03 Oct 2011, MarketAxess , Rick McVey , Risk magazine
The Dodd-Frank Act in the US was triggered in the wake of the credit crisis of 2008 and, among its aims, is to create a more open, transparent and efficient over-the-counter (OTC) derivatives market. In Europe, the remits of the Markets in Financial Instruments Directive (MiFID) II and the European Market Infrastructure Regulation are broader, encompassing a wider range of asset classes. The overarching aims of the regulations, however, are in line with those of the US: to increase pre- and post-trade transparency in the capital markets and reduce risk. The primary means by which regulators aim to do this is through enhanced trade reporting requirements and by calling for a greater number of OTC products to be cleared through a central counterparty and to be traded on an exchange or electronic venue.
In the US, regulators are still in the process of defining exactly which derivative products are standardised or liquid enough to be required to be centrally cleared and therefore traded on an electronic venue (an exchange or swap execution facility (SEF)). Even as the rules are being worked through, however, we can observe the ripple effects of the regulations as the broader markets shift to adapt to a new era of trading.
Fixed-income market trends
The corporate bond markets are one example of an OTC market that has seen an increase in the volume traded electronically. Transaction volumes in this market, at least in the US, are also relatively easy to track. The Financial Industry Regulatory Authority’s Trade Reporting and Compliance Engine (TRACE) tape – launched in 2002 to promote bond market transparency – captures most corporate bond trades, whether traded by voice or electronically, within 15 minutes of execution.
Between the second quarter of 2010 and the same period in 2011, overall corporate bond volumes recorded on TRACE remained more or less flat. Yet, over the same period, the total volume on the MarketAxess platform – which represents the majority of corporate bond e-trading in the US – increased approximately 35%. In Europe, where there is no consolidated trade tape, these trends are harder to measure. Indeed, one of the stated goals of MiFID II is to introduce a trade tape of this kind to help bring a similar level of transparency to the European markets.
US Treasury market automation
The Treasury markets are much more liquid than corporate bond markets. Tabb Group estimates that just over three-quarters of client-to-dealer, on-the-run Treasury tickets are electronic. In his February 2011 report, Treasury Trading 2011: Automating the Yield Curve, Tabb Group’s Adam Sussman examines how Dodd-Frank is likely to further increase automation in these markets. In the Treasury markets, he argues, the shift is likely to be towards more algorithmic trading, with “the derivatives section of Dodd-Frank having a knock-on effect in the underlying cash markets”. He adds: “A large percentage of interest rate swaps are going to be centrally cleared and traded on a SEF – does anyone doubt that this will impact the Treasury market?”.
It is unlikely we will see algorithmic trading even in the most liquid corporate bond markets for some time, but the same principle may apply. Even absent a direct regulatory requirement for cash bonds to be traded electronically, the credit crisis of 2008 and the regulations it has trigged are likely to shift the momentum in those markets.
Changes to the dealer trading model
One outcome of the regulators’ desire to address systemic issues that led to the collapse of parts of the banking system in 2008 is the more onerous capital requirements, particularly for larger banks. As capital requirements grow and balance sheet capacity shrinks, dealers tend to hold less inventory on their balance sheets. Prior to the credit crisis, US primary dealers held approximately $220 billion in corporate bond inventory for market-making. Today that aggregate inventory total stands at about $70 billion, down almost 70%. Part of the reduction in capital from large dealers has been offset by an increase in capital by regional dealers and new market-making firms. Investors need to access more dealers to source their liquidity needs and many of them are finding that electronic trading is the most efficient way to expand trading counterparties. Prior to the credit crisis, MarketAxess had approximately 35 market-making dealers on its platform. Today there are 81 dealers providing liquidity across the full spectrum of credit bond markets. On the back of increases in capital requirements, dealers and banks are looking for ways to reduce costs. Bolstering dealer returns in the new regulatory environment will depend on increasing trading turnover and reducing trading costs. Given this new dealer paradigm, it is not surprising to see an increase in focus on e-trading venues that offer broad client connectivity and lower trading costs. The accelerating growth of electronic market share is being driven by investor and dealer demand for more open and more efficient credit trading.
Transaction cost analysis
In asset classes other than corporate bonds, such as equities, it is possible to use highly sophisticated data to measure the cost of transactions. By this means it is possible to demonstrate that the introduction of a broader group of market participants through electronic trading venues has created better pricing through enhanced liquidity. Transaction cost analysis is a key requirement in today’s equity markets for investors to prove they have achieved best execution and satisfied their fiduciary duty. In less liquid markets such as bonds, measuring transaction costs in an accurate way is more challenging. With a greater portion of the overall market now traded electronically, however, and with the benchmark offered by the TRACE consolidated tape, today we have much more substantial data with which to measure transaction costs in the corporate bond markets.
MarketAxess’s research team has developed a new methodology to do just that. We have undertaken extensive studies on behalf of investor clients to help them identify how they may reduce their execution costs, and have quantified the economically significant cost savings achieved by electronic trading in the corporate bond markets.
The research clearly identifies that, in these more fragmented markets, execution cost savings result from reaching a broader group of dealers to access a deeper pool of liquidity with increased price competition. In practice, this can only be achieved through electronic execution given the ease of engaging a larger number of trading counterparties using an electronic platform, relative to the number that can be reached using the phone. The extent of the cost savings is significant and, over the long term, can also be shown to result in a material increase in portfolio returns.
Market forces triggered by the credit crisis and accelerated by the incoming regulation have affected the full spectrum of market participants. Large dealers are fundamentally shifting their business models to remain profitable with new regulatory requirements on capital and transparency. New dealers have entered the markets to fill the void created by reduced balance sheets among large dealers. As a result, investors are now sourcing liquidity from a broader pool of market-makers, due to the efficiencies provided by electronic trading. Thanks to the levels of transparency already available today in the corporate bond markets, these efficiencies can now be accurately quantified to validate the benefits to be gained from greater electronic execution. Market forces seem to be moving electronic trading forward well in advance of the implementation dates for many of the new financial market regulations.