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A mystic voyage into fixed income tradingnews
Mitali Kalita
03 December 2003

Chennai: Bonds are known to be the most effective remedy for financial risks of the global economy. They serve as the funding source for governments and thus act as catalysts for a well-balanced economic environment. In addition to this, the introduction of electronic trading systems in bond trading has brought the US bond market from a so-called ''neglected'' state to that of becoming the ''hottest'' topic on Wall Street.

Tower Group, a research firm in Needham, Massachusetts, predicted in a recent report that 68 per cent of all bond transactions will be electronic by 2005, up from 33 per cent in 2001. Similarly, another recent survey by the Bond Market Association (TBMA) estimates that trade volumes have grown an average of 70 per cent, with individual rates ranging from 20-140 per cent.

The flourishing era
Online trading in the bond market flagged off around six years ago in 1997. During the three initial years (from 1997 to 2000), the market witnessed a huge proliferation in electronic bond trading platforms. Participants rushed to take advantage of the lucrative market opportunities and the ostensibly unlimited access to funding.

The move reached its zenith during 2001 with the list of electronic trading platforms reaching almost 90 — up from 11, 27, 40 and 80 in 1997, 1998, 1999 and 2000, respectively. If we include financial institutions'' own websites, the number touches more than 300.

Source: Celent Communications

The ease and comfort of dealing with e-bonds totally changed the nature of the fixed income market. Customers who were reluctant to invest in bonds for fear that they would not be able to sell them easily at a reasonable price started finding bonds more attractive.

When we analyse the driving force behind this trend, we find that there are five factors that contributed towards the success of electronic bond trading. These factors are:

  • Speed
  • Efficiency
  • Convenience
  • Liquidity
  • Transparency

Telephonic or other traditional methods used for bond trading earlier dissuaded many customers from investing. Online bond trading became more interesting as it saved time, reduced human errors and became more secured.

Moreover, even smaller firms got a chance to take part in the race, which was earlier, only available to the larger ones — thanks to the advent of the Internet. Technology in bond trading created a homogenous platform for all firms irrespective of their sizes, doing away with a trend, which was once dominated only by a handful of big players. The other visible change was the unsettling of institutional stock trade, collapsing brokers'' commission fees in a general realignment of market dynamics.

The mushrooming of more and more players was helpful for investors. Newer features like connectivity for automated trade processing, pre-trade services such as research, analytics and services tailored to syndicated underwriting of new issues, were added to lure online investors.

The downturn
But, as the old adage goes, ''Too many cooks spoil the broth,'' the online bond market also met with a similar fate.

A report published by Celent Communications during August 2002 said 2001 was a very tough year for the once high-flying e-bond trading platforms. The hype surrounding the enormous potential of electronic fixed income trading platforms was replaced by pessimism as many wondered: "Who will fold next?"

Though the market passed through a rapid-growth phase during the first four years, it reached a saturation level during the last two years. There was an increase of only one trading platform in 2002 at 81 from 80 in 2001. Experts have estimated that the cost of developing, staffing, marketing and launching an electronic trading platform cost a player around $50-100 million.

Trading systems range from online auction systems, cross-matching systems, inter-dealer platforms, multi-dealer systems and other trading systems that cover almost the whole financial market ranging from US Treasury bills and European government bonds to corporate and municipal credit.

A recent TBMA survey of electronic transaction systems for fixed-income securities found only 77 electronic fixed-income trading systems are currently operating in the US and Europe, versus 81 in 2002. Of the 77, 46 are based principally in the US and 31 are in Europe.

It has been noticed that compared to others, multi-dealer systems are the most difficult to manage due to the conflict of interests among multiple numbers of founding members. Disagreements in governing decisions such as the selection of bank members, oversight committee, strategies, and rules and regulations lead to poor customer service. On the other hand, the cross-matching systems saw a rapid growth with their numbers tripling during 2002.

"The founders of the electronic trading systems must be also careful in selecting a software vendor for designing and developing an online bond trading system. It is very important to select a vendor with the right mix of expertise in the technology area as well as the domain. This right blend of expertise will help them to make the right decisions in moving forward during all phases of design and development," says Mark Engelhardt, director (business development), Pinnacle Systems, a US-based technology consulting and solutions provider to capital markets firms.

After the boom, came the lull. Too many new players affected the trading as activities fractured into fragments lacking coherence, which made it difficult to generate sufficient liquidity and revenue. Industry reports said that growth slowed in the treasuries sector, which was once considered to be the most liquid and standardised product market. Whereas mortgage-backed, agency and municipal markets achieved the highest growth.

And the market moved towards a matured and consolidated phase. Vendors learned the tips for survival in the market and began adding newer features to their trading systems. Thus only a core group of players came into the vanguard.

The FIX factor
In April 2003, FIX Protocol Ltd, in association with TBMA, published version 4.4 of the Financial Information eXchange (FIX) Protocol. The FIX Protocol is a language defining specific kinds of electronic messages for communicating securities transactions between two parties.

"TBMA is continuing to push for the adoption of FIX version 4.4 because of cost-reduction. When FIX is adopted, it will make using the systems much easier. It has cost-reduction benefits as well with respect to trade processing," says Michael Decker, senior vice-president, TBMA.

The industry has also initiated the development of a common message hub for the fixed-income market, a ''market data definition language'' for bond descriptions and standards for operational aspects of prime brokerage services for smooth electronic trade execution.

The FIX factor made its entry into the market during 1993. Now, it has spread its arms from cash equity to fixed income and credit derivatives. The FIX protocol is poised to become the preferred messaging format for inter-firm communications in capital markets with attractive attributes being:

  • Easy to implement
  • Open standard
  • Secured
  • Independent platform
  • Real time

The industry is speculating the entry of FIX as a positive move towards the realisation of straight-through processing (STP) by the fixed income market. However, according to Kevin Houston, chairman of the European FIX Protocol Technical Committee, FIX is more than just an STP engine. "It''s also a way to automate all pre- and post-trade processes. It enables the communication of large numbers of orders with exceptional accuracy, supporting different types of trades, reducing errors throughout the process, and allowing more timely access to the markets."

The online bond market seems to have witnessed a positive trend during its six-year journey till date. From humble beginnings with 11 electronic trading platforms, the number exploded to a high of 90 in 2001. But a recent survey by TBMA illustrated the exit of five players from the trading fray as compared to last year. In a way, it has been beneficial for customers because only the principal and the best ones managed to stay aboard, while the weaker ones sank.

The TBMA report has rightly estimated that fixed income trading will continue in 2004. Trading volume will continue at its own pace, platform vendors will continue their effort to bring in more and more enhancements to their product offerings. There may also be a trend towards mergers among trading platforms in the coming years. Ultimately, in this whole scenario, the real winners are the aspiring customers.


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A mystic voyage into fixed income trading