Bond Trading Takes Steps to Resolve Voice and Screen Conflict

Ever since the equity markets first went fully electronic, countless column inches have been devoted to whether the same will happen in fixed-income markets. Great strides forward have been made in this regard—the increasing dominance of platforms such as Bloomberg, MarketAxess and Tradeweb, for instance, is evidence of that—but even with the effects of sweeping new regulations in Europe being felt this year, the future shape of market structure is more like a chimera than a brand new digital beast.

“Electronification will start affecting relationships. All that said, though, I still believe that voice will have a role in all the big deals,” says Usman Khan, co-founder and interim CEO of bond-trading network Algomi. “I think electronification still counts for 30 percent of the volume; 70 percent is still done by voice. And that is psychological. Think about it—when you want to buy mortgage or you want to buy a large premium type of contract or product, you still want to talk to a human. So that psychological barrier is yet to be crossed from an electronification point of view.”

Indeed, just as the American essayist Charles Dudley Warner once observed that politics makes strange bedfellows, voice and electronic are increasingly facing a future of uneasy coexistence.

Mifid II

The fact that voice and electronic trading may reach a détente in the future, as opposed to one killing off the other, may seem incongruous given the stated aims of regulators in their reform of market structure since the financial crisis. Across asset classes, this has often taken the form of pushing trading onto electronic platforms, as in the case of swaps and other over-the-counter (OTC) derivatives, or in the case of the fixed-income markets, sweeping changes to improve transparency in pre- and post-trade processes.

Nowhere was this more evident than in the revised Markets in Financial Instruments Directive and Regulation, known as Mifid II. That package of rules, which came into force in the European Union (EU) on January 3, 2018, enforced a new regime for requesting quotes and reporting trades that is, if not entirely electronic, then at least substantially so, says Marcus Schueler, head of regulatory affairs and trade structure at Tradeweb, one of the leading electronic platforms for bond trading.

“From a Mifid II perspective, the main change for the corporate bond market was the introduction of pre- and post-trade transparency requirements, as well as the systematic internalizer regime,” he says. “From January 3, for every transaction involving a European platform or a European counterparty, you need to check what type of pre-trade and post-trade transparency obligations apply. This is somewhat similar to what we have had in the US in the form of the Trade Reporting and Compliance Engine (Trace) for a number of years. But it is a much more carefully calibrated and therefore complex process.”

The new rules effectively cemented a process that has been underway for decades in bond markets, in that tickets are written and executed on-screen, as opposed to purely over the phone. This is not an accident—regulators have believed for some time that auditable, traceable electronic means of trading are preferable to the relatively opaque world of phone trading, and have built their rules accordingly.

“We have experienced a lot of growth over the past few years but I think Mifid II has definitely helped drive clients toward electronic trading solutions,” says Gareth Coltman, head of product management, Europe and Asia, at MarketAxess, which operates one of the largest corporate bond trading venues. “In order to protect the best interests of the end-investor, the regulator feels it beneficial to create transparency and broader oversight of market interactions traders.”

Regulators themselves have also been open about this. Consider, for instance, recommendations to improve reporting standards for the corporate bond market issued by the International Organization of Securities Commissions (Iosco) on April 5. 

Among its recommendations is the need for regulatory authorities to have access to pre-trade information, as well as implementing post-trade regulatory reporting requirements for secondary markets. A regulatory source familiar with Iosco’s thinking explains that it is more common for regulatory reporting to cover post-trade information, but it is less common for them to report to regulators’ bids, offers or indications of interest. Where such information is available to regulators, the source says, they will have a better perspective on how the market is working. For instance, a plethora of bids but a drought of offers may indicate liquidity problems, or point to market integrity issues that require consideration and urgent resolution.

Despite this, however, many traders—and especially salespeople—see the need for voice in the future, and warn that inexorable drives toward electronification may serve the end user in terms of reducing cost, but may harm them in other ways.

Impersonal Relationships

Given its nature as a highly voice-reliant market, fixed income has traditionally been a people business. It is not uncommon for veteran sales traders at banks and brokerages to have relationships with the key people at their accounts that go back years, and often blur the lines between professional and personal circumstances—they go to their children’s weddings, they often meet outside of work, and these relationships endure across institutions as well. A particularly effective salesperson, for example, will often take their accounts with them when they change banks or brokers.

The implications of this aren’t just limited to personal friendships, though. A long-term relationship between a broker and their account allows each side to understand investment objectives, to recommend specific instruments and to tailor sales to suit the risk appetite of an institution. While screen-based trading offers obvious benefits, some of them say, it risks abrogating these relationships and reducing them to transactional associations.

“I’ve been in this market for a long, long time and I don’t see it ever going back to the way that it was, when it was dominated by voice,” says a New York-based salesperson at a fixed-income boutique with more than 30 years of experience. “The regulators and the clients don’t want it, but it has the result of pushing the market into being transactional rather than relationship-based. In the past, I knew my accounts well, I knew what they needed, what bonds they should buy, and what would help them achieve their investment aims as a result. That’s starting to slip away now, and is it going to be better in the long run for the client? I’m not so sure.”

The move to the screen has shrunk spreads, they say, which may be good for the bottom line of the client, but is bad for the people on the sell side, most of whom are paid on commission. This is having the effect of squeezing out those with institutional knowledge gained from years of experience.

Some traders are more sanguine about the transformation prompted by regulation such as Mifid II, and point to the fact that large-in-scale trades are still largely arranged by voice. Mike Nappi, a senior trader at Eaton Vance, is one of them. His team uses a combination of trading platforms as well as voice. The majority of trades on a ticket-count basis are done via platforms, but when it comes to volume the majority is done by voice. 

“The voice market is still where you would trade your really large-sized corporates,” he says. “I think some of the things that have come out of Mifid II, people here look at and say they kind of make sense to do. We are looking at things like transaction-cost analysis, best execution analysis, being able to prove best execution—things like that were already in the works here at our firm long before Mifid II. What Mifid II does for the firms is validate the path I think the market has been going down anyway—which is more regulation and transparency—moreso than maybe was in the market three or even five years ago.” 

Algomi’s Khan, too, acknowledges that these reforms have prompted a shift from relationship-based to more transactional trading, and that trading is no longer about “having a discussion over a football game and doing the trade the next day.” However, he says, there have been benefits as a result, one of which is how it has empowered clients to challenge pricing set by their brokers.

“Now it is more about whether it’s a good price for me,” he says. “When they perform transaction cost analysis, it is all about understanding why the price is what it is as opposed to just accepting it for what it is. So there is a lot of that happening now.”  

Chimera 

As such, most see a place in the future for both voice and electronic trading. Large-scale orders still aren’t suited for electronic trading in the same way that smaller trades are, and given the nature of corporate bond markets—particularly those that aren’t classified as investment grade—the liquidity profiles of instruments actually make it actively difficult to trade through a displayed order book.

“Corporate bonds are what would be considered less liquid,” says Michael Sobel, president of New York-headquartered bond-trading platform Trumid. “There are fewer transactions in a given security during the day. So you don’t have kind of continuous pricing that is important as a backbone for many electronic trading systems. They are less liquid and trade in chunky sizes, which makes trading in them electronically bit more complicated.”

In addition, the growth of electronic platforms for fixed-income trading—according to the International Capital Market Association, which tracks them, there are over 100 operating at present—means that many struggle to build a critical mass of users.

“No one is really going to want to be able to put their orders up on the screen that other people would be able to see, if they are not going to be able to have that order filled,” says Brad Tingley, an analyst at research firm Greenwich Associates, who recently authored a white paper on the impact of Mifid II on corporate bond trading that was published on March 15.

Still, even as voice may continue to play a part in the future of the bond market, electronic trading is continuing to eat away at its territory, especially given the shot in the arm it received via Mifid II. Indeed, many expect other jurisdictions to follow suit.

Trumid’s Sobel, for instance, says he thinks it is likely that regulations such as Mifid II will become best-practice in the US. He also sees an increasing desire, if not demand, for best-execution measurement and the like. “There are significant operational efficiencies around straight-through processing and general cost of execution that electronic trading can provide. And improvement in the quality of platforms themselves I think will continue to pull traffic to electronic platforms,” he says.