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The Trading Mesh

Fixed Income Robot Wars & the Rise of the Machines

Tue, 18 Nov 2014 04:26:32 GMT           

Continuing global regulatory reform, is leading to significant change in financial markets across all asset classes. Change causes disruption and disruption presents opportunity with winners and losers.

Winners will be new entrants or existing players who adapt – succeeding at the detriment of those who remain attached to the old ways of doing things. No one knows who they will be but one thing is apparent, with an accelerated timeline, the financial markets landscape will change dramatically in the years to come.

Electronic transformation of cash equities markets was driven by waves of regulation from the mid 1990s to late 2000s. The effect on other asset classes is likely to be magnified given the wider scope of the new regulations. Will we see the trend that manifested itself in the equity markets play out in fixed income markets with the advent of more automated and algorithmic trading?

Regulatory changes, enabled by advances in technology, have led to the rise of electronic trading of fixed-income securities. Although, to this day, approximately 50% of U.S. government-bond trades and 80% of credit markets and corporate bonds are still negotiated and traded telephonically (due to structural issues primarily centred around the lack of size and liquidity). Plain vanilla interest rate swaps and government bonds are easier to automate as they are more standardised, while mortgage bonds and corporate bonds are less standardised and therefore harder to automate.

Transparency driven by regulation and technology innovation can act as the catalyst to drive more electronic price discovery and, as critical mass builds with a good mix of buy-side and sell-side liquidity in any given trading venue, so will order driven trading. However, the negotiation model works well for less liquid instruments and will not die any time soon albeit it will be screen based with smarter use of automated price discovery rather than phone traded. New business models will emerge and we are already seeing a plethora of players trying to compete, with the aim of changing the existing model, such as Deutsche Börse backed Bondcube, Liquidnet’s acquisition of Vega-Chi and ITG, the latter two capitalising on what has succeeded in cash equities markets. However, lessons should be learnt and those who believe simply applying equities-like models to them will succeed will be proven wrong.

Transparent trading on SEFs will also help the broader cause of these markets, be it in credit or interest rate swaps (IRS). In Europe we are seeing traditional buy-side firms, looking to in-source their trading desks and take more control of their execution strategy, replacing prime broker phone trading with in-house systems beyond the standard Execution Management Systems to full-suite Order Management Systems. Vendors are also looking to capitalise on fixed income automation with those, such as Trading Technologies, expanding their already mature fixed income futures offerings into the more traditional fixed income space with a suite of automated trading and analytics tools to help optimise execution. There are new players entering these markets bringing additional liquidity, such as Citadel, as a swaps dealer. Other non-traditional players are likely to follow to add liquidity to the market place as some of the sell-side’s appetite for market-making wanes, given balance sheet constraints and reduced risk appetite.  All this will further drive the automation momentum. It will also present opportunities for automated hedging tools between fixed income and fixed income derivatives markets. At GMEX for example, we see opportunity to utilise automated strategies to hedge a 30 year gilt issue with our IRS constant maturity futures products and continually adjusting the hedge not only for this but for a multitude of other instruments given the already mature liquid nature of fixed income derivatives offerings on exchanges both at the short and the long end of the curve.

Stephane Malrait who is Head of eCommerce FX & FI of Societe Generale recently cited that automation and auto hedging will become the norm in IRS markets and JP Morgan has introduced an automated trading suite, Quantitative Market Maker, to automate fixed income pricing and trading. This trend to automate sell-side fixed income desks will only accelerate and is starting to play out at some of the larger banks with some human capital movement from the cash equities side and set up of e-trading teams and associated strategies. One such example is the UBS NEO platform, which aggregates liquidity from the various SEF venues as well as fixed income exchange traded derivatives markets to offer their buy-side client base integrated smart tools for execution.

Interdealer brokers have seen their voice broking revenues fall coupled with high costs and over reliance on the sell-side. They are addressing this by further electronic platform provision beyond their SEF solution. John Phizackerley, the newly appointed CEO of Tullett Prebon recently cited that the key focus would be in this area. Others, like Tradition have focused heavily on their electronic trading strategy through the Trad-X platform offering run by Daniel Marcus with ICAP also having various offerings including iSwap and Brokertec.

Whilst fixed income desks have been extremely profitable over the last few years, there is a growing realisation that change will lead to revenue erosion and those who keep their heads buried in the sand will suffocate. It is a case of adapting or dying a slow death with a thousand cuts. There will be resistance from those within the organisation that have the most to lose, but this must be overcome more centrally to ensure that best interests prevail. The robots have not taken over yet but their march will continue at an increasing pace. Nonetheless, much like other automated markets, effective on-going regulation and human oversight will be key ingredients to preserve market integrity so that the age of the machines does not lead to a terminally ill state of the market and the humans remain in control.

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