Fixed Income Focus | Bob McDowall


The future direction of fixed income


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


Best Execution | Spring 2013


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


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