E-trading platforms: Electric dreams

E-trading platforms have bounced back from the Lehman-induced dip in trading volumes, with the leading brokers reporting a surge of activity since the spring. Credit looks at the factors influencing this recovery.

The extent to which e-trading retreated during the dark days of late 2008 and early 2009 was starkly illustrated in a survey by the Securities Industry and Financial Markets Association (Sifma). Market participants reported a decrease in fixed income e-trading volumes in 2008, with 50% of buy-side respondents trading more than 60% of their fixed income volumes electronically. This compares with 60% of respondents trading the same level electronically in 2007.

Dominic Holland, European head of e-distribution at RBC Capital Markets, confirms that during the crisis, “electronic trading was largely used as a price discovery mechanism and execution was done on the phone”. As Andy Nybo, head of derivatives at financial markets advisory firm TABB Group, explains, the level of uncertainty in the market could most effectively be dealt with by picking up the phone to source additional information.

Speaking at the time of Sifma’s survey release, Mark Austen, managing director of Sifma affiliate, the European Primary Dealers Association, said: “These results seem to be only temporary and credit crisis-related, as the market expects continued growth of electronic volumes in 2009.” That prediction proved to be correct. Volumes on MarketAxess, for example, have risen almost every month since the crisis (with some seasonal exceptions), climbing from a low of $13.3 billion in October 2008 to $34.7 billion in October 2009. Similarly, since November 2008, TradeWeb says its volumes have risen to a record level – double the previous peak recorded in July 2007. Bloomberg says its volumes are up by around 60% in the past year.

“Last year, the trend towards e-trading was stalled by the financial crisis but it has clearly now been resumed. It now represents a higher proportion of trading overall than ever before,” says Roger Barton, managing director of TradeWeb.

The turnaround in e-trading volumes mirrors the recovery of the credit market itself. “The credit environment has improved dramatically in 2009 with spreads retracing almost all of the widening of 2008,” says Richard McVey, chief executive of MarketAxess. “The turning point came in the spring when risk appetite increased and the market tone turned more positive. There was an immediate reduction in spreads.”

Similarly, liquidity is much better than a year ago although it has not reached pre-crisis levels: bid/offer spreads are still wider than in 2007.

The improvement is down to a number of factors. Firstly, investor appetite for risk has increased. “The recovery in electronic trading is partly a practical necessity,” says RBC’s Holland. “The huge volume of money coming into credit had to go to work. For index trackers, in particular, there simply weren’t enough hours in the day to do all the trades they needed manually.”

Secondly, as the large dealers recovered financially they began to ramp up their market-making activity. “The improvement in the health of large market-makers is best exhibited by primary dealers holding corporate bonds on their balance sheets,” says Kelley Millet, president of MarketAxess.

Before the crisis, the 17 largest dealers had inventory of $235 billion, according to data from the New York Fed. This fell to as low as $60 billion during the worst of the crisis. “There has since been a recovery of perhaps $25 billion, which is an indication of larger dealers’ willingness to increase risk. But dealer appetite for risk is a long way short of pre-crisis levels,” says Millet.

Balancing act

A point related to liquidity, which helps explain the rise in e-trading volumes in recent months, is that directional flow has become less of a one-way street. “In the autumn of 2008, everyone wanted to de-risk and that was hard for the dealer community to handle,” says Millet. This year, the flows into credit made it hard for dealers, which had reduced their balance sheets and were afraid to short the market. “In the last quarter, we’ve seen a better balance between bid and offers and therefore the market is working better,” he says.

An additional explanation for the improvement in liquidity is the number of new dealers entering the market and committing new capital. “A year ago, the average investor client on MarketAxess had approvals for 26 dealers; the figure is now 35,” says McVey.

New dealers that came onto MarketAxess in the past year now win approximately 20% of all trades, although this figure might decline as larger dealers begin to commit more of their own balance sheet to credit. “The trend of expanding sources of liquidity has probably reached its peak and there is instead a new interest to optimise use of existing sources of liquidity with main product activity migrating back towards larger dealers,” says McVey. “Nevertheless, the trend that began as a result of the market dislocation looks set to be a permanent feature of the market with more of the smaller off-the-run trades continuing to go to regional dealers.”

According to Phil Gee, head of credit trading, Europe at RBC Capital Markets, the level of competition for tickets is similar to the pre-crisis period with banks working hard to make up lost ground; especially where relationships with clients broke down when liquidity was withdrawn. At the same time, the credit crunch has levelled the playing field. “In the past, clients had a list of five to 10 brokers,” says Gee. “That has now disappeared and governance people within fund management firms now appreciate that liquidity provision is key.”

Having undergone such upheaval in the past year, one might assume the electronic trading space would have experienced a shake-out. However, there have been no departures from the market and none are expected in the imminent future. Similarly, the balance of business between individual bank platforms and multi-dealer platforms remains broadly similar.

“The lessened commitment of some dealers to multi-dealer platforms during the crisis was a simple reflection of the need to rationalise their participation in bond markets due to balance sheet constraints,” says TABB Group’s Nybo, who adds that commitment to multi-dealer platforms has now been restored.

Lawmakers take aim at CDS market

Impending regulatory changes have cast a shadow over the credit world in the past year, with much of the focus on the creation of central clearing houses for credit default swaps.

Regulators in both the US and Europe want the CDS market to have greater transparency. “There has been progress but there is still clearly a lot to do,” says Richard McVey at MarketAxess. Similarly, in Europe, there is some way to go before the shape of legislation on derivatives clearing and trading is finalised. “So far all that is certain is that the European Commission has said it will require standardised derivatives to be centrally cleared, and traded on exchanges or multilateral trading facilities,” says Roger Barton at TradeWeb.

In the dealer-to-client market, CDS is largely voice traded. “If the current legislation goes through, a significant amount of that business would have to move to exchanges or multilateral trading facilities,” says Barton. “An exchange model would represent a substantial shift as dealers typically make markets to specific clients. We think it is more likely the business will go to MTFs, which preserve the benefits of the OTC market structure and allow dealers to maintain existing relationships.”

While clearing of cash bonds is less of a concern for regulators than for derivatives, transparency is a core issue, according to RBC’s Dominic Holland. “Dealers are not opposed to transparency but it is important that measures designed to protect retail investors aren’t detrimental to institutional investors,” he says.

Certainly, the appetite in Europe for a Trace-style system as in the US is limited, as it only served to reduce volumes in less liquid instruments. Similarly, the characteristics of the credit market – such as multiple deals from issuers – make an equity-style system, with daily trade averages and other detailed information, inappropriate.

“One possible solution for credit is a daily market price, possibly using information from Euroclear, and an indication of volumes, possibly in bands or buckets,” says Holland. “There should be a clear distinction between any new transparency requirements and those already in place for retail investors, who, for appropriate instruments, already have all the pre-trade information they need.”