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Fixed Income Trading: New venues

A simple question came up recently in a conversation – how many new Fixed Income trading venues are there?  I could not think of anywhere th...

Friday, 17 April 2015

Fixed Income: New market for Corporate Bonds

A topic we have covered before is the evolution of the market place for Corporate Bond trading - "Matching engine for corporate bonds?".  Since the demise of Lehman Brothers we have seen the banks pull back capital from the corporate bond flow trading business and a subsequent drastic reduction in liquidity.  This post is a modest proposal for the structure of how a new Fixed Income market could work.
Firstly, let's establish some principles of business:
  • The aim is not to disintermediate banks and drive them out of this line of business.
  • The aim is not to disintermediate interdealer brokers and drive them out of this line of business.
  • The purpose of the new market is to be a fair and open place for buyers and sellers of bonds to transact.
  • All participants are welcome, as long as they respect the rules.
  • Best execution is the goal
So, what's different between this proposal and the 80 or so other venues out there?
 
The market model here is based upon observations of market behaviour within the buy-side and the sell-side in a number of European firms.
 
Per the earlier post on "Bond fund distance, liquidity and trading" we see that there is an opportunity for a type of matching to occur even when there is no direct match.  So, let's illustrate this more clearly:
 
Model 1 - "Buy-side to buy-side in complete size via one or two brokers as agent or principal"
  • Buy-side A enters an order into the new venue matching engine to buy 8m of the Vodafone bond 1.25% of 26/09/2017.  This may or may not have a limit price.
  • Buy-side B enters an order into the new venue matching engine to sell 8m of the Vodafone bond 1.25% of 26/09/2017.  This may or may not have a limit price.
As a first pass, the matching engine looks for sellers of any bond with buyers and buyers of any bond with sellers. In this case we have a perfect match for size. 
 
The issue is now - did either firm place a limit price on their order?  If there were one or more limit prices then the new venue matching engine will have to start a process of negotiation between the two firms.
 
I see this as being anonymous and probably facilitated by one or more banks.  So the buy-sides do not enter into direct negotiation, one or two banks act as agent or principal in this process.  If a deal can be done then the trade is executed and anonymously given up, so neither buy-side is aware of the identity of the other.
 
Model 2- "Buy-side to buy-side in partial size via one or two brokers as agent or principal"
  • Buy-side C enters an order into the new venue matching engine to buy 8m of the Vodafone bond 1.25% of 26/09/2017.  This may or may not have a limit price.
  • Buy-side D enters an order into the new venue matching engine to sell 7m of the Vodafone bond 1.25% of 26/09/2017.  This may or may not have a limit price.
In this case we have a size imbalance. Buy-side B is selling 7m and buy-side A wants to buy 8m.  The issue is then - will buy-side A be willing to trade on a reduced size of order or will they wait for a seller of 8m? If they are willing to trade in 7m then the process looks like "Model 1"
 
Model 3 - Buy-side to retail investors via one or two brokers as agent or principal"
  • Buy-side E enters an order into the new venue matching engine to buy 8m of the Vodafone bond 1.25% of 26/09/2017.  This may or may not have a limit price.
  • Retail investors 1 to 80 enter orders into the new venue matching engine to each sell 100k of the Vodafone bond 1.25% of 26/09/2017.  These orders may or may not have a limit price.
When aggregated in size the retail investors match the institutional size order.  At this point the institution needs to make a bid to take all 8m of the bonds at one price.
 
This will require a bank or other institution to face the 80 retail investors since most real-money long-only institutional asset managers will have no desire to process 80 tickets for a trade of 8m.
 
Again, I see this as being anonymous and probably facilitated by one or more banks.  So the retail investors and buy-side E do not enter into direct negotiation, one or two banks act as agent or principal in this process. 
 
Model 4 - Buy-side to near match buy-side via one or two brokers as agent or principal"
  • Buy-side F enters an order into the new venue matching engine to buy 10m of the Vodafone bond 1.25% of 26/09/2017.  This may or may not have a limit price.
  • Buy-side G enters an order into the new venue matching engine to sell 10m of the Vodafone bond 1.625% of 20/03/2017..  This may or may not have a limit price.
Here we return to the process advocated in "Matching engine for corporate bonds?".  As suggested, the new venue matching engine will maintain a comprehensive database of instruments. 
 
When an order for a specific bond is received the order will contain a number of fields - such as ISIN, Size, Side - the usual economic information needed for any order.  For this new venue though there will be a set of new attributes:
  • Will accept less than full execution?
  • Minimum % of order accepted
  • Limit price
  • Publish limit price
  • Will accept attribute based near matches
  • Maximum number of contra-trades accepted
So, when the order from buy-side F is received, if the correct flags are set, then the matching engine will look for possible contra-trades that are for a different ISIN.
 
In the event of a near match being found the matching engine will transmit information to both parties to allow them to evaluate the alternative on offer.  This would be rather like a traditional equity market IOI workflow.
 
So, what's different here?
  1. No one is disintermediated.
  2. Retail and institutional can trade against each other if they choose.
  3. Near matches are possible based on configurable parameters.
  4. Anonymity is controlled closely
Of course, that's just an overview and there are a lot of details to be resolved, but most of the key features are listed here.

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