Hanging Up The Phone – Electronic Trading In Fixed Income Markets And Its Implications
Morten L. Bech
Bank for International Settlements (BIS)
Annamaria Illes
Bank for International Settlements (BIS)
Ulf Lewrick
Bank for International Settlements (BIS) – Monetary and Economic Department
Andreas Schrimpf
Bank for International Settlements (BIS) – Monetary and Economic Department
March 6, 2016
BIS Quarterly Review March 2016
Abstract:
This article explores drivers and implications of the rising use of electronic and automated trading in fixed income markets – a process we refer to as “electronification”. We take stock of the current state of electronic trading and how it has changed the market ecosystem, its resilience and its overall functioning. We argue that the impact of electronic and automated trading is visible in a number of dimensions of market liquidity and price efficiency. With market participants adjusting to the new market structure, several new challenges have emerged that warrant attention from policymakers.
Hanging Up The Phone – Electronic Trading In Fixed Income Markets And Its Implications – Introduction
Electronic and automated trading have become an increasingly important part of fixed income markets in recent years. They have replaced voice trading as the new standard for many fixed income asset classes – market participants are literally “hanging up the phone”. For the most actively traded instruments, the take-up of electronic and automated trading has reached levels similar to those observed in equity and foreign exchange markets, although other fixed income segments (eg high-yield corporate bonds) still lag behind.
“Electronification” (ie the rising use of electronic trading) is shaping the process of price formation and the nature of liquidity provision. It has facilitated automated trading (AT), particularly in the form of high-frequency trading (HFT) strategies in fixed income futures and wholesale markets for major benchmark bonds.2 New market participants (outside the traditional dealer community) have emerged and actively participate in these markets as liquidity providers and seekers. And, reinforced by changes in the nature of intermediation, innovative trading venues and protocols have proliferated. What many of these initiatives have in common is that they aim to overcome some of the liquidity challenges inherent in asset classes where trading is infrequent, such as corporate bonds.
These trends can have broad implications for the functioning of financial markets and the distribution of risks among their participants. Given the importance of fixed income markets for the funding of the real economy and financial stability more broadly, policymakers have a strong interest in assessing how electronification may be affecting market quality. By market quality, we mean the extent to which it is possible to transact at prices that accurately reflect the fundamental value of the asset, with immediacy, and in volume. The concept can be viewed as the amalgamation of price efficiency and market liquidity.
Drawing from two recent reports by the Committee on the Global Financial System (CGFS) and the Markets Committee (MC), respectively, this feature takes stock of the current state of electronic trading in fixed income markets and investigates its drivers and the implications for the market ecosystem and its functioning.4 The remainder of the article is organised as follows. The first section describes how the market structure is evolving. The second looks at its current state based on an MC survey of electronic trading platforms (ETPs). The third explores the possible implications of these changes for market quality, the nature of liquidity and its monitoring. The last section concludes with a discussion of policy challenges. How is the market structure evolving?
Traditionally, trading in fixed income securities has been centered on dealers (large banks or securities houses) and their network of trading relationships. Trades have been executed bilaterally – over the counter (OTC) – that is, without a centralized marketplace or exchange.
This market structure separated the dealer-to-dealer market, in which dealers trade exclusively with one another, and the dealer-to-customer market, in which they trade with customers, such as asset managers, pension funds, insurance companies and corporations (Graph 1, left-hand panel). Market participants predominantly negotiated terms of a trade via telephone or electronic chatting systems (ie bilaterally). The process of matching buyers and sellers involved significant search costs (Duffie (2012)). A customer needed to contact one or more dealers, asking for currently available prices and quantities to buy or sell a specific security. Within the dealer-to-dealer market, specialized voice brokers helped facilitate and anonymize the matching process by exchanging information on dealers’ buy and sell interest.
Fixed income markets experienced a major shift starting in the late 1990s (Graph 1, right-hand panel). At that time, ETPs started to gain traction in dealer-to-dealer markets for the most actively traded sovereign bonds. One example was the launch of EuroMTS in 1998 as a pan-European platform for sovereign bonds, agency bonds and repos. eSpeed and BrokerTec, both founded in 1999, are examples of ETPs for dealer-to-dealer trading of benchmark (“on-the-run”) US Treasury securities.
Electronic trading in the dealer-to-customer segment emerged around a similar time. It has taken two basic forms: single-dealer platforms (SDPs) and multi-dealer platforms (MDPs). SDPs are proprietary trading systems offered by a single dealer to its clients. Trading via SDPs essentially represents an electronic version of the bilateral dealer-client OTC market. MDPs, by contrast, allow end investors to request quotes from a number of dealers simultaneously, effectively putting dealers in competition for the transaction as in a multilateral auction. This mechanism tends to lower the costs of finding a counterparty with offsetting trading interest. MDPs also automate record-keeping, making it easier to audit best execution.
The main driver of electronification has probably been the potential to reduce the cost of trading and improve market liquidity. One key advantage of ETPs is automating the processing and settlement of trades, so-called straight through processing. This reduces the need for human processing, lowering both the cost of trading and operational risks. That said, other factors, such as regulation, have also incentivized market participants to trade electronically (see the discussion in Box 1).
The shift towards electronic trading changed how market participants interacted in a variety of ways. One aspect is the change from on-the-phone bilateral negotiation to multilateral, often anonymous, interaction on screen. Trading on those ETPs geared towards the most liquid government securities, for example, is often based on a central limit order book (CLOB). A CLOB is a trading protocol where market participants submit limit orders that are stored in a queue based on predefined rules. Limit orders, if not cancelled, are executed against matching incoming market orders.
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