Four years ago, in an office high above one of New York’s cab-choked downtown streets, an executive at a proprietary trading firm was explaining why he was fed up with central limit order books (Clobs).
He didn’t want to spend all day trying to make money by passing bonds back and forth with his peers – the future was bilateral trading.
“I can show a better price to a bank or a fund bilaterally than I can to an order book stuffed full of prop shops,” he said.
At the same time, participants in over-the-counter derivatives markets were still getting their heads around post-crisis rules that implicitly told them bilateral trading was the model of the past, and forced them to connect to Clobs.
Both perspectives have something going for them. A Clob is a great way to execute a large number of smallish trades, generating data the entire market can use when pricing. Bilateral execution makes a lot of sense when the trade is large, and the parties want to keep the information to themselves – moreover, liquidity providers in these large transactions will turn to the Clob when they need to hedge.
So it’s not a zero-sum game – there is room for both approaches to flourish.
But there are two additional points worth making. First, regulators on both sides of the Atlantic have shown a worrying propensity in recent years to take the choice out of the market’s hands: in the US, under Gary Gensler’s chairmanship, the Commodity Futures Trading Commission sought to dictate how swaps should trade.
In Europe, more recently, regulators have decided that dark pools undermine the democracy of the stock market – and are now scrutinising auction-based trading, which has grown since caps on dark pools were introduced this year.
Second, while choice is a good thing, too much choice may not be. Today’s US Treasury market now contains multiple platforms with differing trading protocols, as well as liquidity streams that can be accessed via bilateral connections or one of a number of aggregation venues. Some banks promise to help clients navigate this more effectively via agency algorithms that can be rented, and UBS has been experimenting this year with an approach based on the equity market concept of a central risk book.
Winners and losers will emerge from this melee. Market participants may be hoping that happens before liquidity fractures.