By Cathy Gibson, Director and UK Head of FI Trading, Deutsche Asset Management
MiFID II is reshaping the bond trading landscape, imposing more transparency and tighter monitoring of the order execution process, but it is also a catalyst for technological innovation that the buy-side is keen to apply.
New regulatory instructions and guidelines are having a major effect not just on operational models, but on the development and application of new technologies to fixed income trading. The industry probably under-estimated the catalytic impact of Markets in Financial Instruments Directive (MiFID) I to equities trading in 2007, but the technological response to MiFID II has been immediate and the potential for major changes recognised.
There is a subtle, but important shift in definition of “best execution” contained within the European Union’s MiFID II compared with MiFID I from a commitment to take all reasonable steps to obtain best execution to taking all sufficient steps to obtain to best execution.
However, in practical terms, it won’t affect the trading processes already being implemented at Deutsche Asset Management. The more significant effects will be on the monitoring, testing and verification of trades, which will create a considerable administrative burden on the buy-side by increasing the amount of documentation it needs to compile and record.
Many investment firms are applying the transaction cost analysis (TCA) methodology used for equity trades to their fixed income operations – including Deutsche Asset Management. TCA is not required as proof of best execution under MiFID II, but among other things it is good way of capturing live market data at the point of execution. Ultimately, TCA in fixed income is and will remain below the quality of the equity offering because there is no consolidated type in fixed income. This is a significant information gap for a large sector of the fixed income market.
The European Securities and Markets Authority (ESMA) paper, published in April 2017, emphasises that firms should aim to achieve best execution, although it recognises that the intention will not always be attained on every occasion. Instead, we must institute a process that that can reasonably achieve best execution on an on-going basis, rather than obtain the best possible results on every single occasion. The key will be the ability to demonstrate and document the best execution process and show it can be monitored, assessed and rectified should any weakness be identified.
In addition, TCA and its variations do not just apply to trade execution: they are applicable along the whole investment process, including pre-trade price discovery, communication with portfolio managers, inventory checks and post-trade settlement and confirmation.
However, sometimes the focus is too much on the challenges the legislation imposes rather than the benefits. There will be an increased level of transparency for those bonds deemed to be liquid and increased visibility to our clients on exactly how best execution is achieved and monitored. Also, the increased data the regulators will receive will allow them to more closely monitor for market abuse, which is a positive for all market participants.
Regulation spurs technological innovation
Necessity is a great innovator and the changes in liquidity and market structure that recent and upcoming regulation has created has led to an explosion of Fintech innovation and the provision of an abundance of sophisticated and valuable services and products offered by third-party vendors as well as within buy- and sell-side firms.
It is essential to keep abreast of Fintech initiatives and what they can offer to enhance the fixed income trading process. The order delivery process is changing across all stages, with real-time information updates and higher quality data. Clearly, there is a trend towards more efficiency and accuracy that will further enhance trade execution for fixed income securities.
Some firms, such as Deutsche Asset Management, have already adopted new technology after carefully assessing their potential value. For instance, we now have higher quality pre-trade price and inventory discovery. We utilize open-trading platforms that give us the capacity to act as a price-maker, where we post selective axes and positions, and all participants enjoy access to rich sources of data.
We also use matching pools that enable us to trade with other market participations, achieving execution prices inside the bid-offer spread and it allowing us to trade leaving a minimal foot print in the market.
Trading in this way has the advantage of directly tapping liquidity, but it means that we must be especially vigilant and transparent about ensuring best execution processes are followed.
Buy-side takes the initiative
Buy-side bond traders are becoming ever more proactive about what they actually need from vendors and sell-side technology.
They regularly advocate their interests and communicate their requirements at conferences and through formal channels, for example to ESMA via the International Capital Markets Association . At Deutsche Asset Management, we believe in taking the initiative and help drive innovations and creative solutions to the challenges we face every day. Given that the vast majority of bonds now reside on end clients’ balance sheets and not with market makers it is a necessity to invest our time and resources in this space.
We have a constant dialogue with sell-side counterparties and Fintech companies, sharing concerns but also expressing our different motivations and objectives. Most especially, the buy-side wants ample liquidity, competitive pricing and non-volatile markets.
These demands sometimes conflict with sell-side interests where balance sheet constraints can take precedence over maintaining consistent, fully-functioning markets. It is therefore vital that we partner with our key sell-side counterparties to ensure their limited balance sheet is available.
There has been a behaviour change in the market, one that evolves working more closely and transparently to achieve an outcome that is ultimately in our client’s best interest.
The best platforms have fast, efficient search engines that contain high quality, timely data. These venues are especially suitable for illiquid bonds, and enable traders to reduce the time previously spent scouring the marketplace and also minimise the risk of triggering adverse price movements.
These are advantageous to all participants, allowing the sell-side to reduce their inventory and free up their balance sheet while allowing us to source the paper we need.
More can be done to make electronic trading more efficient and accurate. A consolidated tape, recording transactions and their timings from all the myriad venues would be ideal. However, at the moment we don’t have solution to the creation of a European consolidated type, so this is definitely a space ready for innovation.
Nevertheless, as much as 60% of trading in liquid, developed market rates and cash bonds is already conducted at electronic venues, on platforms such as MarketAxess (US dollars), Tradeweb (Euros) and Bloomberg. Dealers need to justify their choice of venues, which typically charge licensing fees or on a trade-by-trade basis.
There will be increased onus on the buy-side to justify their choice of trading venue where there is direct or indirect fee charged on a trade-by-trade basis, as this will be part of the best execution decision.
Electronification is an important and evolving trend, but in some spaces, such as off- the-run credit default swaps and less liquid bonds, such as high yield and emerging markets, they continue to trade in the traditional fashion – by voice.
The new trading desk tasks
The buy-side trader’s role has changed significantly during recent years, and it is continuing to evolve. The trader needs to have the ability to follow and interpret a plethora of regulations, as well as assimilate and exploit the rapid improvement in data volume with sophisticated analysis.
Quant expertise is being recruited to work as or with dealers, and their importance will grow. Moreover, the fruits of the analyses must be shared with portfolio managers in a meaningful way, which add a further layer of responsibility and expertise to the duties and skills of the trader.
In the new post-MiFID II world the problem will not be the lack of data, it will be how to mine and manage the amount of data to get markets intelligence that adds real value to the investment process.
Although fixed income trading is becoming more scientific – or at least increasingly dependent on technology – there is still a strong need for individual expertise and intuition based on experience and strong relationships. The art of trading is not dead. The rise of the quants and the application of more automation, especially for data collation, analysis and interpretation supplements rather than replaces human agency.
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