Electronic Debt Trading: Back to the Future
By: Philip D. Wright
The Canadian investment community can draw on the experiences in the United States and Europe as it embraces the electrification of financial markets and debt markets in particular, says Philip D. Wright, of CanDeal.
The introduction of alternative trading systems (ATS) to the financial markets has re-opened debate among market participants about the structure of markets and the benefits that these new technologies can deliver. This is a healthy process because in achieving clarity of understanding we reflect on the fundamentals that form the basis of each market.
Globally, secondary trading of debt securities has taken a path that differs from trading equities, futures, and foreign exchange. Why is this? There are a number of market characteristics that contribute to how any market evolves:
- number and proximity of participants
- volume traded
- range and complexity of the instrument traded
- objectives and trading patterns of the investor
Comparing the equity and debt markets in the context of these elements reveals some important differences.
Equity markets evolved from a centralized structure necessitated by access to financial capital and the ability to settle trades efficiently. Conversely, modern debt markets evolved as a decentralized structure connected by an electronic conduit and without the existence of an order book.
Dollar volumes traded in the equity exchanges are dwarfed by the volumes traded in the debt markets.
Equity markets trade a limited number of products that are relatively generic in their characteristics – most trading is in common and preferred shares. By comparison, the debt markets include a very broad range of securities with each group having its own unique characteristics and cash flows.
Debt obligations are subject to the terms and conditions of the original trust indenture which stipulates the size and timing of cash flows, embedded optionality, and prescribed covenants. As such, the complexity of many fixed income products calls for a specialized knowledge of the products and the market. Retail investors who trade stocks will frequently defer management of their fixed income exposure to mutual funds or indirectly outsource it through pension funds, insurance companies, savings bonds, or bank deposits. Conversely, equity markets have a broad spectrum of participants that number in the millions.
Equity investors often have a shorter term trading horizon than fixed income investors who may buy and hold a security until maturity. Passive fixed income investors will respond to an event shock in the market when it happens. The resulting move by investors can often be simultaneous and in the same direction. Conversely, equity markets have a large number of participants moving in opposing directions which helps to offset the move.
The most obvious consequence of these differences is that equity markets evolved as a single ‘place’ where traders could gather and the debt markets have remained largely decentralized because of the broad range of products traded and the regional origination process that exists in some markets. Technology is having an impact. It is expanding the reach and range of the equity exchanges while simultaneously pulling the debt markets closer together.
The most important characteristic in determining an appropriate trade protocol for a given market is the inherent presence of liquidity. Significant liquidity, or lack of it, will dictate the most effective means of ‘clearing the market’ and maximizing market efficiency. If a market is centralized and has a large number of participants that trade commoditized instruments and display an uncorrelated trading pattern, then the market lends itself to an order book matching mechanism – for every bid there is simultaneously an opposing offer to clear the market. This is seen in the equity and futures markets where the instrument being traded is relatively generic and there is the presence of limit orders. Conversely, in the debt and foreign exchange markets there is not a centralized location for an order book and the trading direction of the market participants is highly correlated in one direction – often participants are simultaneously buyers or sellers. This creates the need for a ‘liquidity provider’ to put their capital at risk and take the other side of an investor’s trade to preserve market efficiency. This raises the issue of the roles of participants in the market and how they interrelate.
Investment dealers act in two capacities. They underwrite securities issued by their borrower clients for primary distribution to their investing clients and they act as a liquidity provider for their investing clients in the secondary market. This dual role forms the basis for a mutually beneficial relationship between investment dealer, borrower, and institutional investor.
Institutional investors, acting in their clients’ best interest, are typically mandated to ‘take’ liquidity from the market – not provide it. In taking liquidity, they may indirectly create a source of liquidity for the investment dealers by providing an offset to an existing inventory position or by facilitating placement of a primary distribution. Institutional investors value highly the liquidity that investment dealers provide to them and they may develop strong personal relationships with their coverage through daily contact.
Inter Dealer Brokers (IDB) provide a venue for dealers to lay-off their risk among their competitors without being seen in the market. Once an investment dealer assumes a client’s position they look for an opportunity to offset the risk. The dealers’ need for an offset spurred the creation of the IDB market in the 1970s. As such, the inter-dealer broker has had an important and often personal relationship with their trader clients.
The role of each market participant in the debt market and the benefit of their relationship with other participants have evolved over the long term. Attempts to innovate in a manner that disintermediates one participant from another have typically failed because they did not address the underlying need of the intended user to preserve their valued relationships. Conversely, innovations that have preserved the traditional relationship model while automating the process have met with the broadest market acceptance.
One indirect benefit of the IDBs is that their market screens have provided investment dealers with a source of price transparency that only recently has become available to investors. One of the criticisms of the IDB displays as a source of transparency for institutional investors is they seldom provide complete, current, or twosided views of the entire market; nor do they necessarily represent what can be achieved by an investor for their exact requirement. As well, they are vulnerable to ‘gamesmanship’ on the part of a single dealer. These issues were addressed in part with the introduction of commingled multi- IDB price displays in the 1980s, but evolution has introduced a new solution. The most recent innovation came in 1998 with the introduction of ‘indicative pricing’ in the U.S. Treasury market. This model of transparency gathers prices directly from a number of dealers and publishes the best indicated bid and offer price in a commingled display. This creates a complete two-sided view of how the dealers as a community are currently valuing each government security in their own books. The price displayed is suggestive of the ‘inside’ market and is much less vulnerable to influence by a single dealer. The actual price an investor receives is a function of how they choose to execute a trade, the liquidity of the security, and the size of the transaction.
There are three basic trading models used by ATSs in the debt markets. The simplest and most flexible is the ‘Inventory’ model, which allows a dealer to electronically publish their inventory in whole or in part to their clients. It is most similar to printing an offering sheet but it can be updated in real-time. It can accommodate the widest range of securities. However, it is typically used by a single dealer as a proprietary conduit to distribute their second tier prices to external clients. Institutional investors have demonstrated a preference for the larger liquidity pool and competitive trading protocols that are offered by multidealer systems.
The second oldest protocol is the ‘posted price’ or IDB model. It allows participants to post dealing prices on a screen for a specific size that can then be aggressed by another market participant. It is burdensome for the ‘poster’ because they assume market risk by displaying live prices in a dynamic market environment for the benefit of a counterparty that is yet unknown. For these reasons, the IDB model has enjoyed the broadest acceptance in the dealer-to-dealer market where traders have specific short term objectives and the knowledge that they are dealing exclusively with competitors and not their clients.
In the electronic debt market space, the most successful trading protocol to date has been the Request For Quote (RFQ) model. This is a multi-dealer-to-client model that simulates much of what investors currently do using the telephone. All participants are part of a network. All trades are between the dealer and investor using an electronic conduit – the same as transacting with a telephone. Participants in the network have a prescribed role as either price taker or liquidity provider, but not both. The RFQ model preserves existing relationships and trading practices, and allows investors to achieve their objectives in a neutral dealing environment. It may be used as a compliment to telephone trading or on a stand alone basis. It differs from the telephone in that inquiries can be directed to multiple dealers simultaneously rather than sequentially. The net effect is to create a controlled and competitive dealing environment that is governed by the client’s specific terms and trade size. Trade practices are defined by the programmed trading rules of the ATS and are consistently applied to all users. The RFQ trading protocol allows for due diligence in the price discovery process, superior and unambiguous recordkeeping, and post-trade processing of trades.
The Canadian debt markets are undergoing changes in response to developments in other G10 capital markets and the positive experiences those markets have had applying technology to trading. Since 1998, it has become clear that there is a role for the electrification of financial markets and the debt markets in particular. Technology has been successfully applied to the equity markets, foreign exchange and futures markets, and the international debt markets. We now have a body of experience in the United States and Europe that the Canadian investment community can reference in moving forward. One thing is clear; this will be an incremental process that evolves over time in response to the needs and participation of the broader investment community. Canada is a few years behind the U.S. and Europe in developing our own electronic market solutions but we are making gains that are consistent with the exponential growth experienced in those markets only a few years ago.
Philip D. Wright is vice-president, director of sales and marketing, for CanDeal.
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