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Q3 2021 Buy-side Articles

Fragmentation in Fixed Income Markets

With Louise Drummond, Global Head of Investment Execution, Aberdeen Standard Investments

Please describe the profile of Aberdeen Standard Investments and its fixed income dealing desk.

Aberdeen Standard Investments is a global asset manager dedicated to creating long-term value for our clients. With over 1,000 investment professionals, we manage £456.9 billion* of assets worldwide and have clients in around 80 countries. (*as of 31 December 2020). We have a global presence supported by multi-location trading capability.

Fixed income dealing in the UK is split into two specialist teams. One team trades investment grade, high yield and all emerging market debt product; the other team covers derivatives and governments. In the US, we have one fixed income team covering all fixed income product, which  predominantly trades credit and high yield. There is a similar structure in place for dealing in Asia. We have a high-calibre global trading team with broad and diverse dealing experience. The team has traded throughout many challenging events and is well-placed to manage risk in difficult and volatile trading conditions. The structure provides local expertise with connectivity to liquidity provisions globally. 

How would you characterize fragmentation in fixed income markets – how did it come about and where does it stand currently?

Louise Drummond, Aberdeen Standard Investments

Fragmentation has always existed, but maybe more so now than historically due to regulation, monetary policy, Brexit and an increase in technology solutions. The latter is of particular interest to ASI, with technology having accelerated fragmentation when it comes to ways in which to access the market. Fragmentation also impacts the quality of data – specifically post-trade data – available to participants, and this continues to be an issue for the buy side and the market as a whole.

How do buy-side dealers navigate market fragmentation and still achieve best execution?

There are now numerous trading venues available and they vary in terms of liquidity, transaction costs, transparency, speed, number and size of participants. All of this has to be evaluated. As a leading global asset manager, we are well-placed to ensure that we are able to connect to those that  will enhance our ability to trade and access liquidity, while ensuring we do not invite more fragmentation onto the desk than is necessary. We are able to partner with venues that show innovation and so help drive the direction of this. In addition, our dealers are highly experienced specialists in their asset class, so are best placed to know when and where the liquidity can be accessed to ensure best execution, whether that be dark pools, a specific trading venue or our long-standing relationships with the market makers.

When it comes to helping the buy side navigate market fragmentation, what is the role of in-house resources versus external technology solutions providers?

The fragmentation in data as a result of the many avenues on which to trade will often cause issues for the buy side when navigating market fragmentation. At ASI we place a high value on ensuring our transactional data and the data we receive from external providers is properly collated and analysed in-house. Using this market information, we are able to clearly see patterns and evaluate trends, adapting our route to market accordingly; this blended approach works best for us and ensures that we are able to achieve best execution.

Our in-house teams also play a vital role in ensuring connectivity between our external platforms and order management system. Looking to the future, we expect them to play a pivotal role in enabling us to pull more data into our OMS so we have a single source of pricing and liquidity data.

What innovations (whether new technology, trading protocol, or other) are helping the buy-side navigate fragmentation in fixed income markets? 

The new primary issuance platforms that are in the process of being launched this year will allow the buy side to manage the new issue lifecycle more efficiently and free up dealers’ time to focus on more value-add activities. However, it is worth highlighting that there could still be fragmentation on the products that the platforms support initially, and the banks are yet to align behind a single solution. 

The range of trading protocols on-platform to access liquidity in different ways is changing rapidly with the request for two-way markets, packages for interest-rate swaps (IRS), credit portfolio trading, all-to-all trading and anonymous auctions (to name but a few!) seeing increased usage by the buy side.  

The level of automation incorporated within platforms is also increasing, and the next step is likely to be truly low-touch trading with the logic built into order and execution management systems. 

Distributed ledger technology (DLT) evolution is resulting in new solutions coming to the market, impacting the way in which data is shared and owned. In terms of transaction cost analysis (TCA), the provision of clean, accurate data has always been an issue due to the fragmentation of source, cost, and the need to balance the provision of timely data versus the commercial sensitivities of liquidity providers. Consolidated tape is getting more traction again and there are several consultations out at the moment, which it is key that the buy-side participate in so that our voice is heard, as it’s important to get the balance right. On large trades, or trades worked over several days, there needs to be an adequate time delay in the print to ensure that liquidity provisions are not compromised.

What specific regulation(s) are having or will have an impact on fragmentation in fixed income markets? 

The post-Brexit deadlock has shifted a significant proportion of over-the-counter derivative activity to swap execution facilities (SEF), which have been recognised as mutually equivalent venues by both UK and EU authorities since October 2017. In practice, this means that orders for both UK and EU funds can be routed to, and executed on, a SEF that will meet the derivatives trading obligation (DTO) requirements for each jurisdiction. This approach offers UK asset management firms the opportunity to collate orders and execute in a single venue, thereby removing fragmentation on multiple platforms, where relevant and/or appropriate. 

In addition, the overlapping DTO requirements have led to a reduction in available counterparties under certain circumstances. For example, despite several EU banks operating branch structures in London, they are restricted from trading on UK trading venues, even when facing non-EU clients. As a result, UK asset management firms’ UK-domiciled funds no longer have access to EU market-makers for instruments that need to be traded on a UK DTO recognised venue, for example Credit Default Swap (CDS) Index.

The EU’s CSDR Settlement Discipline Regime mandatory buy-in requirement will have an impact on liquidity and add to costs for investors, and could have a negative impact on market operations during stressed market conditions. We’re closely watching developments in this area and we are supporting the proposal that the mandatory buy-in rules will not be applied on 1st Feb 2022, when the relevant regulatory technical standard (RTS) is due to come into force.

Esma has acknowledged concerns in respect of order and execution management systems operating in a way similar to trading platforms operated by trading venues. This could also apply to other data providers and could lead to higher costs for the buy side in receiving data.

What does the future look like with regard to fragmentation in fixed income markets? Will there be more or less fragmentation, and will the buy-side be better at navigating fragmentation? 

There will always be some degree of fragmentation in fixed income markets, due to the structures of the different sub-asset classes and liquidity provisions. The key is to have a good trading desk with the relevant expertise to source both liquidity from different channels and reliable data that is easily available, to be able to build these into the decision-making process. To help prevent or navigate fragmentation, the buy side also needs to focus on more early engagement with regulators.