.”

Market interest
As with any new online marketplace, the first challenge for BNY Mellon is to encourage participants and to get the initial liquidity that will beget market interest – a task that often relies on persuading the market that your intentions are honourable.

Magnolia says: “We are not trying to get an angle on a particular market, we’re trying to improve the efficiency and get the securitised market active once again because it is a big part of our business but we don’t originate the deals. A more active securitisation market will also be good for the economy as a whole because it encourages lending.”

“If the right third-party provider came along with the right participants, an online marketplace or crossing network could be very successful,” says Lee Sanders, head of trade execution at Axa IM. However, the firm has once again taken matters into its own hands to an extent when it comes to matching trades.

He says: “Towards the end of last year we approached a fellow buy-side firm that we knew had quite a lot of positions that were opposite to us and we ended up crossing a lot of trades with them – the hit rate was surprisingly high.”

Part of this success, says Squires, is down to the quality of the relationships that exist in the fixed income world, where telephone use is arguably more prominent than in the equities market. “If we did not have those relationships, we might well have hidden behind an agency broker and been more cautious about approaching a counterpart for matching trades.”

The importance of relationships could be a crucial factor in how trading technology evolves in the fixed income world. The low latency, high frequency algorithms and the dark pools of the equities world may not prove so enduring when used to trade bonds.

“The fixed income market will look at what has happened in equities and not necessarily follow. They will have seen electronic trading and execution algorithms make margins so tight in the equities world and wonder if it is worth buying into,” says Squires.