The economics of fixed income dealing operations is evolving due to market structure changes, emerging regulations, and disruptive technologies already in the market and on the horizon.
As new regulations continue to put pressure on revenue models, firms are investing in innovation in areas such as trading models, price discovery, and trading technology, according to a new report from Celent called “The future of electronic fixed income trading-cash and derivatives: regulation and dealer economics spur innovation in dealer-to-client markets”.
There are a myriad of regulatory drivers, and they all have teeth. The Basel III regulation (global) and the Volcker rule (US with global implications) are driving a greater appetite for capital efficiency and impacting dealer models (i.e. inventory of bond holdings) and thus liquidity in secondary markets. In the US and Europe, EMIR and Dodd-Frank are mandating central clearing models for standardized swaps, inspiring new trading protocols, and creating a greater need for collateral and therefore collateral efficiency and optimization models. Finally, MiFID2 in Europe will push for more transparency in pre-trade prices, post-trade reporting, and a best execution guarantee with some rules and exemptions.
Most fixed income dealers have been spending the last few years responding to the financial crisis and future-proofing their business models. However, as new regulations continue to put pressure on revenue models, firms are investing in innovative business designs. Today, this innovation is primarily in response to developments in the US and European cash fixed income markets. However, as Dodd-Frank and EMIR become more fully developed with respect to the swaps market, Celent expects further innovation (rather than just integration) to accelerate in the OTC markets beginning in 2013.
Innovation in cash fixed income markets is occurring in trading models, price discovery, and trading technology. From a trading model standpoint, the efforts centre on concentrating liquidity with a minimum of capital and operational overhead. Price discovery innovation centres upon gathering data and building proprietary models to determine a view on price. Trading technology innovation will focus on providing the building blocks of creating a more electronic market structure, with an emphasis on connectivity, smart order routing, and algorithms.
In US corporates, Celent predicts a gradual migration to electronic, continuous order books for liquid issues and other more episodic but selective liquidity mechanisms which seek to concentrate liquidity for less liquid issues. At the same time, Celent expects US sovereign debt to trade in the future very much as it does today, as a highly electronic market but also one where the fundamentals are highly susceptible to policy interventions. Celent also expects a very gradual (i.e. marathon not a sprint) migration to electronic platforms for standardized swaps in US derivatives (CDS and IRS). Players will have time to test and learn and adjust business models over time.
In European cash, Celent predicts further selective liquidity provisioning by dealers, while in European derivatives, Celent has only question marks until greater clarity arises from regulatory developments in EMIR legislation. At the same time, as greater clarity emerges from EMIR, Celent anticipates a similar type of standardization of the European swaps market.
An evolved and more electronic market structure will drive demand for advanced technology available in trading other asset classes, including in-memory, high computational processing databases, advanced order management and execution management systems, algorithmic trading platforms, smart order routing, and even complex event processing engines.