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The Breakneck Speed of Fixed Income Market Structure Change

This article originally appeared on The TRADE News.

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One of the well-documented pandemic outcomes for bank trading desks was the accelerated pace of electronification in fixed income trading.

The move to a virtual environment required shifts in how liquidity was sourced for asset managers, how traders interacted with their colleagues and how the banks themselves interacted with clients.

The workflow gained precedence, as banks sought to connect risk, sales and trading functions. Optimal pricing, response times and execution quality became critical with the rise of alternative protocols, which encouraged buy-side firms to trade away from dealers and on electronic platforms. This was exemplified by the increase in all-to-all trading for investment grade (IG) corporate bonds, which increased by 50% in 2020 and accounted for 12% of all IG volumes, according to research from Coalition Greenwich.

Banks have responded by incorporating more of these protocols – namely portfolio trading – into their trading capabilities. But, is that enough?

The reality is the pace and impact of market structure change is increasing, even as traders return to the office. And banks must now accelerate the pace of their own technological evolution to keep pace.

Three drivers stand out:

Regulation: This has arguably been the biggest catalyst over the last decade. Regulation brought on higher standards of transparency and risk management, while also emphasizing open and equal access to liquidity. Dodd-Frank kicked off a massive deleveraging, which still continues. Capital constraints forced banks to sharply cut their bond inventory.

The combination of these requirements and best execution rules have upended the entire business model of bond trading – as we can see in the impact on liquidity.

Liquidity: Even with reduced inventories, banks had to find a way to fill their clients’ orders and maintain longstanding relationships. This required banks to connect with more platforms and liquidity providers.

In essence, banks have moved away from being principal dealers and now operate more like agency brokerages. The need for deeper connectivity, data exchange and workflow-driven activity means that trading systems are becoming more automated and digital.

Buy-side empowerment: We know that asset managers are trading more directly with one another via electronic platforms. They’ve enhanced their trading capabilities to reduce their reliance on dealers, improve their liquidity access and take more control of execution.

Asset managers have also doubled down on measuring and reducing trading costs. This has culminated in the uptake of multi-asset order management and execution management systems, as well as the use of aggregation tools that enable deeper transaction cost analysis. Sell-side desks that can quote competitively and swiftly – even with the limitations of deleveraging – will get the lion’s share of buy-side business.

How the banks are adapting – and how that is driving market structure change

Banks understand how critical technological innovation is to help them keep pace with market structure changes. But having witnessed the same development in equities trading a decade earlier, they also know that when electronification accelerates, competitive differentiators will dwindle.

The result: banks are increasing their trading technology spend but doing so in strategic ways that promote the development of new differentiators. This includes incorporating new venues and protocols and considering how to best use their proprietary capabilities in pricing and analytics – all while integrating with third-party capabilities.

What’s emerging at the major banks is a platform approach, where various tools are enlisted to leverage more data from multiple systems and drive workflows across the trading lifecycle. This approach gives banks the means to incorporate their own algorithms, pricing mechanisms and analytics, without skipping a beat.

Analytics are where banks can develop a true edge. In a challenging environment for liquidity and returns, analytics uncover opportunities and deliver greater clarity on when, where and how to trade. It’s no surprise then that more banks are deploying AI and machine learning to add even more power to their workflows.

Better analytics and automated, data-driven workflows will enable trading desks to allocate more resource to higher-value trades, especially those that aren’t suited for electronification.

Integrating proprietary analytics and pricing engines into workflow solutions will increase the quality of execution and continue to ensure that banks remain a formidable part of the fixed income landscape.

This threatens to create a gulf between the largest banks and superregional or regional banks, which don’t have the resources to build or integrate data-driven workflows at that scale. In response, smaller institutions will lean more on third parties to provide more end-to-end coverage, while focusing more on trading relationships.

Many experts have pointed to market structure evolution as an inevitability, albeit one that was supposed to take years to unfold. The pandemic, the explosion of electronification and emergence of new protocols in bond trading has accelerated this, making the response a priority for nearly every sell-side institution. We can expect to see a widescale shift in fixed income market structure in the next 12-24 months, with workflows and the platform approach becoming more of a staple for all participants.