The Future of Electronic Fixed Income Trading - Cash and Derivatives: Regulation and Dealer Economics Spur Innovation in Dealer-to-Client Markets
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.
In the report, The Future of Electronic Fixed Income Trading-- Cash and Derivatives: Regulation and Dealer Economics Spur Innovation in Dealer-to-Client Markets, Celent dissects trends and developments in the fixed income trading value chain and explores how regulation and revenue pressures are fostering innovative designs in the marketplace.
The fixed income trading value chain is evolving more significantly than any other across the range of asset classes. Whereas FX and equities underwent significant transformations toward electronic platforms and technology supporting trading workflow years or even decades ago, fixed income is only just catching up.
Some of this evolution is industry-led due to declining profits and a desire to improve efficiency by leveraging technology, but most of it is due to factors outside the industry's control, as a myriad of national and multinational regulatory efforts strain business models, force capital optimization, and mandate certain clearing models. Major initiatives include Basel III, the Volcker rule, EMIR, Dodd-Frank and MiFID2 in Europe.
"The net result of these regulatory initiatives will severely impact dealer models, putting pressure on revenues, and thus liquidity in secondary markets," says Josephine De Chazournes, Senior Analyst with Celent's Securities & Investments Group and coauthor of the report.
"Due to the impact on liquidity and dealer models, a number of firms are investing in innovative business designs," adds David Easthope, Senior Analyst with Celent's Securities & Investments Group and coauthor of the report. "Innovation in cash markets is occurring in areas such as trading models, price discovery, and trading technology."
This report examines the evolution of fixed income, developments in the value chain, and the evolution of liquidity and trading. Celent identifies innovative new business designs in fixed income trading models, price discovery and trading technology. The report also provides market scenarios for different instrument classes in the US and Europe.
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 center around concentrating liquidity with a minimum of capital and operational overhead. Price discovery innovation centers 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.