The Evolution Of Fixed Income

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With Lee Sanders, Head of Execution FX and UK and Asian Fixed Income Trading, AXA IM
Regulation is an increasingly important and dominant part of the trading world. New regulatory requirements dealing with transparency around fixed income markets are going to be hard to prepare for. The pre-trade transparency side of MiFID II and then the post-trade side will provide the fixed income world with considerable challenges.
Liquidity remains a principal concern. The first two months of this year have been some of the hardest since 2008 in terms of sourcing liquidity and that’s before the new regulation comes into force. The delay to MiFID II gives the industry longer to prepare for these changes, but as the deadline draws nearer and nearer, we are thinking more and more about how we will have to adapt to the way we trade.
Buy-side mind set change
In terms of a longer frame of reference for the evolution of fixed income trading on the buy-side, a few years ago I was speaking with a market practitioner who said that we should hire some equity traders in fixed income trading to better deal with the changing market structure, and at times I can see how we have moved in that direction in terms of trading and market structure. There are a variety of metrics examining what we do, but one of them, which is outstandingly clear, is that fixed income orders are fragmenting in a meaningful way.
It is hard to find the balance sheet to take down orders so there are two choices with regard to the way we trade: either break the order down and try to find the aggregated liquidity or work it as an order. The banks don’t want to take balance sheet risk. They would rather bypass that risk if they can and act more like agents.
What is clear to us is that more of the inventory sits with the buy-side hence it might be worthwhile if the buy-side traded more with the buy-side. However, there still seems to be a reluctance from the buy-side to trade with one another even in the dark or on platforms. In addition, the buy-side is more aggressive on pricing in the dark than with their more established liquidity providers. The buy-side views other buy-side firms as competition and are less likely to want to leave anything on the table.
The buy-side will never be pure market makers as that is not the business we are in. However, there could be a change to the extent that the buy-side become a price maker and this is the direction the industry should be heading towards. The development of bond trading means that there is nothing wrong with orders coming in from the fund manager and our posting them on an aggregated liquidity environment and staying firm on that price. The investment bank model is changing which could be a good thing for market structure. Regulation and capital constraints are helping to facilitate that and it is all key to the industry’s continued evolution and development.
Next developments
Risk is effectively ‘warehoused’ when firms all move in the same direction, so the firms that may do well could be ‘contrarians’ – those who make prices and decisions opposing the direction of flow. However, it is difficult to see this method being effective given the size of the books being moved around by the largest asset managers in Europe.
The next wave of development could come from those contrarian investors and opportunistic liquidity providers as they come into trading platforms and put their liquidity on systems for traders to find. Certain banks are reinventing their business model into a more hybrid agency model, but they could also be called opportunistic liquidity providers. This model allows them to potentially take advantage of market conditions with a more prohibitive bid offer spread.
More patience is required by the buy-side; if fund managers have time orders can be worked to completion at the market level but this may be compromised if time is an issue.
There are many different definitions of liquidity and price, immediacy, bid offer spread etc are key but one I like to use is that liquidity is the confidence that we will be able to sell something which we bought at a fair price at a given point in the future. Other areas of interest are transaction cost analysis and liquidity points. There are some excellent pieces of work around optimum trading times being prepared by think tanks.
Another key development is the change to our management style relating to how the industry manages fixed income. We still have active portfolios but there has been an emergence of buy and maintain products, and short duration products.
One of the metrics which we use to show liquidity is our trades fully executed on the day. As an example, if liquidity were poor, we could say that a figure below 50% of trades completed on the day would illustrate that liquidity was poor – and we have never been below 92%. But AXA IM is an established asset manager and does have an advantage. Most banks have been discussing the 80/20 breakdown where around 80% of revenue comes from 20% of the client base. Increased regulation could cut that tail away as banks could simply stop servicing those smaller clients therefore smaller asset managers could be at a huge competitive disadvantage come January 2018 – no one will want to send liquidity their way because of the new transparency regimes.
Sell-side rationalisation
The rationalisation taking place across most of the banking sector could be perceived as positive. Banks that want to be everything to everyone in every market are likely to experience problems with that model. But fundamentally MiFID II is at the forefront of everyone’s mind. It frames all those other things which take place day-to-day; the liquidity conversation, the research conversation, the market structure conversation etc – it all comes back to MiFID II.
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