“Fintech 1.0” began in the early 1990s in the stock exchanges and among equity desks in the U.S., with the electronification of trading and its supporting infrastructure.
More than 20 years later, bond markets other than U.S. Treasuries have yet to catch up. “The bond market is backward,” a Hong Kong-based head of fixed income at a top-tier American fund house told DigFin. The lack of electronic trading makes it harder for investment firms to achieve best execution, opens trading to errors, and inhibits operational efficiencies.
Even as equity markets are now embracing artificial intelligence and other variants of today’s fintech scene, bond trading still largely takes place over chat messages and phone calls. The situation is particularly old-school in Asia where, except for Singapore, there is no electronic trading of local fixed income.
(There is in China’s domestic market, which is now opening to foreign investors, but its infrastructure is isolated from the rest of the world.)
Regulation and market dynamics are prizing open this closed shop, and some aspects of tech and processes invented for the equities space, such as transaction-cost analysis (TCA), are being adopted. But in other respects, bonds are different animals, and so the tech supporting these markets has to be different too.
Bonds are different
Whereas stocks are traded at central exchanges, bond trading is over the counter, with major banks holding the lion’s share of supply. Buy sides grew used to receiving coverage from known bank salespeople. In an era of big data, such personal relationships have becoming limiting instead of enabling, leaving investment firms dependent on trade ideas that brokers pitch instead of an awareness of market dynamics.
Buy sides suffered a similar lack of information in equities, but electronic trading changed the power equation; buy side traders went from being their portfolio managers’ order-takers, armed themselves with tech and data, and the big ones became price makers.
That’s not the case in fixed income, where buy sides remain price-takers. Could that change? After all, the big banks, scarred by post-2008 crisis regulations that raise the capital cost of warehousing bonds, have pulled back from secondary markets, whether the instrument is a corporate bond, a utility bond, or other non-Treasury securities.
Fintech for the status quo
Not so fast, say both buy sides and vendors. Technology should help fund houses get a better handle of trends and pricing in fixed income, but buy sides are unlikely to seize the upper hand in their relationships with sell sides.
Enabling fintech to modernize bond markets also requires the restoration of sell sides. Banks were forced to shed their proprietary trading desks in the wake of the 2008 financial crisis, and adopt agency-only models (trading on behalf of customers and not themselves).
This cost the sell side its information advantage at a time of declining volumes, and investment-bank revenues from trading fixed income have fallen. But the OTC nature of fixed income (lacking a central exchange) means markets can’t return to health without robust sell sides.
Is technology the answer? Well, in part. Regulation is forcing changes. Europe’s Mifid 2 regulation, separating research from execution, is adding to margin pressures among both banks and investment firms.
This has sparked a rush of fintechs providing on-demand research, offering and sharing information on credit markets and other niche areas, says Mushtaq Kapasi, Asia-Pacific chief representative for the International Capital Market Association, speaking at a recent bond-market conference in Hong Kong.
Data and liquidity
But the biggest opportunity lies in data and liquidity—particularly when liquidity is scarce, such as in most Asian bond markets (hard dollar or local currency).
Let’s take a look first at liquidity. For fund managers looking to boost returns, the tactic over the past decade (an era of central bank-boosted easy money and low interest rates, which led to rising bond prices and falling yields) was to go long credit and duration. That trend is now going into reverse and bond markets are becoming more volatile. Liquidity, therefore—the ability to trade without impacting market price—is what managers seek.
“Liquidity is becoming more important with rising yields,” said Angus Hui, head of Asain and emerging-market credit at Schroders, speaking at a conference.
Buy-side portfolio managers want to know what bonds are liquid, but this is difficult information to come by given the OTC nature of the market. Vendors such as Market Axess and Broadridge are proffering platforms that are meant to aggregate liquidity and provide indications to buy sides. But for now these remain limited to U.S. markets, according to buy-side traders.
Spotting liquidity, then, is becoming all about data. Data for analyzing trading costs and performance; data about who owns what; data about pricing and market movements.
On the one hand, firms are awash with data, in part because regulation such as Mifid 2 demands it be recorded and warehoused. But the data that exists and is being dutifully reported is not the kind of data that traders actually need. Vast gaps exist in the data that does get reported. And there’s too much data: so much gets recorded and reported that it’s difficult to make sense of it; and it’s all being reported in formats that vary by jurisdiction and can’t be downloaded or collated by machines.
Price takers to price makers
Buy sides, traditionally price takers in bond trading, are slowly waking up to the notion that they can deliver outperformance if they can derive insights into market pricing. This means controlling data.
“I expect the buy side can increase its voice if we can aggregate our data,” said He Xuanlai, executive director and fixed-income manager at China Life Franklin Asset Management, speaking at a conference.
He says it’s difficult for buy sides to get a handle on the foundations of liquidity, such as speed of execution, block size and limiting market impact—and the reduction of sell-side inventory has only made this harder. Electronic platforms can help buy sides get access to the right data, He says.
But are platforms delivering on improved liquidity? “Trading systems that aggregate all trading activity—when conditions are right—allow the buy side to become a liquidity provider,” said Lu Liying, senior portfolio manager at Alliance Bernstein, speaking at a conference. “But just having the system to tell you about liquidity isn’t enough… Tech is now impacting not just trading, but how portfolio managers make decisions.”
Vendors second this view. “Electronification means liquidity is easier to get, but it’s not just about having a view, but having the means,” said Christophe Roupie, head of Europe and Asia at Market Axess, a bond-trading vendor.
Putting data to work
Buy sides need to streamline processes from order management to execution, and they are borrowing techniques such as TCA from the equities world in order to measure how well they’re doing—and how they should be paying their traders.
The upshot is that buy sides, by joining platforms and adopting new tech, can access liquidity and use information to be price takers by trading illiquid blocks more confidently. Unlike in the equities world, buy sides in bonds are unlikely to evolve into market making. But they can use data to figure out when the market herd is making a mistake, take the contrarian side of a trade, and prove their alpha.
So for those buy sides seeking liquidity, the challenge today is about data: storing it, accessing it, structuring it, and using it to make trading decisions.
The next step will be to apply artificial intelligence. Vendors and buy side managers alike see the value in machine learning—if they can get to the point where it’s applicable.
“The buy side is spending more time on data strategy,” said Jesper Bruun-Olsen, regional head at vendor Algomi, speaking at a conference. “They want to apply machine leaning, intelligence augmentation, and at some point, A.I. But first they need to acquire and store the data.”
Another vendor told DigFin: “A.I is the next big change, but that will require an investment in trading processes to allow for automatic execution of orders. That’s the next trend.”