Electronification developments and trends in Fixed Income Markets

ICMA Conference – Electronification and Regulation, what now ? Copenhagen – 29/11/2016

Yann CALENGE Head of e-Rates

Summary

A bit of history…market structure evolution

The past century

The early 2000s

The mid 2000s

Where we are now

In short…

The forces behind the changes

Regulation, regulation, regulation…

Mifid II: trading on venue obligation

Mifid II: pre-trade transparency…a game changer for the dealers

Mifid II: best execution

Beyond regulation: other influencing factors

The costs problem

Technology

Monetary policies

The Changes

Tomorrow’s platform landscape

Markets participants will be different too

The new structure

Conclusion

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A bit of history… Market structure evolution

The past century…

Voice brokers

Dealer Dealer

Customer Customer

Voice interactions

In the flow world, this may seem like a far distant picture but for highly illiquid instruments and in the exotic/structured derivatives space, it remains very much alive

This may come as a major relief to some, but not everything can be electronified !

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The early 2000s

The first electronic venues appeared in the Fixed Income world. Bonds at first:

Almost simultaneously, Dealer to Dealer (central order books model) and Dealer to Customer (RFQ based) platforms

This model remains very much the dominant one in the Nordic countries:

In some asset classes ( Swaps in particular) we are hardly at this stage.

Voice brokers

Dealer Dealer

Customer Customer

D2D platforms

D2C platforms

Voice interactions

Electronic interactions

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The mid-2000s…

Dealers started introducing Single Dealer Platforms

FX was the primary objective.

But some offered Bonds and Interest Rates Derivatives…with various fortunes.

This is yet to happen in the Nordic region and given the lack of success of Single Dealer Platforms in the Fixed Income space so far, other than on some very specific asset classes (structured products ?), it may never materialise.

Voice brokers

Dealer Dealer

Customer Customer

D2D platforms

D2C SDP SDP

Voice interactions

Electronic interactions

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Where we are now

In the G4 currencies, the last few years have seen the arrival of new types of liquidity providers.

They are targeting the highly liquid instruments space (Vanilla Swaps and Benchmarks Bonds)

Their business model is heavily biased towards electronic

A new type of ”venue” has emerged: the dark pools.

Voice brokers

Dealer Dealer

Customer Customer

D2D platforms

D2C SDP

Prop trading firms

SDP

Dark Pools

Voice Interactions

Electronic Interactions

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In short…

Electronification has already happened.

At a different pace in each asset class

Certainly at a slower pace in the Nordic countries than in the wider G4 Markets.

Pockets of “voice business” remain

Primary market, various illiquid asset classes…

The dealer to dealer interactions in Bonds, remain voice based (if not “chat”) as opposed to the highly electronic FX world (bilateral links) and derivatives (D2D, “SEF”, D2C). In fact volumes traded on European dealer-to-dealer platforms in the recent years have been depressed.

Importantly, none of the past transformations of the Fixed Income market structure were induced by regulatory changes

This is about to change dramatically

After these initial waves of electronification, market players who have missed the first turn will face the difficult challenge of a rushed transformation.

The others will move on to the next stage: Automation.

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The forces behind the changes

Regulation, regulation, regulation…

MiFiD framework in place since November 2007

It scared a few at the time, but hardly affected the Fixed Income market structure.

For Fixed Income it was mostly a lot of paperwork: execution policies, client classification, suitability and appropriateness…

The post-crisis regulation: Dodd-Frank, MiFiD II, Basel III, NSFR, TLAC, BRRD…and coming soon FRTB

Prevent tax-payers bail-outs of failing banks by:

Separating prop-trading from other more traditional market making activities

Discouraging Banks from taking excessive risks on financial markets

These will impact the Fixed Income market structure, as they will directly affect Banks.

Reducing costs and capital consumption while maintaining profitability is the new grail.

This can only be achieved one way: automation.

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MiFiD II: trading on venue obligation

ESMA will confirm the scope of the “Trading Obligation”. But there is already a pattern :

EUR plain vanilla swaps will be caught:

Buy-side and sell-side players still need to make the necessary investments.

In the Nordic countries,

SEK could be caught on the most liquid part of the curve.

NOK, DKK will be spared.

Even if Scandy swaps were left aside, the electronic transformation could still happen:

The extra investment on top of what is necessary for EUR swaps is very small. The temptation to re-use the infrastructure will be strong.

If Banks do not make the move, the mandatory clearing (SEK,NOK) could allow for new participants to fill the void.

The Nordic Swaps industry is late on the electronification curve.

At least on EUR, it will have to catch-up. But we could see a two-speed market.

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MiFiD II: pre-trade transparency…a game changer for the dealers

In the Nordics the following bonds will be deemed to have a liquid market:

Sovereign bonds: all of the Government and most of the SSA bonds

Covered Bonds:

All of the Swedish Mortgages (except 5) in stage 1, all of them by 2020

Half of the Danish mortgages bonds in Stage 1 and almost all of them by 2020.

Then it is all about the SSTIs:

Sovereign Bonds: 900 k€ in stage 1 all the way up to 5 M€ by 2020

Credit, from 250 k€ to 722 k€ by 2020

Derivatives still under discussion

Pre-trade transparency and systematic internalization rules:

Make dealing on own account below these levels a risky and expensive business.

Offer easy waivers for transactions done on OTFs, MTFs and Regulated Markets.

Will be the new rule for transactions below SSTIs…and not so small ones

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MiFiD II: Best Execution

Migrating to electronic venues offers the best alternative to both buy-side and sell-side.

The multi-dealer RFQ model remains sufficient from a regulatory point of view, but…

The compliance cost for Banks to maintain too large lists of customers,

The multiplication of price providers (including non Banks dealers),

The greater independence of brokers towards dealers over platforms’ access,

Will like facilitate the emergence of new models or the renewed success of old ones:

One to all RFQs,

Dark pools (when not executing client orders !),

The return of the CLOB pushed by some OTFs/MTFs

The next two years: multiplication of platforms, protocols and players all

pushing in different directions.

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Beyond the regulation, other influencing factors (1/2)

The costs problem

Low yields and increased competition are forcing market participants to reduce costs.

Some may pull out of dealing activities as the rewards do not seem to outweigh the costs anymore.

Others will try to adapt via greater automation of the trading process.

Technology in not just a way to reduce cost:

On its own, it can also be a source of ”new businesses” for the industry.

High Frequency Trading firms are the best example of it.

With increased competition in Equities and FX, Fixed Income will be their next target.

The Nordic markets will not be totally immune to this change.

Whatever the reason, expect more of its kind.

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Beyond the regulation, other influencing factors (2/2)

The monetary policies:

The prolonged low interest rates environment is impacting the market structure:

Buy and hold approach of FI investors has been reinforced by the low yields

High level of new issues in the last 8 years, have spread the liquidity even thinner

The buy side is looking for alternatives to dealers’ balance sheets

Despite Central Banks policies (or because of ?), the velocity of newly printed money has been reduced.

Adverse market conditions could easily derail the electronification trend…for a short period of time

Stressed markets are showing how fragile the electronic liquidity is.

The pace of the market structure evolution will be decided by how smooth the rates normalization process will be.

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The changes

Tomorrow’s platform landscape

The diversity of the platforms should remain but with a clear separation between liquid and illiquid instruments:

RFQ type of MTFs are here to stay in the least liquid assets classes

In liquid instruments (vanilla swaps, government bonds, some SSAs…) we will likely see a resurrection of the Central Order book model, as brokers allow more and more participants on their platforms

The Nordic markets will follow this evolution: it is imposed by regulation, not driven by markets specificities.

Illiquid Liquid

Large size

Small size

Phone-Dealers/Brokers

Regulated Exchanges

CLOB

MTFs-

RFQs

OTFs -

CLOB

MTFs-

RFQs MTFs

- One to all RFQs

Dark Pools

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Market participants will look different too

Prop-trading firms will overcome the dealers in the highly electronic liquid asset classes

This could take longer in the Nordic markets but will eventually happen

Dealers willing to remain will have to reach a high level of automation

Overall , less Banks may engage in Bonds and Swaps dealing activities

The “dealer to customer” historical relationship will become looser

More and more one-to-all RFQs and use of central matching counterparties

Phone dealing will only be used for large transactions and on the primary market.

Everybody will be taking liquidity from and providing liquidity to… everybody else

Prop Trading firms

Dealers Customers

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The new structure

For the sake of clarity, not all possible relationships are represented

Voice brokers

Dealer

Dealer

Customer

Customer

OTFs, RE, MTF

(CLOB)

MTFs RFQs

Prop trading firms

SDP

Dark Pools

Voice Interactions Electronic Interactions

MTFs RFQs

MTFs One to all

RFQs

Dealer

Dealer

Voice brokers

Customer

Customer

Customer

Liquid Illiquid

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Conclusion

Conclusion

The next couple of years will be difficult

A lot of changes, a lot of uncertainties

The transformation will affect all parts of the European Fixed Income markets:

At a different pace, but in the same manner: in fact the future European market structure will look very much like the current US one.

The gaps between liquid and illiquid instruments will likely get even wider

The Nordic players are late and the Mifid II deadline is fast approaching

Here as elsewhere, the natural tendency to keep things “as they are” may provide a false sense of comfort.

Failure to adapt - quickly enough- could ultimately damage the attractiveness of the Nordic Financial markets and hurt liquidity.

But there is hope:

The region has traditionally embraced the digital changes in other industries and adapted much faster than in other parts of Europe.

A well capitalized banking sector will keep on contributing to the financial stability of the region…a dream in other parts of Europe.

New rules always create new opportunities!

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