The fixed income market has undergone dramatic changes and has become

The Journal of Financial Services Technology 41 Electronic Bond Trading: reaching the tipping point By David Easthope Celent David Easthope is a senior analyst in Celent s securities and investments practice and is based in the firm s Boston office. He is a Chartered Financial Analyst (CFA) and member of the Boston Security Analysts Society. Easthope s expertise lies in straightthrough-processing (STP) systems, exception management, and post-trade/pre-settlement solutions. He is the author of Celent s Corporate Actions Automation vendor report and has written widely on straight-through processing issues for broker-dealers. He has also co-written a report with Octavio Marenzi on the impact of Reg NMS on ECNs. His recent consulting work involves advising CIOs and IT planning teams on issues ranging from electronic trading and the effect on post-trade systems to spending trends among ECNs. The fixed income market has undergone dramatic changes and has become increasingly electronic. Currently, electronic trading represents 57 per cent of the US fixed income market, which represents a CAGR of 17 per cent since 2003, when electronic trading accounted for 30 per cent of the US fixed income market. The development of electronic trading occurred particularly in the most liquid fixed income segments, which are US treasury and mortgage-based securities (MBS). As a matter of fact, treasury instruments represented an average daily trading volume of US$539.5 billion for the first half of 2007, and MBS reached an average daily trading volume of US$319.3 during the same period. Currently, electronic trading represents nearly 80 per cent of the treasury segment and 32 per cent of MBS. Meanwhile, the development of fixed income electronic platforms led to a change in market structure and a diversification of product offerings towards multi-asset trading. Indeed, major platforms have expanded their product coverage either geographically in Europe and Asia or by entering other markets such as derivatives products. Finally, these platforms are increasing their focus on value-added services such as post-trade processing. Overall, standardisation of the fixed income product and the resultant liquidity is the key deciding factor whether a bond will be traded electronically or not. Standard products are less profitable but more likely be traded electronically. Introduction Electronic bond trading, or e-bond trading, represents the electronification of one segment of over-the-counter (OTC) traded products. Unlike traditional exchangebased liquidity, electronic trading has been far slower to penetrate the OTC segment. While this particular report highlights activity related to a single asset class, namely bonds, the providers of e-bond trading, which are both interdealer brokers (IDBs), dealer-to-client brokers (D2C), and exchanges cover an increasingly wide array of asset classes. With exchanges (NYSE Euronext) moving into traditional OTC products like bonds, and interdealer brokers becoming increasingly interested in a Financial Standard publication Volume 2 Number 1 2008

42 The Journal of Financial Services Technology exchange-traded products, particularly derivatives, the line between OTC and exchange-based products is blurring. This report analyses the development of electronic fixed income trading that occurred over the past 10 years both in the interdealer market and in the dealer-to-client (D2C) market, but not in every market segment. In addition, this report analyses the new market trends in electronic US fixed income and makes projections about future e-bond trading potential. Market Structure The evolution of fixed income trading has resembled more of a slow burn than a big bang, despite frenzied efforts in the 2000 time period to create a more technology-oriented trading marketplace. Fixed income, as a primarily OTC market, is dealer- and inventory-driven rather than order-driven. Unlike traditional exchange-based liquidity, electronic trading has been far slower to penetrate the OTC segment. Although this report discusses activity related to a single asset class, the providers of e-bond trading cover a wide array of asset classes. Role of IDBs In terms of electronic trading of bonds, the development of the IDB platform has been the most significant trend of the last decade. IDBs deal in both exchange-traded and OTC instruments, including fixed income. However, turnover in OTC instruments dominates the overall trading turnover of IDBs. In terms of revenue, IDBs receive the highest percentage of revenues (27 per cent) from bond trading, followed by interest rate derivatives (IRDs). In the OTC market in general, instruments can be divided into two categories: flow instruments and exotic instruments. Flow instruments tend to be highly standardised and resemble exchange traded products in simplicity, trading mechanism, and documentation. Exotics tend to be nonstandard and are either newly introduced instruments or structured using two or more standard flow instruments (see Figure 1). Most bonds fit into the liquid or flow category of OTC instruments, but not all. CDOs and asset-backed fixed income securities often remain illiquid and fairly exotic. For the most liquid segments of the bond market, there has been a small drift to exchange-traded (i.e. NYSE Euronext) but little evidence to support the full evolution of bonds to becoming exclusively exchange-traded. Structural Shifts Over the past 10 years, the fixed income market has undergone dramatic changes and become increasingly electronic. The development of electronic trading platforms has occurred both in the interdealer market and in the dealer-to-client market, either single or multiple dealer platforms. Forecasted Electronic Trading by Segment Currently, electronic trading represents 57 per cent of the US fixed income market, which represents a CAGR of 17 per cent since 2003, and should account for 62 per cent of the whole US fixed income by 2010. However, the development of electronic trading has not been equally adopted by each instrument segment. Indeed, the most liquid segments, which are US treasury and mortgage-based securities (MBS), are more electronic than the other segments. In fact, electronic trading represents nearly 80 per cent of the treasury segment and nearly 32 per cent of MBS. Projections and Methodology To gauge the level of electronic trading in different fixed income product segments, we will look at second quarter 2007 estimates for electronic trading in treasuries, MBS, and less liquid segments, such as agency, municipal, and corporate debt. These snapshots Figure 1. Characteristic of IDB instruments Source: Celent analysis Volume 2 Number 1 2008 a Financial Standard publication

The Journal of Financial Services Technology 43 Figure 2. Electronic trading of US treasuries to increase by 2010 Source: Celent estimates, Firm public reporting provide a look at the current market penetration. In addition, we make assumptions for each product segment in terms of electronic trading penetration by 2010. For each of these segments, we identify leading electronic platforms. The market leaders in electronic fixed income trading are Tradeweb, ICAP s BrokerTec, BGC Partner s espeed platform, and MarketAxess. MarketAxess strength is in high grade corporate bonds. (The profiles of these electronic platforms are available in the full version of this white paper). Liquid Segments: Treasuries and MBS The following figures (Figure 2 and Figure 3) show the current state of electronic trading for treasuries and MBS, as well Celent assumptions through 2010. According to our estimates, currently 77 per cent of the very liquid treasury segment is traded electronically, and 32 per cent of the MBS sector. Moreover, greater than 84 per cent of the treasury segment (see Figure 2) and nearly 35 per cent of the MBS segment will be electronically traded by 2010. Less Liquid Segments: Federal, Municipal, Corporate The three other market segments of US fixed income (federal agency, federal, and corporate bonds) are far less liquid than treasury and MBS. Thus, it is not surprising that electronic trading is less developed in these segments (see Figure 4). Indeed, electronic trading is currently estimated at 15 per cent of federal agency securities, 10 per cent of corporate bonds, and 8 per cent of municipal bonds. According to our estimates, electronic trading will increase slowly until 2010 and will represent 16 per cent of federal agency securities, 12 per cent of corporate bonds, and 10 per cent of municipal bonds. Overall Electronic Trading Currently, electronic trading represents 57 per cent of the US fixed income market, which represents a CAGR of 17 per cent since 2003, when electronic trading accounted for 30 per cent of Figure 3. Electronic trading of mortgage-based securities 2007 2010 Source: Celent estimates, Firm public reporting a Financial Standard publication Volume 2 Number 1 2008

44 The Journal of Financial Services Technology Figure 4. Electronic trading in less liquid fixed income segments Source: Celent estimates the US fixed income market. Celent projects overall electronic trading in fixed income to be 62 per cent in 2010, led by treasuries (84 per cent) and mortgage-based (36 per cent) and followed by federal agency (16 per cent), corporate (12 per cent), and municipal (10 per cent). Figure 5 provides a summary of the steady penetration of electronic fixed income trading by product type over this period while Figure 6 projects the entire US electronic fixed income marketplace. A number of industry trends are affecting how electronic platforms address the electronic fixed income market segment as well as other types of financial products. (A summary of the trends can be found in Table 1 on page 46.) Changes in Market Structure In the electronic credit market, there seems to be a movement toward a less clear distinction between interdealer and client-todealer platforms. An example is MarketAxess, originally a clientto-dealer platform, entering the interdealer market with the launch of Dealer-Axess. Also, a decrease in single-dealer platforms has been observed as demand for multiple, competitive prices increases. The exchange model in electronic trading has also resurfaced with NYSE Euronext s relaunch of its electronic bond platform in 2007, the London Stock Exchange s majority ownership of MTS in Europe, and ICAP s long-discussed plan to petition for exchange status (and the recent hiring of a new COO for exchange projects to further this matter). Furthermore, hedge funds have expressed their increasing demand for direct access to interdealer platforms. Hedge funds already have access to some client-to-dealer platforms like Tradeweb and BondVision, but they recently requested access to Italy s MTS, which is owned in part by NYSE Euronext. Indeed, with access to their dynamic pricing instead of static request-for-quote models, a direct connection with interdealer platforms would facilitate hedge funds complex algorithmic trading strategies to exploit arbitrage opportunities. In September 2007, MTS said it will allow non-banking entities access to its EuroMTS interdealer trading platform as long as they are viewed as broker-dealers by the UK s Financial Services Figure 5. Increase in electronic trading by product 2007 2010 Source: SIFMA, Electronic platforms, Celent estimates Volume 2 Number 1 2008 a Financial Standard publication

The Journal of Financial Services Technology 45 Authority (FSA). As a consequence, Credit Suisse Group decided to stop making markets in European government bonds on four trading platforms operated by MTS, protesting MTS s decision to open trading to hedge funds. Primary dealers such as Credit Suisse are afraid that hedge funds could exploit the European market-making system in order to speculate with high-frequency automated spread trading instead of providing liquidity to the market. Additionally, new order matching models are emerging in the US to meet the demand of buyside traders for the more liquidity in certain segments of the marketplace. For example, State Street Global Markets s fixed income business, in addition to the traditional methods of trading of all types of bonds, has developed a matching model that allows anonymous crossing and trade facilitation. The anonymous crossing, which does not involve dealers, is a model that has gained wide acceptance in the equities markets and has become more appealing in certain bond segments, such as illiquid corporate bonds, according to industry sources. Developments Toward Multiasset Electronic Trading Tradeweb and partners offer the premier multiasset client-todealer platform to accommodate demand, both from buy side retail and institutional investors, for more complicated trading strategies and asset classes. Moreover, platforms have been expanded outside their core product segments, i.e. Tradeweb into corporates, interest rate swaps, credit derivatives, and repos, and espeed into FX. But impediments to cross-asset trading still include uneven adoption of electronic trading across assets, and the absence of centralised multiasset clearing houses. Furthermore, as clients are demanding additional products on a single platform, most of the leading platforms have introduced products that they developed themselves or in partnerships. Geographical Expansion Most of the US-based electronic fixed income platforms have aggressively moved into European and Asian markets as competition increased on the US products. For instance, ICAP BrokerTec has been especially successful in penetrating the European market despite the existence of MTS in most of the attractive European markets. Other examples include Tradeweb s recent offering of access to its electronic platform to the Asian market and Bloomberg s offering of Singapore government treasuries. Expanding Product Offerings to OTC Derivatives The OTC derivatives market has grown by leaps and bounds in the past three years and is projected to continue its explosive growth. Especially noteworthy have been credit derivatives, for which the actual average annual growth in notional (rolling three year) for 2006 was 113.8 per cent. Not surprisingly, trading platforms have been rolling out their derivatives offerings in quick succession in the past three years. l Tradeweb: Interest rate swaps (US and Europe), credit derivatives indices (US and Europe) l MarketAxess: Credit derivatives (US and Europe) l ICAP BrokerTec: Credit derivatives (US indices, Europe), interest rate swaps (Europe) l BGC Partners (espeed): Interest rate swaps (US and Europe) Increased Focus on Value-Added Services Over the past 10 years, electronic trading platforms have expanded their product and service offerings. Indeed, many platforms have broadened their range of services designed to alleviate the often intensively manual post-trade processing of fixed income transactions, such as confirmation, allocation, and settlement of trades as well as order management, pre-trade analytics, regulatory and compliance services, and identity management. Figure 6. Overall projected increase in electronic trading 2007 2010 Source: Celent estimates a Financial Standard publication Volume 2 Number 1 2008

46 The Journal of Financial Services Technology Table 1. Electronic fixed income platform trend summary Source: Celent Other developments included the increasing adoption of the FIX protocol 4.4 due to its perceived cost-reduction benefits, greater focus on straight-through processing (STP), and connections to clearance and settlement facilities to automate back office functions. STP is seen as the industry solution to timing issues, whereby real time views of positions are essential. Manual processes also entail booking errors and disagreements about collateral value, and positions. Finally, the growth of algorithmic trading in the fixed income market follows the increase in liquidity. But compared to equities, fixed income trading is still lagging in frequency, liquidity, and efficiency, which might limit the development of algorithmic trading. Conclusions The fixed income market is becoming increasingly electronic, and the development of electronic trading platforms occurred both in the interdealer market and in the dealer-to-client market, either single- or multi-dealer platforms. Indeed, electronic trading currently represents 57 per cent of the US fixed income market and should increase to 62 per cent by 2010. Electronic trading is particularly developed in the very liquid treasury segment, where nearly 80 per cent of trades are already electronic. Thus, the growth potential is in the mortgage-based securities segment, where only 32 per cent of trades are currently executed electronically, and we can expect that this will reach nearly 35 per cent in 2010. The development of fixed income electronic platforms led to the diversification of product offerings. Indeed, major electronic platforms have expanded their product coverage either geographically in Europe and Asia or by entering other markets such as derivatives. Indeed, derivative instruments have become more and more popular, and the volume of derivatives traded has increased, particularly instruments like interest rate derivatives, foreign exchange, and credit default swaps. Moreover, we can predict that electronic platforms will be more focused on value-added services to differentiate themselves from their competitors. For instance, they will expand their range of services designed to alleviate post-trade processing of fixed income transactions, such as confirmation, allocation, and settlement of trades as well as order management, pre-trade analytics, regulatory and compliance services, and identity management. This white paper is an extract of Celent s Electronic Bond Trading: Reaching the Tipping Point. The full paper has details of the Profiles of Leading Electronic Platforms. For more information, please go to www.celent.com Volume 2 Number 1 2008 a Financial Standard publication