August 10, 2016
Basel III has placed significant capital and leverage restrictions on banks, making it increasingly expensive for dealers to warehouse securities and forcing them to pull back from their traditional role as market-makers. As fixed income market structure has evolved in recent years, both clients and dealers need more efficient and cost effective ways of locating liquidity as well as more opportunities to utilise their assets. With the buy-side holding more and more fixed income securities, they are now positioned to help improve market liquidity and increase secondary turnover. However, just holding the assets is not enough – the buy-side need the appropriate technology, reach and skillset to move into a world where they are potentially competing with their traditional liquidity providers.
It’s worth noting, however, that buy-side investors are not becoming market makers in the traditional sense, by providing risk-services to the market on a continuous basis. This is more a case of opportunistic trading, where they are offering natural liquidity at a price target which suits their risk profile. It’s also important to recognise the changing behaviour of the sell-side dealer. Dealers are looking to optimise their use of risk, and grow their agency trading capabilities as they look to find cost efficiencies in their own businesses.
With the advent of MarketAxess Open Trading protocols in 2013, buy-side clients now have access to the requisite technology and investor network for the first time. The phenomenal growth and adoption of Open Trading provides evidence of a seismic shift in buy-side behaviour – the fixed income trading landscape has undoubtedly changed. As a true all-to-all platform, Open Trading is also available to the sell-side, and the dealer community has been quick to take advantage of accessing this liquidity network with over 70 dealers participating globally and 24 in Europe.
Open Trading connects disparate pools of liquidity, with market participants from both the buy- and sell-side able to respond to anonymous inquiries and axes as well as post liquidity directly. The demand and uptake for Open Trading has been remarkable - the number of client responders has increased from 375 in the second quarter of 2015 to 619 in the second quarter of 2016. Furthermore, approximately 50% of all the liquidity being provided via Open Trading is coming from buy-side clients, which further highlights their increasing assumption of the role of price maker.
What is being done to facilitate this change and what tools do market participants need to better access the fixed income markets?
We are seeing a gradual behavioural shift amongst buy-side traders, as their ability to offer liquidity grows. Experience from other more ‘electronified’ markets, such as equities, is moving to fixed income buy-side trading desks, or from sell-side dealing desks that have experience in market making. Evidence for this is borne out of the activity we are seeing on Open Trading, where the number of price responses has increased 251% year-on-year. Furthermore, in the third quarter of 2016, Open Trading delivered an estimated $26 million in cost savings to liquidity takers.1
Clients are now realising that they cannot afford to ignore this type of opportunity.
Furthermore, firms will need access to quality data tools which can provide market intelligence to allow traders to approach the market. Recognising the importance of data in the trading workflow, MarketAxess and its subsidiary Trax have developed a robust composite price tool, with data being sourced from MarketAxess dealer inventory & Request for Quote (RFQ) bid and offer responses, Trax traded prices and FINRA traded prices from the US. MarketAxess and Trax have also built Axess All, the first intra-day trade tape for the European fixed income markets. Axess All brings a thoughtful level of post-trade transparency to a previously opaque market, providing unique insight on fixed income market activity.
What does the future hold?
In times of market volatility, such as the uncertainty caused by Brexit, liquidity provision can become transient as the supply of risk is limited – moving quickly from traditional providers to more opportunistic and alternative sources. Buy- and sell-side clients need confidence that they can rely on sophisticated and demonstrable trading tools to successfully engage with the market when it is in flux.
As the/ dynamic between the buy- and sell-side evolves, we believe the liquidity landscape will only become more fluid and complex. A hub-and-spoke model with centralised, risk based liquidity providers will be unlikely to survive any significant market stress. It is in the interest of market participants to improve the robustness of secondary market liquidity. To achieve this, there has to be variety in the types of liquidity on offer (risk, opportunistic, natural), trading strategies being employed must be adaptive and disparate markets need to be brought together. Open Trading will play an increasingly significant role in helping market participants respond to the new realities.
1Activity is for Market List-winning trades only. Cost Savings is defined as the difference between the best cover (non-winning) level from a disclosed dealer and the winning level times the quantity across all anonymous trades. Products include U.S. high-grade, high-yield, emerging markets and eurobonds.