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The electronic trading revolution


Front Capital Systems, a provider of real time trading technology and related services, has recently launched a fixed income trading platform offering connectivity to electronic bond and derivatives markets, with analytics and risk management. Here, Front's Andreas Thatcher and John Mooren* outline their views on the way fixed income trading is transforming and how that development differs from the equity markets...

We are witnessing a revolution in the fixed income markets. The rapid migration of telephone based fixed income trading to electronic marketplaces is developing at three different levels: voice brokers are turning into electronic platforms such as eSpeed and ETC (electronic-only brokers are also growing, such as Brokertec); inter-dealer trading is moving to exchanges including MTS, Eurex Bonds, SWX; and, albeit slowly, customer flow is moving to the web, to platforms such as TradeWeb, BondVision and to single bank web sites. This trend is dictating the way fixed income markets are traded and is increasing demands on the technology.

The main consequence of the electronic trading revolution is greater efficiency. This arises in a number of ways. For the buy side, electronic order entry and trade confirmation, transparent prices, centralised counter parties and the potential for cheaper clearing can all enhance market efficiency. On the wholesaler side, these benefits can be complemented by automating the dealing, funding and hedging process, allowing current businesses to handle more trade flow. These advantages can enhance profits directly by lowering operational costs and reducing capital charges.

This movement of markets into electronic media is accelerating. Trading volumes are increasing, and electronic markets are consuming, or threatening to consume, almost all asset classes. Fixed income traders already have bonds, futures, repos, loans, deposit, and fx markets available electronically.

The pace of these changes has left dealers with quite a challenge. They have already invested in pricing and risk management systems and quoting engines. Now they must incorporate typically three to five electronic marketplaces for a range of products, from bonds to futures. Each of these markets requires integration and an order entry and quoting tool, typically supplied by the market. This proliferation of front-end systems not only crowds the traders' computers screens, but brings the resulting 'IT Spaghetti' to boiling point. How can banks achieve straight-through-processing and automated processes when each step is built, implemented and managed separately?

Yet, the pressure to automate the process is severe. Traders and their clients expect electronic execution to be faster than it ever was. Customers want speed and transparency when trading, and banks are trying to make their client relationships more efficient. At the same time, banks want to leave their trading options open, with links to as many platforms as possible.

Cleaning up the spaghetti can be solved with current technology. However, there is a further consideration to be made.

Uncertainty prevails as the markets develop
Revolutionary change creates uncertainty. Although the nascent fixed income electronic marketplaces are already established, the high number and variety of exchanges suggest that numerous growing pains are still in store. There is some suggestion that the development of the equity markets, aside from being partly responsible for the pace of early development of the fixed income markets, can provide some kind roadmap for the future. However there are a number of ways in which the new markets are likely to diverge. Among questions that are still outstanding:

A. With the complexity of interest based products requiring more analytical tools when trading, can market-making and connectivity technology be adapted, or will a new breed of trading platform emerge?

B. Can exchanges handle the proliferation of instruments in the interest rate world and will instruments conform to find liquidity on exchange?

C. Will the brokers, who have quickly adapted to the electronic conditions, survive or will they be driven out by the search for cheaper and more efficient clearing methods?

D. Will the fixed income 'pricing model', based on bid-offer spreads, make way for the commission model prevalent in the equity markets?

E. As bonds are inter-listed among markets, will consolidation create "super" exchanges, or will exchanges differentiate by incorporating other asset classes?

Waiting for these questions to be resolved means missing the opportunities fixed income revolution provides. How can a business invest in this uncertainty?

The biggest global banks have already started to invest, mostly due to the opportunity cost of not investing early and giving up market share. This provides an advantage to these players and is likely to lead to the further development of exchanges and ECNs, but does little to further the operations of smaller banks and the resulting market liquidity.

A number of software entrepreneurs have stepped in by developing front-end tools to reduce the temperature of the IT spaghetti. These solutions typically are restricted to connectivity to electronic markets. Many of the solutions are, like the markets themselves, transported equity functionality. The difficulties here are the unique features of the new fixed income markets: multi-market quoting of the same instrument, the greater analytical demands in pricing and hedging fixed income instruments, and the need to quote in multiple formats, including price, yield, and spreads.

Moreover, these connectivity tools are typically restricted to particular markets and their instruments, allowing banks to quote and trade, but not to hedge or to fund their positions. Also, they still leave the greatest pain for all banks: the costly inefficiencies of disparate pricing, order management, trading and risk management systems.

The reason for the continued hesitation is clear. Changing a front-end trading tool is much cheaper and less intrusive than replacing an entire pricing, quoting and trading infrastructure every time the trading tool is superseded. Clearly the uncertainty in these markets is considered enough of a risk to let the IT spaghetti boil and to forego large productivity gains. This need not be so.

Uncertainty does not necessarily create risk
Just as the development in the fixed income markets has been technological, we should look to technology for the solution. In this case, banks investing in market making or electronic trading tools for fixed income markets should prize versatility, which in effect is avoiding the issues mentioned above altogether.

First, any trading tool should be exchange independent, in fact aggregating multi-listings. This will prevent banks from having to take a view on consolidation in the industry and on the future pools of liquidity. By being both market independent and an aggregator, banks will have access to more liquidity than the individual markets themselves.

Second, the trading infrastructure must be able to handle a wide range of instruments, both in pricing and execution. Integrated businesses may be quoting and hedging instruments other than bonds. These include swaps, futures, repos, equities, foreign exchange and commodities. Some brokers and some traders argue that illiquid or complex products can only be traded over the telephone. In fact, every type of product can be traded easily and efficiently electronically. The difference between liquid and illiquid and vanilla and complex products is the degree of interaction that has to take place between the buyer and seller. Illiquid and complex products often need to be defined before they are traded, but this negotiation can happen electronically. The system should be prepared to price, quote and trade any instrument.

Third, the same technology should be able to (and banks must be prepared to) automate the entire process of pricing, execution, and market making. Automation will allow traders to handle more deal flow, to take advantage of opportunities through arbitrage, and to attain straight-through-processing (STP). STP will be an inevitable consequence of markets moving on-screen; the advent of electronic fixed income trading has shown many institutions just how far they are from seamless transactions.

Fixed income electronic markets offer productivity gains for banks and the chance to improve profits in a continuously lower margin business. However, the current environment is full of uncertainty, preventing banks from achieving key efficiencies such as market aggregation, cross asset capabilities and STP. But with flexible enough systems, banks can invest in and benefit from electronic markets without assuming the risks.

John Mooren is product manager for fixed income and joined Front from HypoVereinsbank in 1999.

Andreas Thatcher is sales executive for fixed income and joined Front in 1998. He worked previously for FNX and prior to that at CIBC running their structured products desk.




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