Fixed Income: The First Dark Pool?

Terry Flanagan

Typically, dealing bonds has been a relationship business, but the influx of regulation and electronic trading is standardizing the trade.

The debt market remains one of the largest of the asset classes and its diverse array of products, with drastically different maturities, and wide spreads, has long kept the bond market from being standardized. Bond investors, especially those going after high-yielding products, have long struggled with liquidity, meaning that a move from voice to electronic is still being met with resistance.

“In days of yore, anyone who wanted to trade high-yield bonds would pick up the phone to get a quote from one or more of the major dealers such as Credit Suisse, Morgan Stanley or Goldman Sachs,” said Sal Trani, an executive managing director at BGC Partners, a fixed-income brokerage firm, told FTSE Global Markets. “It was a clubby world dominated by a few big players.”

Inventory in the more illiquid fixed income instruments is often hard to come by and is primarily claimed by Wall Street’s best-of-breed broker-dealers, which has also meant high levels of “pay to play” and business that is mastered by exclusive relationships.

Fixed income investing and trading still primarily takes place via voice, especially in the derivatives world, but electronic is slowly catching on. Their equities counterparts have long laughed at fixed income’s inability to adopt state-of-the-art technology. Yet, some market participants believe the bond trader’s original “who-you-know” code of conduct has, in some ways, preceded the electronic equities market.

“Fixed income was the first dark pool,” said Chris Weldon, managing partner at Prospect Hill Capital Management, an event-driven hedge fund, and he told Markets Media that he was skeptical about the popularity of fixed income electronic trading.

Yet, the cash market, which largely includes Treasuries, comprised more than 60% of trading volumes in 2011, rising from 56% in the first half of 2010, according to consultancy Celent. With the flight in recent years to more safe-haven assets such as bonds, investors have taken an asset-class agnostic stance on increasing market transparency but bonds are not immune from greater regulation.

“The market is likely to continue to move electronically because regulatory mandates will continue to push the market in this direction,” said Marshall Nicholson, managing director at Knight BondPoint, who told Markets Media that the Trade Reporting And Compliance Engine (Trace), the bond price reporting system that originated in corporate bonds, has now expanded into mortgage-backed securities, which is also growing in the electronic realm.

“I think regulators deem this post-trade transparency a success and will look to continue to expand and look for alternative ways to introduce more transparency into the bond markets, and redefine best execution requirements,” Nicholson continued.

Of course, it may seem that fixed income is in need of an electronic push. Such a transition would provide greater efficiency for trading desks because an increase in electronic trading may mean less manual pricing, order ticket writing and duplicative workflow, according to Nicholson.

Whether the fixed income markets will successfully move from voice to electronic and mimic the equity markets’ trajectory, remains to be seen.

MarketAxess, an electronic trading platform for fixed income, traded just over 11% of U.S. corporate bonds in February of this year; a drop from an all-time high of 14% last December.

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