07 Dec 2009, Rob Davies, Credit
The bond market recovery has brought with it an expanded group of dealers. Coupled with the enthusiasm of regulators for electronic execution, this development holds promise for the progress of electronic trading, explains the CEO of MarketAxess in an interview with Credit.
Q What have been the key trends in electronic trading in the credit markets over the past 12 months?
A The environment has improved dramatically in 2009 with corporate bond spreads retracing almost all the widening of 2008. The turning point in the credit markets came in the spring when risk appetite increased and the general market tone turned more positive. Although dealer liquidity is much better than it was a year ago, it has not returned to pre-crisis levels. Bid/offer spreads are still wider than in 2007. Thankfully, the extreme levels of market volatility that were not conducive to electronic trading 12 months ago have moderated, and we are now back to a market environment where the benefits of electronic trading are readily apparent.
Another trend we observed was the unprecedented imbalances in the trade flow between bids and offers. In the last half of 2008 when market participants looked to deleverage, the majority of the investor order flow was selling corporate bonds. By the second quarter of 2009, this trend had virtually reversed as risk appetite returned and investors began buying corporate bonds. More recently, we have seen a more normal balance between bids and offers, leading to improved market liquidity. Helping the recovery process was $195 billion of gross investment grade new issuance in the third quarter and a strong flow of cash into exchange-traded funds focused on corporate bonds.
Lastly, over the past 12 months we saw new dealer participants increasingly enter the credit markets, increasing the sources of liquidity as well as facilitating trades on an agency basis. As liquidity becomes more dispersed with more dealers in the mix, e-trading becomes an essential tool to access best price.
Q What is driving the increased activity?
A One major driver was the improvement in the credit markets, and thus the environment for electronic trading, which was due to a number of factors. First, the financial health of large dealers has improved, allowing them to use their capital more freely and ramp up their market-making capabilities. Second, we have observed new dealers entering the market to provide new sources of capital, as liquidity appears less exclusively concentrated among the largest global dealers. Third, institutional investors’ appetite for risk has increased. These factors, combined with the steps we have taken to enhance our business, have allowed electronic trading over our system to surpass pre-crisis levels of activity.
Our overall trading volumes in the third quarter are up 64% over the same period last year and well off the lows we saw in the fourth quarter. In fact, our trading volume in October was the highest it has been since June 2007. In the US, our share of overall high-grade Trace volume has resumed an upward trend, as electronic trading on MarketAxess improved to around 7.5% of the entire high grade market as of October 2009. Particularly encouraging is the 78% increase year-on-year in client inquiry count on the system for the third quarter, which demonstrates investor client demand has never been stronger. With the resumption of growth in e-trading and the large portion of the market still trading by phone, we are excited about the opportunity that lies ahead.
MarketAxess benefited in the last few quarters from a number of initiatives in 2008 to expand the sources of liquidity on the trading system and greatly increase institutional connectivity. We believe those changes have strengthened our electronic trading offering and deepened the liquidity on our platform.
Q What changes have you made to the platform?
A With large dealer balance sheets so constrained in the latter part of 2008 and into the first quarter, investors had a very difficult time sourcing liquidity and executing trades, regardless of whether the inquiry was over the phone or through e-trading networks like MarketAxess. The challenge for us was clear. How can we enhance the liquidity available on the system and improve investor clients’ e-trading experience?
One of the most significant changes to the platform has been the expansion of our participating dealer group. By the end of the third quarter, we increased our global dealer group to 67 dealers, more than doubling the number of participating dealers in 12 months. Although it takes time for investor clients to establish trading relationships with new dealers, we have already seen their activity on our system increase as a group to approximately 20% of all US corporate bond trades by count. We are seeing completed trades as a percentage of investor inquiries climb back towards our historical average of approximately 80%, in part due to improving market conditions, but also due to the growing participation of our new dealer group.
Q What asset class-specific or regional trends are you seeing?
A In US high grade, our volume of fixed rate bond trades in the third quarter was above pre-credit crisis levels, although the floating rate note business has yet to return in any meaningful way. We have seen strong improvements in both our high yield and emerging markets trading volumes.
Our European system has also seen a substantial rebound in activity, indicating the strength of our network and the support for our multi-dealer request-for-quote protocol. Trading volumes in Europe for the third quarter were 93% above year-ago levels, benefiting from the increased investor order flow and expanded range of fixed income products that can be traded on the European system. We are also seeing substantial increases in the number of clients who are trading multiple asset categories on the platform.
Q Will these trends continue?
A Prior to the credit crisis, we were on quite a consistent growth path in terms of electronic trading adoption. Clearly, this growth was interrupted by the dislocations in the market that drove trading temporarily back to the phone for bilateral negotiation. However, we have emerged from the crisis in an even stronger position to resume the growth trajectory. In fact, the crisis highlighted to investors the importance of using technology to efficiently expand access to trading counterparties. Most institutional investors simply do not have the trading capacity to interact with upwards of 40 dealers by telephone.
While we have seen some increase from the lows in primary dealer balance sheet usage for corporate bond market-making, the aggregate balance sheets are still down by around 60% from Q3 2007. We do not believe primary dealer balance sheets will grow substantially in the foreseeable future, making the new sources of capital emerging in credit markets crucial to overall market liquidity.
In aggregate, while it would be normal to see some seasonality affect the credit markets in the fourth quarter, we believe electronic trading is still in the early stages with plenty of room for growth in the long run. Given the deep e-trading connectivity we have established with both our investor and dealer customers, and the breadth of our global trading network, we are well positioned to help clients and dealers benefit from the connectivity, speed and efficiency of electronic execution.
Q What impact do you expect regulatory change to have on electronic trading, particularly with regard to CDS?
A With respect to the timing of the regulatory reform, legislation is likely to be passed early in 2010 and the new rules would be in effect somewhere around the end of next year. In the meantime, it’s worth noting electronic CDS trade volumes are still very small. However, most of the current proposals for regulatory reform contemplate the execution of standardised swaps on an exchange or an alternative swap execution facility, which we believe is intended to capture the benefits of electronic trading within the legislation.
In that context, we’re taking all the necessary steps to prepare for this shift in market structure. We’ve already equipped the trading system for the new standardised single-name contracts in CDS, and have built a variety of trading protocols we think might be relevant in the new CDS space. We currently have in place multi-dealer request-for-quote capabilities for CDS indices, as well as single names. We have our patented bid and offer list technology available for single-name lists. Finally, we have live cross-matching technology available that was built for the interdealer business.
Q How does the move to central clearing facilities figure in this process?
A Central clearing is an important step to reducing counterparty risk in OTC derivatives markets. Plenty of hard work is going into adding a sound customer-segregated account clearing structure that will provide important safeguards for investor clients. With these changes, it is likely that participation in OTC derivative markets will grow.
It is critically important for OTC derivative clearing houses to be open to accept trades from other qualified trading venues. These would include dealers, interdealer brokers, electronic trading networks, alternative swap execution facilities, exchanges and prime brokers. Any clearing solution that lacks open access will limit execution choices and competition in the marketplace, leading to higher costs and lower trading activity.
An open clearing solution would greatly support the expansion of electronic trading of OTC derivatives. We believe an electronic environment can increase the number of market participants, thereby improving liquidity and price discovery.