Taking stock in fixed income
Fixed income markets have historically been a bastion of high-touch trading, with manual processes, large tickets and little standardisation. But as recent years have seen inventory slashed and balance sheets cut in face of rising regulatory pressure, finding liquidity has become more of a challenge. Project Neptune, an initiative between a group of 30 large banks and asset managers, looks set to change that.
The project, which started in October, aims to create a standardised language and messaging system for fixed income based on FIX. Participants include Barclays, BNP Paribas, Credit Suisse, Goldman Sachs, JP Morgan, HSBC and Société Générale, together with asset managers Aviva Investors, Axa Investment Management, Nordea Investment Management and Standard Life Investments, among others. It is thought that the project will help everyone in the market, because it addresses two of the biggest problems in fixed income: the lack of inventory, and the lack of clear, concise information.
Inventory has become a key issue in fixed income over the last few years. The credit market is relatively illiquid and inventory-driven, and balance sheet constraints are much more heavily felt in credit bonds. Since 2008, the market has experienced balance sheet reductions and regulatory pressure. According to Sassan Danesh, chief executive at Etrading Software, a consultancy which manages Project Neptune together with the FIX Trading Community, this has increased the need to turn over the inventory held by market makers.
Participants in the fixed income markets have historically communicated through phone calls, email and the Bloomberg messaging system. But Danesh notes that these channels are very manual, ad hoc and unstructured – leading to difficulty for buy-side firms attempting to process all the information. Indeed, he recalls one head of trading who receives 30,000 emails a day from banks and brokers in the market, mostly seeking an indication of interest in a particular bond. With a deluge of emails and spreadsheets like that, buy-side firms are unable to respond efficiently.
“We want to standardise the dissemination of inventory information, so that at a pre-trade level it becomes much easier to work out who has the inventory needed to trade,” said Danesh. “One of the key elements of Project Neptune is that it aims to directly connect the buy-side to the market makers that have the inventory.”
Despite being envisioned as a means of communication, privacy is a key part of Project Neptune. Because the fixed income market is still very relationship-based and is expected to stay that way for the foreseeable future, it was decided that the new messaging standard must allow for any two counterparties to specifically agree the exact granularity of the information that will flow bilaterally between them, even though both are part of a shared network. This mirrors the current market structure, in which the sell-side is often guarded about the information it is willing to share.
However, there is more to it than that. It is also about the shift of the fixed income away from high-touch trading methods, towards a more low-touch model more in line with the post-crisis new normal found in other securities markets. “The whole fixed income markets are much less automated and much less electronic than other asset classes such as equities and there’s a reason for that,” added Danesh. “It’s because the products are much less standardised, the size of each trade is higher, ticket sizes are higher and there are fewer tickets. It’s been easier to justify a higher touch approach. But as that changes because to margin compression, everyone starts scrambling to see how we can streamline and move to a lower touch approach. That requires standardisation.
“A lot of the high touch nature of the pre-trade distribution was based around there being no standard for providing this information in a structured manner. We had spreadsheets, we had different mechanisms and of course the good old phone call, but all of these methods were different, all of them proprietary. However, there’s been such pressure on margins within the industry that the move away from high touch, high service and high cost models – there’s a big commercial driver to move away from that towards lower touch, more streamlined, more automated servicing of client needs. It’s a classic case where standardisation can drive down the costs and increase control.”
Tough calls needed to improve transparency
According to a Tabb Group report published earlier this year, fixed income will be characterised by regulatory deadlines and increasing electronification of the markets. Mandatory clearing of IRS is likely to start in the fourth quarter of 2015 for clearing members in Europe, while credit default swaps are expected in Q2 2016. In Japan, electronic trading of yen swaps is due to start from September 2015.
Tabb added that the US Treasury market has grown 70% since the end of 2008; the US corporate bond market is 45% larger and poised to have record issuance of $1.5 trillion in 2014; and as the Federal Reserve Board moves to raise rates, the subsequent exit from fixed income may prove to be “sloppy at best, devastating at worst”. Traditional liquidity providers may not be able or willing to provide the orderly withdrawal they have in the past.
Transparency is likely to become an increasingly important theme, as venues and market players seek to market services aimed at improving pre-trade information and efficiency. For example, in January the London Stock Exchange’s fixed income trading venue MTS launched an initiative with B2SCAN, an aggregator and search engine of bank inventory, runs and axes for the buy-side, to improve pre-trade information and efficiency for traders on MTS’s BondVision platform in Europe. The platform gives participants the choice of executing using a range of protocols, including request for quote, click-to-trade, as well as the option to trade via a sponsor bank in an order book. The idea is to help buy-side traders to identify a bank that is willing to buy or sell a particular bond, or list of bonds and then electronically execute their trades – a need symbolic of the challenge faced by market participants working in an increasingly fragmented environment where liquidity may be limited.
Meanwhile a separate report by consultancy GreySpark Partners notes that post-financial crisis regulations, particularly the Basel III accords, have shrunk the balance sheets of banks trading in the fixed income markets. As a result, banks are moving away from principal trading toward an agency trading model, and they are increasingly seeking balance sheet internalisation opportunities.
But from a technology perspective, there is no single vendor that covers all the technologies available for fixed income, so market participants are forced to pick and choose suppliers to cover their needs. Tough decisions will need to be made on functionality, connectivity, trading, pricing and risk management, sales-trading tools, e-commerce and client tools.
The lack of clarity in the fixed income markets has long been recognised as an issue. According to Bill Gartland, senior director of continuous evaluations at Interactive Data, technology firms have been wrestling with the problem since the early 1990s at least. At the time, Gartland was involved in creating a system that gave the dealers a way to put a set of ISINs into a table and send that table out via email. Then in the late 1990s and early 2000s, some firms had the idea of taking those emails and looking through for matches and extracting the pricing information. Not long afterwards, Bloomberg introduced scrapers for its own messages, Markit introduced a scraper, and it seemed as though the whole market was trying to extract information out of the unstructured data contained in the email traffic. But according to Gartland, this approach had its limits.
“The harvest rates for that information are good but not great,” he said. “You get a lot of duplicate information. If a dealer changes the format of his email ever so slightly you may miss a price or you miss a spread for a yield. It’s noisy data. If the industry could adopt a standard protocol, getting the information flowing consistently, then it means you’re not missing the best trade you could have made for your portfolio re-adjustment. Perhaps it was sitting right there in an email that didn’t get parsed, and you missed it.”
The appeal of Project Neptune to the FIX evangelists is that by using FIX, it should be possible to eliminate some of the complexity and risk from the fixed income market. Specifically, by getting rid of proprietary data formats for JP Morgan, Goldman Sachs, Barclays and others, all players in the market interact using the same language, helping to remove potential errors arising from incompatible data formats and human error.
The other significant advantage of the Project for its supporters is that it should help to boost investor confidence, which has been dented by the crisis of 2007-8. According to Gartland, having a plausible price to trade against is a vital component of getting participants to agree to trade, but prior to the project it was difficult to obtain the data to work out what the price should be. This was a particular problem for Interactive Data, which has always used batch processes for its end of day services, which involved collecting data about where assets were quoted and traded and offered and posting it at the end of each day. However, in recent years the company has updated its system to include real-time messaging, so that it can publish the information it collects to a Message Bus that downstream servers can pick up and subscribe to. The end purpose of all this is to create a benchmark pricing service for fixed income, which is published on a data feed. The idea is to create a reliable price benchmark for market participants to trade against. The prices are updated typically several times a minute. By standardising the communication infrastructure in the fixed income market, Project Neptune also makes defining a price significantly easier than it was previously.
“When you’re trying to build an electronic marketplace the first thing you need to be able to do is figure out who are the buyers and who are the sellers,” he said. “This problem has been gating the adoption of electronic trading. But the next problem is having a level where buyers are willing to buy and sellers are willing to sell. If you are a trader, in the old days you could see a quote came back on RFQ from Deutsche Bank or whoever else, and you could judge because you knew who sent you the quote. But these days, if it’s anonymous, who’s up there? Having that reference price helps with the regulatory impetus to give the public investor a reference price that they can use to justify trading, but it also helps the institutional investors who have fiduciary responsibilities, best execution requirements and increasingly those are being driven by regulation.”
Initially, Project Neptune is focusing on the credit markets only, and its buy-side focus is in Europe. However, Danesh at Etrading Software believes that the project has the potential to broaden its scope, both in terms of asset classes and in terms of geography. The illiquid end of the rates market, for example, shares many characteristics of the credit market. A move into cash rates and even derivatives such as single name credit default swaps, which share similar behaviour in terms of how they are traded, is a possibility. He also believes the project should be expanded around the globe. Furthermore, the project could also become a kind of embedded connectivity standard, around which third parties such as technology vendors can build further value-added services.
“I envision Project Neptune expanding into those asset classes that exhibit the same kind of inventory-driven trading behaviour that cash credit has,” said Danesh. “Positions and risk that have been warehouses can benefit from a standardised flow of information. This whole project is going to reduce costs, and as we help to turn unstructured data into structured data, everyone will reap the benefits.”