Fabien Orève, Global Head of Trading at Dexia Asset Management examines the changing strategy of multi-asset trading.
OTC is today, in Europe, around 25% of equity trading, but if you look at bond trading, it is mainly bilateral.Trading fixed income depends on the willingness and ability of market maker or counterparty to make a market in particular instruments and commit capital. In equities today investors can interact with a much wider range of liquidity pools and market participants than in bonds.
However, I think much more importantly there is an ongoing slow process of convergence emerging amongst the different asset classes, and I believe this convergence is driven by two things. First is technology, second is regulation.
First of all is obviously the growing presence of electronic trading. Beyond equities, electronic trading is very important in foreign-exchange and now, in bonds.
Smart order routing and algorithmic trading in European equities have significantly increased since MiFID. Many investors now split their orders, and splitting an order has become the main way to trade intraday. Either you do it yourselves from your desk or you trade it with the partnership of a high-touch desk.
If you look at the derivatives side, we trade lots of listed futures at Dexia Asset Management and we are now thinking about putting all of the small size orders into algorithms. It’s basically another aspect that is automating.
If you look at the OTC markets, they have embraced technology as well. There has been massive growth in electronic enquiries to ECNs or multi-dealer trading platforms in fixed income products. We’ve seen that for the small to medium size orders over the last few years. Another thing is market makers. Many large banks we work with have improved their pricing technology, all of these dynamic pricing algos that tighten bid-offer spreads, but mostly for the liquid instruments.
For the liquid instruments, execution costs are low today. In core Eurozone sovereign bonds, we can execute at a very cheap level now because it’s highly competitive, and we are able to detect the basis points of cost.
I can make similar comments in foreign exchange for the G10 currencies. All of the algo trading now used by banks helps tighten spreads gives faster quotes and it is much easier than before to trade.
In addition to ECNs in foreign exchange, there are now algorithmic tools that are available for us. We are not using them yet, but we’re thinking about using algo tools for clients who would like us to trade new order types, like limit orders, which are quite new in FX.
Foreign exchange used to be seen primarily as a hedge. Now we’re seeing that some portfolio managers invested in bonds think about Forex strategies to get more exposure on trading ideas and to generate alpha for their portfolios.
The second area that is really driving the convergence, I believe, is the new capital and leverage rules. All of these new regulatory models that are coming mean that banks and our counterparties have less capacity to carry inventory. This is a significant issue in bonds, but it’s true for equities as well and may alter our capacity to trade on principal.
In equities we have recently traded fewer blocks of full size orders. That means we are more likely to fill partially an order with a block then work the rest in a market. In bonds, we’re seeing the emergence of equity-like solutions, such as multilateral trading facilities (MTFs) that could help us trade more instruments.
The point is with the new MTFs in the bond space, traders have a very low chance to get fills for the full size of an order at the desired price; and that’s a problem. But, looking broadly at this situation, we may consider a strategy where we could find a cross for a part of our order in an MTF, and then we can get the order balance executed or facilitated by a dealer. This is clearly something that gets closer to the way we trade equities.
Being on the right side of the banks
To continue on that theme, with the risk of not getting as much liquidity from banks that we are used to, especially in bonds, we have to stay high on the bank’s client list. As an asset manager, we have a responsibility to ensure that our relationship is very good. We have to concentrate volumes on fewer counterparties.
“Today it’s important that we have enough tier one counterparties in equities, bonds, listed futures and foreign exchange to help us build long term relationships with them.”
We also have to make sure that our tier one list of brokers is spread throughout the various asset classes. Today it’s important that we have enough tier one counterparties in equities, bonds, listed futures and foreign exchange to help us build long term relationships with them. This relationship aspect is only one thing though. As a firm we also have to adapt to the new paradigm. In this context, our portfolio managers and traders have reacted in different ways to the changing trading environment.
I’ve seen my PMs using more derivatives to hedge positions, especially in bonds, which is one way to react to some liquidity problems. We’ve seen some of our teams on the investment side focus on the liquidity of their portfolio, and as a result they try to select instruments that they know will not cause trouble if there is a sharp movement in the market.
I’ve seen other clients making their trades smaller. Also our PMs are trying to improve communication with traders, and this goes straight into their instruction.
We have strengthened our multi-asset model, as now we are trading equities, bonds, foreign-exchange and listed futures on one single desk. That’s one thing.
Second, maybe a more interesting aspect of our capacity to react is that we have adapted our trading tactics. For example, we have tried talking to our PMs, to identify those who are of high conviction on a market and others that have a bit less conviction. For people who have high conviction, they have a very short view on the market and a strong idea of where the markets will go, so we have to focus our efforts on trading immediately; to try to find liquidity for the full size of the order.
But we have also identified clients that have a longer view on the market and they’re happy to leave us more flexibility, to work on their orders carefully. The effort of traders to understand clients’ needs is an answer to our new constraints.
In bonds the traditional model we use is a Request For Quote (RFQ) which means you get the order done at a price for the full size. Today, some of the PMs in bonds are happy to trade a portion of the order at one price and then to have a dialogue with traders for the order balance. Finally is an increasing use of Transaction Cost Analysis (TCA). All of these tools that we use to measure transaction costs are used to improve performance and improve our knowledge of clients. TCA has been much debated in equities, now is getting more momentum in fixed income and foreign exchange. All of these asset classes are now converging with equities in terms of post-trade analysis.
I faced a difficult situation recently while looking at my TCA reports. They showed a very small percentage of our European credit volume in a new MTF. I was surprised by the low number so I was trying to analyse the situation.
One of the reasons for our difficulty is simply technology. The tools we use today are not adapted to getting an efficient completion in this MTF. For example, if I want to be an aggressive liquidity taker in a market in bonds, if I have a one million nominal trade in a particular instrument and I’m seeing a firm offer on a trading platform coming from an MTF, but this offer is only for 300,000 Euros, I will not be able to lift that 300,000 and then manage the rest another way. That’s a problem. A further issue today is we cannot get full visibility of the MTF order book in our system, we have to either manually connect to a web site or rely on the broker’s team behind the MTF front-end over the phone.
This market has not been organised to fit the way we should work orders. It’s an OTC market, so it’s organised around OTC. OTC trading is crucial in fixed-income as there are many more instruments than in equities and we absolutely need market-makers in bonds. However, in certain circumstances, we need more flexibility in the secondary market and the current tools in the market today are not completely available to help buy-side trading desks navigate between MTFs and OTC efficiently.
I’ve been working with my IT team to find a way to split our order and lift or hit a bid-offer in the market for a portion of an order, and then to manage the rest with a market maker. There are still many things to develop in OMS-EMS technology today to fit this new paradigm that is emerging in bonds. You may argue that I can pick-up my phone and leave a full-size order with a broker or a maket maker and let them work the order. But I have to gain flexibility and add new bond tools, because there’s no way I will trade everything over the phone.
Now, we want to keep STP working very efficiently from equities to fixed income – cash & derivatives – and foreign exchange.
I’ve seen a lot of innovation and sophistication in the functionalities that are now available to the buy-side. For example, we have a decent range of tools to manage equities, but I think third party vendors or probably the industry as a whole are focused too much on this asset class where the available tools are very mature.
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I have many requests from my traders to get specific algos on our desk or particular direct access to electronic crossing networks etc. I try to limit this because I think we should get more things done in other asset classes. We have to work more on developing foreign exchange, especially our capacity to improve our transaction transparency in this asset class, and to get some important functionality in bonds that we don’t have today, instead of getting more sophisticated in equities. We have also to focus our system on its main functionalities to minimise the risk of big IT bugs. If your OMS crashes half an hour prior to the closing time it is a big problem.
It’s a matter of balance. You have to balance your technology across asset classes and not to allocate your full resources to cash equities at the expense of bonds, foreign exchange and derivatives.