European Bond Survey Forecasts Change in Trading Landscape
The fixed income market has been a cornerstone of civilised economies for centuries. Given this long lifeline, the tremendous activity seen in the European marketplace over the past 10 years indicates new levels of activity in the near future. Most striking is the advent of electronic trading and the impact it will have on an industry that – while slow to evolve – is now changing its face for brokers and consumers alike.
The first signs of a new evolutionary phase came to light in the early 1990s with the start of the technology boom, during which investments in low-risk government securities with comparatively low yields were being displaced by equities and other derivative products with higher risk and returns. A further development was the introduction of the euro, which reshaped the domestic fixed income markets in Europe. At the same time, the amount of government debt issues decreased because several countries began paying back their debt, causing a shift in the supply and demand of government securities.
These events in tandem prodded a closer examination of the fixed income market’s structure, leading specifically to new developments for pricing and to finding alternative ways for hedging selected risk exposure. Some of the markets and products that emerged during this time were the covered bond market (especially the top-rated German Pfandbrief), interest rate swap market and other credit products.
As the standardisation of the market opened the door for new products and pricing, so it also paved the way for electronic trading platforms. In the last five years different platforms have entered the European market, and Alternative Trading Systems (ATS) have transformed the traditional OTC-driven market into a fully integrated, electronic-value chain across the major players.
In an effort to determine the cause of change and the direction of the marketplace, BearingPoint recently conducted a survey of the industry that considered these ATS and the impact they will have going forward. The study focused on four inter-dealer and two multi-dealer systems in the European bond market, as it dissected the transition of the bond market towards an electronically driven market, and assessed the size and competitive forces of the European cash market.
According to the Bond Market Association, there were 77 total electronic trading systems operating in the United States and Europe in 2003 (versus 81 in 2002 and 11 in 1997). Forty six of these are based principally in the United States and 31 in Europe, with five categories of providers working in the fixed income market: auction, cross-matching, single-dealer, multi-dealer and inter-dealer.
Interestingly, each platform provider has found a market in the current environment in which they have achieved a market share. One reason for this is that each of their business models was better suited to an individual market, as opposed to other models. For example, MTS Group – a leading European platform provider for European cash bond trading in the government segment – employs a market maker model that has proved successful for the inter-dealer space. BrokerTec and eSpeed, on the other hand, tried to enter this market but quickly realised the differences between the US and the European fixed-income market. Players learned that providing an open-dealer system with no mandatory price quoting was not attuned to the European market practices.
The reason for this is Europe’s fragmented fixed income landscape, which lacks regulatory conformity and is still a largely domestic setup. This encourages still smaller issues requiring market making to ensure liquidity. Thus, the MTS model was more attuned to this market and gained the support of the issuing agencies.
Even with providers finding their respective niches, more change is on the way. Electronic trading has added efficiency as well as enabled dealers to gain access to a larger number of customers in the European market at the same time, but these developments have consequently increased competition. Newly gained transparency, although beneficial to the customer community, has a negative effect on the dealers. Thus, the electronic model in Europe has to evolve to accommodate the internationalisation of the market, as well as new trading practices.
There are indications of a new model that could emerge over the next couple of years. The first development should be the fusion of the interdealer and multi-dealer markets. The industry is increasingly realising that there are no clear distinctions between these markets. Today, a domestic bank is seen as a client and a liquidity provider: the trading desk of a regional bank can be viewed as a customer by global players, whereas in its local market it acts as a liquidity provider. Therefore, defining an inter-dealer and multi-dealer market becomes increasingly difficult, and market participants should not be kept from observing the activities in both markets.
Platform providers on both ends of the spectrum are already considering offering this option. MTS Group offers an inter-dealer market along with a multi-dealer market. Due to different technologies, as well as MTS’s business strategy, these markets are still separated. For example, MTS’s B2B platform operates on an open-server technology, whereas BondVision operates on Internet technology. Nevertheless, in the future, BondVision’s customer base will have access to prices and trade in the B2B market, creating a more holistic trading model.
The second development will be an increase among information/data providers entering the electronic trading space. Bloomberg, Reuters and Thomson Financial are aiming to offer the entire value chain from analytics to final processing of the trade via their terminals.
Another role the information providers could assume is the gateway between different electronic providers. Today, larger banks are already connected to the different electronic systems via an automatic gateway. However, information providers would be even more suited to taking over this job in the future and could thereby create a common interface for a large participant group. This would enable a larger participant pool to trade across different markets, decreasing existing barriers to entry. Electronic platforms would benefit since they are able to reach more domestic and international clients. Global banks could reduce their costs by outsourcing some of their interface and system maintenance to secondary providers. Still, clearing and settlement issues will most likely remain, but with banks increasingly turning to global custodians, these hurdles could be overcome.
As a third development, banks and regulatory agencies may look to institute a more regulated or exchange-driven model, such as Eurex futures exchange, where most market participants are trading via one trading platform with the use of a CCP. So far, attempts to provide such a platform have failed because trading features are regarded as not quite adequate for the fixed-income industry.
Global banks would welcome the introduction of the exchange-driven model for exchanging liquidity in the inter-dealer space. Investors, though, are not likely to lend their support since such a model would not aid cost reduction – they would be less likely to receive special price treatment as occurs in current trading models. Moreover, sales desks of larger banks would be unable to track the trading activities of their customers. This implies that an exchange model, although suited to the inter-dealer market, lacks the transparency necessary for B2C space.
Another obstacle to the exchange-driven model is finding a common market price. With the European market still largely dependent on multiple electronic systems and broker quotes, price discovery for an exchange-type platform will be difficult. Additionally, with price differences in the B2B and B2C space, it is hard to determine an accepted bid-offer spread. Consequently, the development toward an exchange model is difficult.
In summary, BearingPoint’s study revealed that the future of the fixed income market will account for a wide variety of trends and capabilities – most of which will be based on “standardisation”. With standardised interfaces and straight-through-processing already implemented, electronic trading should gain further momentum. Existing platform providers and their market models will evolve to facilitate larger trading volumes, and the relationships between B2B and B2C platforms will shift to give the industry a more uniform, highly efficient marketplace.