It was a little note in a Greenwich study that raised a fascinating topic for those interested in market structure. When evaluating causation of dwindling volume in European fixed-income electronic trading, the report mused out loud about the potential for the market to have reached its “natural limit.” Understanding this level, and recognizing how and where to calculate it, is what makes markets and moves prices. But in the big-bank dominated world of European fixed-income electronic trading markets, while the markets may be at a temporary calm point, the shuffling of brokerage leadership hasn’t changed much.

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European Fixed-Income Electronic Trading
By Banco Carregosa (Own work) [Public domain], via Wikimedia Commons

With MiFID II and a new credit cycle approaching, European fixed-income electronic trading could get hit with a storm

“Whether due to low levels of market volatility and trading activity, or the approach of some natural limit, growth has stalled in European fixed-income electronic trading, and volumes have hit a plateau,” said the Greenwich report titled “Stability in European Fixed Income May be Short Lived.”

The market stability that has recently blessed European fixed-income trading has been a welcome respite after years of “post crisis tumult.”

But that calm that traders might be experiencing just might have a storm brewing right beyond the horizon.

With MiFID II approaching, which requires bulge bracket banks to separate the cost of client benefits such as research from commissions charged to customers, this is one reason that market calm “could prove short-lived.”

But it’s not just allowing research costs and trading commissions to be divorced that might be causing the return to volatility, but also a shift in the credit cycle might be at work. With interest rates set to rise in the US and lag but follow in Europe, volatility, the market maker’s friend, might be storm clouds that are starting to appear.

This volatility might benefit markets, but is there a “natural limit?”

Market dynamics at play but EU trading leadership doesn't change much

Most traders recognize the practical size limits of the markets they trade.

The best quantitative investment managers – CTAs, quant funds, high frequency trading firms – all understand market structure dynamics. Each market is assumed to have a limit of interest, which is often factored into the diversification formula. Typically a strategy’s market exposure to a market is not unlimited but often driven by a number of factors, including the perceived size and limits of market liquidity.

Markets are elastic to various degrees, but there has been a general limit to trading volume in each that has been a particular focus of market analysts.

Commodity market analyst Carley Garner has a method of determining the elasticity of a trend that is, in part, based on how “exhausted” the market appears.  Her system was explained in a CNBC commentary from Jim Cramer, which points to using the CFTC’s Commitment of Traders (COT) report to determine the point that most available commercial market participants are in the market, and then she uses this as a signal to potentially trade in the other direction if other signals line up.

Markets do experience dramatic periods of expansion, particularly as new users understand the benefits of hedging. During periods of volatility, often times the markets expand with new participants, but such volume is often shorter-term in nature.

In the case of European fixed-income electronic trading, where the big winners are J.P. Morgan, Citi and Barclays, even though EU rates traders continue to gravitate to the largest players, one trend remains strong regardless of market size: the need for technical proficiency.

“Despite any pause in e-trading growth overall, market participants of all types are investing heavily in algorithmic pricing, which will eventually become a powerful force in fixed income,” Greenwich Associates consultant Tom Jacques said in the report.

Rounding out the list of European fixed-income heavyweights is Goldman Sachs in fourth place in market share, followed by a tie in fifth place between HSBC, BNP Paribas and Bank of America Merrill Lynch.

“There was less volatility in the competitive landscape this year,” said Greenwich Associates consultant Satnam Sohal. “There were no upheavals among the major dealers and investors were less active in shifting wallet among dealers.”