Does electronic trading actually suit fixed-income markets? Or has onerous post-crisis regulation strangled liquidity and forced the market to come up with a sub-optimal solution? The telephone might feel old-fashioned these days, but it remains effective.
The Great Gatsby, Bonfire of the Vanities, Liar’s Poker. Three books written in the 20th century that placed bond markets at the centre of a web of greed, conceit and intrigue. None of them have happy endings. But that’s not why I brought them up. This blog is categorically not going to be a lecture about morality on Wall Street. I am less interested in the whys and wherefores of bond markets, than the how. Specifically, how bonds are traded.
And very little has changed in how bonds have been traded since F. Scott Fitzgerald’s time. Until very recently, the vast majority of bonds were traded in the same way as The Great Gatsby’s narrator, Nick Carraway, traded them in 1920s New York – two individuals shouting down a telephone at one another. The same as Tom Wolfe’s lead protagonist – the uber-WASP Sherman McCoy – traded them in Bonfire of the Vanities, and the same way Michael Lewis traded them (in real life) at Salomon Brothers in the 1980s.
Technology has taken a long time to catch up with bond markets. Equities went electric after the ‘Big Bang’ in 1986 and, since that time, the sheer complexity of the algorithms used to trade company shares, and the speed with which they are traded, has transformed markets. This simply has not been the case with fixed income.
Most bond traders will tell you that electronic trading might well suit the equity markets – which are highly liquid and with a total universe of about 40,000 stocks – but does not suit bond markets, which comprise many millions of different bonds – each with their own unique characteristics. In addition, debt tends to trade in enormous chunks worth many millions of dollars. It is almost impossible to strip out human contact when attempting to make a market with deals of this size.
That was until the last couple of years. The $50 trillion global fixed income market is finally going electronic. But after all these years, why now? It’s a combination of factors. The first of which is the onerous regulation foisted on bank-trading desks in the wake of the financial crisis. To cut a long regulation story short: in the name of openness and transparency – regulators have made it much, much harder for banks to trade bonds with one another.
This has severely reduced liquidity in the market - as fewer participants are offering fewer bonds at fewer prices - and, as a consequence, the risk of catastrophic intra-day falls in the price of bonds has increased. Not just corporate bonds but (supposedly risk-free) government bonds too.
Electronic trading is seen as one way of increasing liquidity by replacing traditional trading desks with a cheap and efficient infrastructure with which to match buyers to sellers. The jury is out as to whether this will really be the case - especially when markets panic - but the electrification of the market has gone on apace. In particular for smaller trades. According to research firm Greenwich Associates, quoted in the FT in May, a fifth of all investment-grade US corporate bond trades are now done electronically — almost double the volume of a decade ago.
But with electronic trading, comes risk. Some fear it can lead to massive intraday volatility in the price of bonds, leading to ‘flash crashes’ in the price of even the safest investments. As was, infamously, the case with US Treasuries in October 2014. Others complain that it does not improve liquidity at all and that – besides – e-trading only really works on smaller deals of a few million dollars or less. Much better just to roll back those onerous regulations and let bank’s bond-trading desks do what they’ve always done – lubricate trade and ensure liquidity whatever the financial weather. Why create a complex, expensive and potentially unreliable algorithm when you could just pick up the phone instead?
We’ll be discussing these issues, and much more, at our Executive Briefing on Electronic Bond Trading on 20th June in Central London. More details here.