THE FUTURE DIRECTION OF FIXED INCOME.

Although electronic trading in fixed income has gained traction, the road ahead is not smooth. Bob MacDowall explains.

This century, at an operating and operational level, fixed income markets in North America and Europe have made considerable advances at the technical level, but they have been overshadowed by the after-effects of the financial crisis and the general macro-economic outlook. By contrast most of Asia is enjoying economic growth and is well positioned to capitalize on the structural and operational improvements developed in North American and European bond markets.

The articles in this special feature section reflect the current level and scale of electronic trading, examples of innovation and product development in fixed income trading as well as the best practices that have been developed.

Institutional traders no longer call two or three broker-dealers, who are likely to hold inventory in the selected bond to see which firm can offer the best price and then execute. The credit crisis, resultant regulation and advances in technology have lead to the development of an increasingly electronic marketplace. The technology substantially reduced start-up costs for new systems as well as operating costs plus it adapts to changing marketplace dynamics. As a result the distinction between broker-dealers and exchanges has blurred.

A complicated picture

However, the processes for trading cash bonds have proved much more complex than for equities. The standard functionality was not available. As a result, a small number of venues developed proprietary protocols but the financial implications meant that the costs of connecting to fixed income venues versus equity trading platforms offering standardised FIX connectivity is expensive.

The fixed income sector cannot ignore other factors which have and will continue to influence this market. For example, trading has been exacerbated by the eurozone reducing the quality of sovereign bonds in comparison with many corporate bonds, which historically had higher yields. Investors have perceived that corporates have higher credit and default risks and an underlying lack of liquidity. In response to the shortage of available capital and increasing regulatory capital requirements traders have reduced inventory levels.

Capital charges under Basel III have encouraged some brokers to leave the fixed income business but electronic trading should enable banks to trade with less capital. They can access a larger number of clients and move positions from their trading books more efficiently. Furthermore, capital constraints are serving to reduce transaction sizes.

A large portion of the fixed-income market remains OTC, which is in defensive mode by dramatically widening bid/offer spreads. There is currently disagreement among the buyside as to the longer-term effectiveness of the Request for Quote (RFQ) model in the current economic environment. Some believe that this model has already ceased to function in stressed markets, while others feel that there is currently no credible alternative. The key issue is that there is no consensus on the best business model for the future. Lack of secondary market liquidity has a direct impact on yields and the flow of debt issuance. As liquidity evaporates and capital providers are constrained, fewer market participants will be able to operate efficiently, leading to reduced competition. It will then fall to the buyside to provide that liquidity and they will require a greater incentive.

Retrenchment by investment banks and brokers in the fixed income sector is posing problems for asset managers seeking liquidity in secondary bond markets. They have significant liquidity risk challenges in managing their fixed income portfolios on an active basis. In that environment electronic platforms, including single dealer platforms and multi-dealer venues run by independent operators, should benefit with managers looking for alternative ways to trade, but it is not providing the full solution.

A growing divide

The current eccentric monetary policies being pursued by central banks in much of the western hemisphere continue to bring price/valuation as well as supply/demand distortions. The sector is witnessing highly visible divergence in economic growth prospects by geographic region. They pose critical investment implications in the years ahead for the US and Europe in particular.

The US Federal Reserve has been trying to strike a policy balance that both mitigates the deflationary impact of a variety of successive crises while at the same time containing the possibility of higher inflation. It has expanded its balance sheet by the policy of quantitative easing, as well as the maintenance of extremely low policy rate levels. In addition, the central bank’s bond purchasing in 2013 is likely to absorb most net US fixed income supply, further distorting markets and exacerbating supply/demand imbalances.

In the eurozone lending has declined. It is particularly weak in the corporate sector in Italy, Spain, and Portugal, where banks have instead rapidly increased sovereign debt holdings rather than lend. The region is continuing to deleverage despite rising unemployment and fragile consumer spending. This is not auspicious for a rapid return to growth. Temporarily at least, the European Central Bank has improved sovereign financing rates, which was critical to alleviating the crisis.

The situation is different in the Asia-Pacific region. Japan is still trying to address structural difficulties, while the rest of developing Asia has strong growth prospects leading to an expansionary bond market. Initiatives are required to develop a pan-Asian bond market. This includes lifting the obstacles to cross-border capital flows and harmonising the regulations, withholding tax provisions, accounting practices, rating conventions and clearing and settlement systems that pose challenges for foreign participation in regional bond markets.

Most of Asia’s challenges within the fixed income market lie within its own grasp to resolve. By contrast the US and Western Europe are dependent on resolution of their economic and deficit problems.