Author: Joan Weber

Location: Stamford

Date: 2012-08-13

New capital rules and other changes to the basic structure of global fixed-income markets might succeed in achieving a transformation that has been discussed — but never realized — since at least the 1990s: the “equitization” of fixed income.

Technological advances in the 1990s gave rise to a host of start-up electronic trading competitors and speculation that the traditional fixed-income market would be ultimately rebuilt in the image of U.S. equity markets. The “equitized” fixed-income market envisioned at the time would incorporate significant amounts of agency-based trading and would feature a variety of e-trading systems, crossing networks, dark pools and other equity-like execution mechanisms. For the most part, however, none of those visions ever became reality outside the biggest and most liquid fixed-income product markets like U.S. Treasuries. The reason: Unlike equity markets, fixed income is composed of thousands of individual issues, each with its own unique structure and tenor. In this heterogeneous market, investors rely on dealers for liquidity, which aside from government bonds and the largest most liquid credit bonds, has proven difficult and in cases impossible to amass in sufficient amounts in any dis-intermediated trading venue.

But changes to global fixed-income markets — and in particular, strict new capital reserve requirements imposed on banks — have set the stage for a far-reaching transformation. They have done so through a consequence largely unintended by the politicians and regulators that set these changes in motion: They have made the business of fixed-income dealing less attractive to the intermediaries central to the existing market structure. The resulting pullback on the part of dealers has already had a negative impact on market liquidity, and could reduce liquidity to the point at which the types of electronic trading venues typical in equity markets become viable alternatives for investors.

The process of fixed-income “equitization” is also getting a big boost from ongoing reforms of derivatives markets and, specifically, from the establishment of central clearing as a firm mandate. The move to central clearing and potentially to exchange-based trading will make derivatives markets more standardized, since contracts will have to conform to consistent rules in order to qualify for central clearing. As the instruments become more homogenous they will be more conducive to equity-style trading — especially electronic trading platforms.

Receding Liquidity

Fixed-income investors are already feeling the impact of new bank capital rules. In the United States — and, to perhaps even to a greater extent, in Europe — investors are experiencing reduced liquidity and in some cases liquidity breakdowns in the trading of corporate bonds and other fixed-income instruments. Although overall U.S. fixed-income trading volume was up 18% from Q2 2011 to Q2 2012, trading volume in investment grade credit products was actually down 6% year-over-year, reflecting a general slowdown in secondary market trading activity in these staple products.

“Prior to the global crisis, investors were accustomed to having their trades cleared in full by individual dealers that maintained huge inventories,” explains Greenwich Associates consultant Tim Sangston. “After the sell-side retrenchment caused by the crisis, we saw much more dealer-driven crossing, both on an internal basis among clients and in terms of dealers teaming up to process individual client trades. The next logical step is crossing between and among investors.”

Electronic Trading

Electronic platforms are a natural fit for such trade crossing, and e-trading systems could likewise play an important role in the new market structure now being instituted for derivatives trading. Currently, 56% of U.S. institutional investors trade fixed income electronically, and electronic systems capture just 25% of overall fixed-income trading. By contrast, approximately 77% of institutions trade electronically and e-trading systems capture 37% of overall institutional U.S. equity trading volume. As investors seek out alternative sources of fixed-income liquidity and central clearing becomes standard practice in derivatives trading, we expect electronic trading volumes in the U.S. fixed-income market to begin moving gradually in the direction of those now seen in equities.

“Existing electronic trading platforms such as TradeWeb essentially took the OTC trading typically done via telephone and moved it onto an electronic system,” says Greenwich Associates consultant Peter D’Amario. “The next generation of fixed-income electronic trading will be something else entirely; it will be closer to an agency model, in which trades are matched or crossed and dealers do not take a position in any of the underlying securities.”

Consequences for Investors, Companies and Dealers

The changes taking place in fixed-income markets today and the potentially even more profound transformation to come will have important consequences for all market participants — some positive, some much less so:

• Investors: Reduced liquidity followed by an eventual increased use of algos to source liquidity.
• Dealers: Thinner margins, increased transaction flow, increased investment in electronic bond trading platforms, increased competition.
• Dealers and Investors: Reduced costs and increased transparency for investors, leading to new client base for dealers.
• Companies: Reduced access to capital.

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