The concept of “best execution” price is becoming increasingly important for fixed income institutional investors, their clients and the regulators who oversee the entire industry.
But in these markets analyses of transaction costs are embryonic at best. One reason is that there is no mechanism for institutional investors to view the entire pool of available liquidity.
Indeed, buyside institutions can only seek liquidity, not provide it. Both dealers and their clients are suffering from this opacity and asymmetry but technology may now be in a position to provide a solution.
The low interest rate environment and the shadow of increased regulation are focusing buyside attention on overall performance. Price slippage – the loss of investor value through inefficient execution – is a key component of return in the equities and futures markets, but is rarely discussed in the over-the-counter fixed income markets.
There are good reasons for this. Simply put, the trading spreads are extremely valuable to dealers, especially when the Volcker rule and capital constraints restrict their ability to trade their own book. For example, JPMorgan generated more revenue in the third quarter from fixed income markets than equity markets and investment banking combined.
But while the cards may appear stacked in the dealers’ favour, the house does not always win. The standard model for trading government bonds and other liquid instruments – the competitive “request for quote” – can make it difficult for banks to hedge positions they have taken on from their clients.
This “winner’s curse” can hurt the dealer with the best price because if other dealers are aware a large trade has taken place (as they are in a competitive auction), they can then move the prices against the winning dealer in the interdealer market. This two-tier market structure – one price for the client, another for the bank in the interdealer market – has fuelled information arbitrage for decades.
While a blurred view of true liquidity causes problems for clients, it is also problematic for dealers, especially with regulators intensifying their focus on fixed income markets. The Securities and Exchange Commission held the first of what is expected to be a series of fixed income roundtables earlier this year.
The over-the-counter (OTC) derivatives market has already been recast by the Commodity Futures Trading Commission, against dealers’ objections; the bond market is likely to be next on the list. The path out of this labyrinth is lit by technology. The major dealers want to maintain control of their hard-won institutional relationships. Early in the evolution of technology they used their own money to control the pace of market evolution through investments in bond platforms.
With the spotlight of transparency shining more brightly across the trading landscape, electronic trading is now lighting up fixed income trading floors.
Indeed, dealers are becoming comfortable embracing rather than fighting greater transparency, though they are not welcoming a fully symmetric exchange model as in futures and equities – at least not yet. But two interesting trends are emerging.
First, dealers are actively promoting their own order books for clients. Second, dealers are exhibiting a willingness to allow institutional investors to use algorithms to help extract the best intraday price.
These two trends are intertwined, as it is not possible to obtain accurate transaction cost analysis (TCA) without an order book or streaming executable prices. Also, there is no advantage of having accurate TCA measurement if there is no way to improve the execution itself.
The corporate bond market isn’t liquid enough to offer this level of efficiency, but the more active government markets are.
While the introduction of execution algorithms has already taken place to some degree in the interdealer market, asset management clients are blocked from access to these venues. With algorithms starting to make an appearance in the client-to-dealer market – some created by individual dealers, others by third parties – a real opportunity has emerged for asset managers to reduce price slippage and improve the returns they provide investors.
Algorithms operating across a range of dealer books do more than provide asset managers with the ability to improve returns for their investors. They can protect banks from information leakage, as well as draw in orders from a broader range of client opportunities.
In a world of low interest rates, this may not sound exciting, but it is certainly good news for clients and their stakeholders. It’s also not so bad for banks, which may get to preserve the dealer-to-client relationships inherent in the OTC market structure and keep the regulators happy.
Robert Almgren is co-founder of Quantitative Brokers, a fixed income algorithmic broker
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