Platform Proliferation: Déjà Vu All Over Again?

By Anthony J. Perotta, TABB Group

Originally published on TABB Forum

We’ve borne witness to this scene before – necessity stirring the entrepreneurial zeal of electronic trading innovators. Many platforms stepped forward; few survived. Back then, the market’s message was clear: Solve a problem, or die trying. Given that the current issue facing everyone may be rooted in market structure, today’s innovators have their work cut out for them.

The development of the internet ushered in many innovations. In financial markets, the technology paved the way for the proliferation of electronic trading and the rise of platforms. For fixed income, in particular, more than 85 alternative trading systems (ATS) and electronic communication networks (ECN) were introduced, utilizing both multi-dealer (MDP) and single-dealer (SDP) concepts servicing institutional dealers and investors.

As quickly as these entrepreneurial ventures arose, many were eradicated in a few short years, leaving a core group of participants to solidify franchises that persist through today. Many of the platforms that avoided the purge did so by solving a clear and obvious problem – a seemingly important requirement when wanting to perpetuate a business. Platforms wanting to garner favor with investors are wise to be particularly focused on this salient point.

Many things have developed out of the wake of the financial crisis, but the one persistently capturing the attention of market participants and the media is the dearth of liquidity. As such, alternative sources of liquidity have become all the rage. This has precipitated a renaissance of sorts in the electronic trading space across fixed income markets.

In the U.S. corporate bond market, liquidity issues have been exacerbated by the changing regulatory environment, the growing weight of assets under management (AuM), the reduction in on-demand trading that dealers provide, and the inherent lack of homogeneity. The days of immediacy (at least, for larger trades) and the unabated use of dealer balance sheet are seemingly gone. Investor appetite is being satiated by a relentless flow of new issues. But illiquidity still pervades 98.5% of the secondary market. The ratio of dealer liquidity (as defined by the capital large banks commit to secondary market-making in IG and HY markets) has fallen from 2.3% to just above 1.2%, a 48% decline.  

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Execution venues are busy introducing trading protocols purporting to solve the problem. MarketAxess currently owns most of the electronic market share (about 15% of the total market), but the solution it provided in 2002 (the list-based, electronic request-for-quote, or “e-RFQ”) facilitates cash flow trades requiring immediacy. These tend to be odd-lots (TABB estimates the average e-RFQ to be approximately $480K). The real problem beguiling the market is the inability to move off-the-run issues (approximately 24,000 outstanding CUSIPs) for notional trade sizes greater than $2 million.

It has taken several years to get new platforms to the deployment stage, but competition finally is developing. Imbedded institutional fixed income platforms such as Tradeweb and Bloomberg are now being joined by upstarts such as TruMid, Electronifie, and Bondcube. Retail ATSs such as KCG Bondpoint and TMC Bonds are diversifying their models, offering connectivity to large asset managers. Established equity trading venues such as Liquidnet and ITG are also getting into the game, as are European platforms including MTS/Bonds.com. In total, there are almost two dozen trading platforms or electronic models servicing the corporate bond landscape, jockeying for market share.

Skepticism abounds. Adoption has been slow. Asset managers are eager to consider alternatives, but their behavior remains mired in the past. We often hear the narrative, “market structure is changing.” But the reality is that market structure remains stubbornly intact. Voice-driven trading is still the primary modus operandi for larger and bespoke trades, and e-RFQ is the protocol dominating odd-lot trading.

There is an undercurrent that ultimately might pave the way for structural change – the market is subconsciously migrating to an order-driven model. Our research indicates “riskless principal” (often incorrectly termed “agency”) trading has risen dramatically over the past year. We estimate that approximately 30%-40% of investment-grade and as much as 70% of high-yield trades are executed following the receipt of an order. While dealers are eschewing execution and inventory risk, they remain intimately involved in the process of risk transfer as the critical link facilitating distribution, protecting information leakage, and providing pricing data. As the corporate bond market starts to resemble an exercise in archaeology, dealers represent those armed with picks, shovels, and toothbrushes.

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Electronic trading venues believe they are the efficient answer to the laborious “dig”; many aspire to become the agents of risk transfer for investors. MarketAxess has launched “Open Trading,” which allows investors to anonymously reveal their indications of interest (IOI) to the entire market. The platform endeavors to use its vast connectivity as a substitute for the search and distribution process that dealers have traditionally provided. The company reported that 9% of all U.S. trades utilize the protocol, but there are undoubtedly questions to be answered. For instance, what happens when an investor tests the market with an anonymous IOI and finds no takers? Do they have the luxury of asking for and receiving immediacy from dealers (who presumably have nowhere to go with the bonds, since their clients have all passed)? The evolution toward new trading behaviors and protocols is undoubtedly going to be filled with interesting challenges.

In reality, the “problems” plaguing the corporate bond market today are not as pronounced as the narrative would have us believe. Large asset managers report they are acclimating to illiquidity by altering their trading and investment strategies. Inflows find their way into new issues, and dealers are providing bids (or can source bids from other investors) when selling is required. The fear is in the unknown – what happens when rates rise and the demand to invest in bonds starts to fade? Will there be an orderly exit, or a rush to the exit? Large investors are quick to acknowledge the market is more vulnerable to extreme volatility and price dislocation.

The proliferation of platforms is a healthy and constructive development for the market. Competition, even if only in the ideas being put forth, ultimately spurs innovation. The key to any of these platforms succeeding lies in whether they can identify a problem and remediate it. Given the issue facing everyone may be rooted in market structure, these firms have their work cut out for them. History has shown runways get short quickly in this world. Solve a problem, or die trying.