By Ganesh Iyer, CAIA, Global Product Marketing Director, Financial Markets Network, IPC
More than 60% of Fixed Income firms will spend 15% or more of their annual budgets on new technology in the year ahead according to a recent report from Worldwide Business Research. Why are technology investments demanding such a big chunk? New regulations have made connectivity for sourcing market liquidity an ever more important component to trading success.
Profound changes in market structure, regulation and business models have significantly affected capital markets following the global financial crisis in 2008. No asset class or product, spanning from equities, fixed income, the foreign exchange markets, commodities and their derivatives, has been immune from experiencing major shifts. The changes have been particularly pronounced within the fixed income markets with a push towards increased transparency, rigorous risk management practices and a stronger regulatory regime. Given these factors, we are now seeing several major trends in the global fixed income markets:
- Traditional market makers are retreating due to stricter capital requirements and leverage limits.
- Shrinking dealer balance sheets have minimised liquidity.
- New institutional players, including non-bank entities, are attempting to fill the void left by exiting major dealers.
- The market is fragmenting with new platforms attempting to facilitate liquidity.
- Traditional trading models are being supplemented with increased buy-side to buy-side trading.
The very active secondary debt market is heavily dependent on communication, collaboration and connectivity in trading government securities, mortgage-backed securities, asset-backed securities, corporate bonds, convertibles, money markets and credit derivatives. In today’s financial environment, investment managers, dealers, liquidity venues, custody banks and clearing/depository organisations require reliable infrastructure in order to effectively execute fixed income trading strategies (Figure 1). This Fixed Income Ecosystem is further complicated by the vast range of buy-side firms trading the asset class – hedge funds, asset managers, pension funds, sovereign wealth funds, corporate treasuries, foundations, endowments, insurance companies, family offices and even private equity firms.
As a result of these far-reaching changes, fixed income players now require increased connectivity throughout the trade lifecycle and access to a ready-made ecosystem of diverse market participants to drive the search for assets and conduct transactions. More and more fixed income traders are taking advantage of specialised technology and managed services to source liquidity, generate alpha and mitigate risk. In summary, groundbreaking technology solutions are now taking centre stage to address increasing challenges firms are facing in trading fixed income securities.
Innovative technology solutions facilitate liquidity and support compliant all-to-all trading by linking market participants to one another. Managed connectivity, communications and collaboration solutions are particularly important in the fixed income market as trading strategies become increasingly complex. Below we explore four different fixed income strategies which showcase how connectivity and access to a ready-made ecosystem is pivotal to successful trade execution and alpha generation.
Swap spread arbitrage
A swap spread arbitrage is a complex strategy that involves an arbitrageur taking positions in an interest rate swap, a treasury bond and a repo rate (Figure 2). The first leg of the strategy is the swap spread – the spread between the fixed rate and the interest rate of the treasury bond. The strategy’s second leg is the floating spread which is the difference between LIBOR and the repo rate. The difference between the swap spread and the floating spread is the arbitrageur’s profit.
MBS Arbitrage
A mortgage-backed security (MBS) strategy consists of buying MBS and hedging the interest rate exposure with swaps. Changes in clearing, reporting and trading requirements for interest rate swaps have transformed the landscape for the asset class.
Why is Connectivity Critical? The different entities that play a role in the interest rate swap trade lifecycle need to connect and communicate with one another.
Capital Structure Arbitrage
This strategy takes advantage of the mispricing between a firm’s debt and equity by buying an undervalued security and selling the same firm’s overvalued security and profiting.
Why is Connectivity Critical? This cross-asset trading strategy centres on reliable access to fixed income and equity liquidity venues.
Convertible Arbitrage
Convertible bonds have features of fixed income, equity and options. A typical convertible arbitrage strategy involves taking a long position in an underpriced convertible bond and a simultaneous short position in the underlying stock to neutralise equity risk. This strategy can quickly become complex since arbitrageurs often have to hedge risks associated with a number of other factors including volatility, interest rates, foreign exchange rates, credit spreads, stock dividend yield and credit recovery rate.
Why is Connectivity Critical? Like the other strategies discussed here, communications and connectivity play a vital role in the execution of a convertible arbitrage strategy since multiple asset classes are often involved. Additionally, implementing effective hedging and risk management depends on reliable connectivity and communications.
Investing in technology helps source liquidity, link market participants and enable all-to-all trading Given the dynamics in the fixed income asset class and the number of complex strategies being utilised, there are several specific areas where institutional investors, hedge funds and asset managers are employing innovative communication solutions such as financial extranets, Ethernet services, managed virtual private networks, voice recording and data archiving. These solutions enable:
- Maintaining reliable connectivity to brokers/dealers, investment banks and liquidity venues to generate alpha, source liquidity, achieve best trade strategy execution and discover prices.
- Efficiently accessing market data and trade lifecycle services such as order management, execution management, risk management and portfolio management systems.
- Improving collaboration among traders, analysts, portfolio managers, economists and risk managers to execute investment strategies and manage risk.
- Facilitating superior communications between fund managers and prime brokers to facilitate securities lending and margin financing.
The most successful fixed income traders generate alpha not only through their use of various investment strategies but also through the implementation and use of state-of-the-art communications solutions and managed services. Technology that provides connectivity throughout the trade lifecycle and access to a diverse financial ecosystem is critical to effective investment of the trillions with which institutional investors and asset managers have been entrusted.
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