Fixed-income electronic trading faces bleak 2008

Fixed-income markets in Europe have been slow to adopt electronic trading. So what impact will a downturn have on the technological future of these markets, asks TowerGroup's Bob McDowall.

Fixed-income trading has been slower to exploit electronic platforms than equities markets. That is because fixed-income markets are very different.

In contrast to equities, fixed-income markets provide no opportunities for arbitrage - the simultaneous purchase and sale of the same securities in different markets to profit from unequal prices - because the securities are seldom quoted on multiple markets.

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Yet electronification of fixed-income trading could improve opportunities in these markets as well as their image. Electronification can democratise the purchase of bonds by enabling all investors to access the markets, which traditionally have been limited to telephone transactions with a few large investors.

Electronic trading of fixed-income securities enables investors to secure instant access to all relevant information about the security being traded. Finally, electronification could increase efficiency and lower trading costs, particularly for small and odd-lot transactions.

Electronic platforms, which compete against single-dealer platforms, are of several types:

• Auction or bidding systems that allow dealers and investors to bid direct on new issues.

• Multidealer systems that allow institutional investors to trade with dealers but not with each other.

• Cross-matching systems that allow buyers and sellers to trade or periodically match orders anonymously.

• Interdealer broker systems that allow dealers to trade anonymously with each other.

As the number of trading and dealer platforms has increased, financial institutions have conducted arbitrage within single markets by identifying pricing discrepancies.

The aspiration of the major platforms must be to become the market, through the scale of deal flow such that they provide real trading connectivity between the various fixed-income markets. In the longer term, the result will be consolidation of some of the fixed-income markets as has happened in equities markets.

If we break down the fixed-income markets into their major segments, government bond markets are highly unlikely to consolidate because underlying political and sovereign reasons would not permit it.

Corporate bond markets will consolidate only when issuers see the benefit of multiple listing or investors demonstrate an overriding demand. That demand does not exist as yet. Electronic trading via trading platforms has been unable to stimulate demand to the expected degree.

So what does 2008 hold for electronic trading of fixed-income securities?

• Online trading platforms have established themselves during times of strong economic growth assisted by easy and even lax credit. The industry has yet to experience electronic trading during a cycle of extensive economic downturn.

• Major dealers will have already reduced the scale of capital they allocate to fixed-income trading, generally as a result of losses and write-downs on mortgage-backed securities, or at least until they re-evaluate or redefine the future strategies of their fixed-income divisions.

• Trading platforms that have strong trading flows in European national government securities as the bedrock of their business should see an increase in these as investors seek fixed-income investments of strong credit quality with a very high degree of liquidity. The trading platforms may seek to complement this by encouraging flows in emerging market debt or, more precisely, in economies that have avoided the fallout of the subprime crisis.

• General tightening of liquidity will see an increase in voice trading, especially for transactions of size across rates.

• Trading platforms without a bedrock of a strong and reliable flow of government securities or high-quality rates products will be forced to seek acquirers and become victims of consolidation if they are not to cease business altogether.

Against this gloomy background there is unlikely to be substantial technology investment beyond necessary technology maintenance. Electronic fixed-income trading platforms have found expansion and wholesale adoption of their services by dealers and the buy side slower than has been the case for equities, even in relatively benign markets.

As a result of the recent credit crunch, electronic trading of fixed-income securities looks set to fall behind foreign exchange markets in wider scale adoption in 2008, certainly until liquidity eases and the major dealers regain sufficient confidence in each other's solvency to transact fixed-income business in size. Meanwhile, end investors are unlikely to see advances in price and market efficiency. Welcome 2008.

Bob McDowall is a senior analyst at financial services research specialist TowerGroup.