Best Execution In Fixed Income
With Gherardo Lenti Capoduri, Head of Market Hub, Banca IMI.
Italy introduced MiFID I on fixed income in 2007. As a result each Italian fixed income market started to compete against each other.
The choice available included two regulated markets (Borsa Italiana-MOT segment and MTS BondVision), four fixed income MTFs (ExtraMOT, Hi-MTF, EuroTLX e MTS BondVision Corporate) and 17 Systematic Internalisers. It is interesting to see how the Italian fixed income markets developed following this regulatory change. (See diagrams below)
These markets target either institutional size orders or retail size orders and within their respective spaces compete against each other by offering members:
- a different microstructure: all to all, quote driven, quote and order driven, auction, RFQ etc.
- different products: government bonds, corporate bonds, emerging market bonds, high yield, sovereign bonds, multi or single currency
- additional compliance related services: fact sheets on each instrument
Following the change in market structure brought about by MiFID I, brokers started to offer best execution in fixed income by adding Smart Order Routing to their fixed income execution policies and their market making desks started to access and capture flow available on several different markets. It is important to note that brokers have strived to offer clients access to both market-traded and OTC liquidity through very creative solutions, which aim at aggregating and normalising as much as possible these two very different sources of liquidity. In short, the core components of this fixed income model include:
- A Systematic Internaliser
- Market memberships
- OTC liquidity
- Sales support: Pre-trade and post-trade transparency: blended customised technology
On the market making side, investments were made in order to compete in a more transparent environment. Both the Hi-MTF and EuroTLX successes show that there is an appetite by market makers to provide liquidity on these markets. What is key is that in a structurally illiquid market such as fixed income, market structure caters to the specific needs of market makers. Hi-MTF is only quote driven: the orders hit the market maker’s bids and offers. EuroTLX is a hybrid quote and order driven microstructure where market makers have an obligation to be present on the book all day of a minimum size but enjoy a certain level of protection through the presence of anti-gaming rules.
“Following the change in market structure brought about by MiFID I, brokers started to offer best execution in fixed income by adding Smart Order Routing to their fixed income execution policies and their market making desks started to access and capture flow available on several different markets.”
Banca IMI launched Market Hub, its multi-asset electronic trading platform, in 2007. The asset classes available from the start were equities, fixed income and listed derivatives. FX was added in 2012. In fixed income, in addition to Banca IMI’s high touch service, it offers best execution and access to over 20,000 bonds by connecting to trading venues, OTC liquidity providers and offering additional liquidity on Banca IMI’s systematic internaliser Ret Lots Exchange.
MiFID II is expected to introduce many of the changes to the fixed income market structure already experienced in Italy, to the wider European market. Of course, it won’t be exactly the same and the market will not react in precisely the same way but the main “ingredients” are there. Looking at the financial services industry in London, what we have observed in Banca IMI over the last two years is a shift from an initial resistance to the regulatory changes proposed, to, more recently, some innovative solutions being thought of and, in some cases, rolled out. What is being rolled out is only the beginning: solutions range from brokers setting up their own market places, to brokers who clearly state the need to provide clients with aggregated rather than fragmented liquidity. In our view, the second approach is more interesting for clients, especially if combined with additional liquidity offered by the broker on its systematic internaliser.
The Systematic Internaliser (SI) allows the broker to provide liquidity to its clients, and flow that is not captured is routed to market venues through a smart order router. D2C venues tend to target either retail size orders or institutional size orders. In Europe the venues that Banca IMI monitors are the following:
- retail size: BME, Stuttgart, Deutsche Borse, Nyse EuroNEXT, Nasdaq OMX/Nordics, SIX Swiss Exchange, Hi-MTF, Borsa Italiana/MOT, EuroTLX.
- institutional size: Bloomberg, Tradeweb, MTS Bondvison, MarketAccess, Reuters TRFIT, NyseBondMatch.
We believe that the industry, once the resistance to change driven by regulation has been overcome, will find innovative ways to adapt. The fact that this change takes place in a business environment in which flow is not expected to increase and margins are expected to decrease, will add edge to the creativity required in order to balance these elements.
The shift from a mainly OTC trading environment to a mainly regulated markets trading environment can be compared to a “Copernican Revolution”. Overall it will introduce greater transparency and major changes such as CCP’s. However, we believe that just as planets continued to exist, so will the key components of fixed income flow within investments banks, which are: sales/information and traders/risk. What changes is the flow generation process. Regulation will force standardisation and this lends itself to industrialisation and automation of processes which have been labor intensive up until today.