Looking over the Edge – seeing bond liquidity in a new light.
The sophistication of electronic trading has evolved rapidly over the last decade.
The sophistication of electronic trading has evolved rapidly over the last decade. The widespread adoption of electronic trading and interaction with new, competitive market models have brought better execution and reduced costs to many asset classes. Yet pockets of instruments still exist that suffer from poor liquidity caused by outdated trading methods.
More liquid securities, such as FX and equities, have moved to electronic channels, delivering the benefits of improved price discovery and post-trade transparency. Assets with a large market, varied participants, and less liquidity – such as credit – have not seen the same improvements in price discovery and transparency.
A new and revolutionary technology promises to enhance liquidity discovery and data protection. It will address the asymmetry in finding and executing less liquid assets and improve trading performance for all participants by enabling market participants to securely exchange information about their trading intentions, while reducing frictional operating costs.
Crossing the divide between bi-lateral and multi-lateral trading
Technological innovation has largely focused on liquid markets, bringing uniformity, increasing speed and visibility of trading. Even as electronic and systematic trading have transformed the efficiency and execution quality of block trades in equities, the transparency of hitherto illiquid markets such as corporate bonds has scarcely changed.
Historically, institutional trading in fixed income markets has relied on intermediaries to find and execute business over the counter. This is because there are potentially dozens of bonds issued per issuer and buy-sides typically hold bonds for some time. Buying and selling requires the identification and movement of often sizeable holdings.
Despite attempts to improve these interactions through the use of requests for quotes, business remains largely manual. Where finding the other side of a trade requires phone calls, quote requests create signals and information leakage that gradually erodes the profitability of the transaction.
However, making these passive holdings available for trading in a centralised venue-like trading model faces many challenges. The disclosure of positions to any form of order book, however dark, risks leakage, slippage and gaming.
Ideally, connecting these pockets of open interest should happen in a decentralised, multi-lateral market. Until now, technical reasons have made such a model impossible.
A new paradigm in the secure exchange of liquidity
Distributed ledger technology, DLT, is one of several advances that bring a new dimension to capital markets. Applied to pre-trade transparency, it allows the widespread distribution of secure, targeted data flows between trusted parties in a new way.
Used to underpin a new type of venue, the advantages of a centralised, regulated exchange combine with the flexibility of decentralised price discovery and secure order interaction.
Put another way, where liquidity discovery in our legacy corporate debt world was a series of opportunistic one-to-one enquiries, the new paradigm is more like a a satellite image of the trading opportunities that meet the investor’s demands –available only to them based on their trusted relationships.
It works by enabling each firm’s DLT node to impart information to others, allowing each party to build their own, unique order book. Each firm owns and controls its own data, ensuring privacy and security where needed. Data is sourced seamlessly from existing portfolio and EMS systems, ensuring onboarding is as painless as possible.
Orders, seeking passive liquidity, can then search the whole market for a match. Thanks to advanced analytics and machine learning, data is even fed back to the originator to indicate how they might optimise their order to improve hit rates and execution quality on both sides.
The market’s enhanced, secure transparency also allows traders to find matches against the profile of an instrument – unique optics that open up the liquidity pool to factor-based discovery.
The advantages go beyond speed (through parallel requests for information), coverage and execution quality, to encompass the other advantages of a fully electronic market. The complete electronic audit trail ensures that manual errors are reduced and reconciliations are simplified, bringing significant operational risk and settlement benefits too.
A decentralized liquidity network promises to bring control, clarity and better execution.