Fixed Income trading – exchanges/MTFs/SEFs/same old stuff? (September 16th 2011)

I try and follow what’s going on in the world of Fixed Income trading as much as the next person in the industry who has a related day job.  After a while the whole Dodd-Franks thing starts to make my eyes spin and I need to sit down with a damp cloth on my fevered brow.
Anyway, the question that I am mulling over is what happens next?
On the one side the Fixed Income hub firms are busy rolling out SEFs and looking to put CDS electronic.
On  the other side we see at least four firms trying to push the European cash bond markets onto an exchange-like model – following on from
The four firms I know of are:
Bondvision MTS – part of the LSE group —
Galaxy – part of TradingScreen
Bondmatch – part of NYSE
Vega-Chi – private firm with a lot of ex-Goldman Sachs guys on the team
All four seem to have similar business models.  But is there demand for the idea of pushing good old fashioned cash settled bonds onto an exchange?
Over the last few years banks have starved their credit desks of capital to the point where most banks will only work an order rather than commit capital.  So if that reading is correct then it would be an efficiency play to disintermediate the sell-side and allow buy-sides to trade against themselves in an anonymous model.  This is a similar model to that of Liquidnet “classic” where real-money buy-sides interact entirely anonymously with Liquidnet giving up all trades to JPMorgan.
But are buy-sides ready?  One analysis is based on three components: systems, people and processes.  Do buy-sides have the three components to do this?  I suggest that many do not.
The critical mass needed for an exchange in this space is not clear – certainly it’s necessary to get multiple participants on the platform but that’s not sufficient.  In order to trade you need differences of opinion in value.  That suggests to me that what is needed are different classes of buy-sides.
If I was starting up one of these exchanges I would approach the big private client businesses and ask them to participate on the platform – to provide limit orders for the book of their inventory.  Allow for multiple small clips on one side of the book to be traded against one big order on the other side in a neat way.  Allow retail and institutional folks to dance on the same platform with protection against stubbed toes…
I would also ask institutions to place limit orders for all of their hard to value/hard to sell inventory.  So many institutions find themselves holding a credit that is traded by one man in a bank in Luxembourg and he’s on paternity leave.  Stick it on the order book and see what happens.  Let’s be realistic – it’s not like you are “showing your hand” anymore than you would be if you phone the Luxembourg bank up for a price – you might find that you don’t get your face ripped off.
Get a few trades done and then you are allowing people to safely dip a toe into the water.  Make sure there is excellent post trade performance and the venue will find more order flow arriving.  It’s not going to turn into a massive amount of liquidity in the way that FTSE100 equity names trade but it will become a self perpetuating virtuous cycle.  The velocity of circulation of bonds will increase as the liquidity is concentrated and prices are published.
Eventually the platform can move to provide a tap auction / primary listing facility.
If you ever read about Drexel Burnham Lambert and Michael Milken you see that he and that firm were credited with popularising below investment grade or junk bonds.  How?  Simple – he sold bonds and he made a two way secondary market. Investors felt secure that they could sell if needed.  I am not suggesting that the DBL model is one to follow – but the provision of the optionality of a place to sell a position makes folks much more likely to trade in the first place.
And what will the banks do if they see a move to exchange trading for cash bonds?  I know of at least two big banks that have built fixed income “MTF-like” platforms.  I cannot imagine it would be hard for them to kick the tyres, light the fires and go-live with a competitor to the four firms named above.
“Build it and they will come….”

[Original post]