Electronification developments and trends in Fixed Income Markets ICMA Conference – Electronification and Regulation, what now ? Copenhagen – 29/11/2016 Yann CALENGE Head of e-Rates
Summary A bit of history…market structure evolution The past century The early 2000s The mid 2000s Where we are now In short… The forces behind the changes Regulation, regulation, regulation… Mifid II: trading on venue obligation Mifid II: pre- trade transparency…a game changer for the dealers Mifid II: best execution Beyond regulation: other influencing factors The costs problem Technology Monetary policies The Changes Tomorrow’s platform landscape Markets participants will be different too The new structure Conclusion 2
A bit of history… Market structure evolution
The past century… Voice brokers Voice interactions Dealer Dealer Customer Customer In the flow world, this may seem like a far distant picture but for highly illiquid instruments and in the exotic/structured derivatives space, it remains very much alive This may come as a major relief to some, but not everything can be electronified ! 4
The early 2000s Voice D2D brokers platforms Voice interactions Electronic interactions Dealer Dealer D2C Customer Customer platforms The first electronic venues appeared in the Fixed Income world. Bonds at first: Almost simultaneously, Dealer to Dealer (central order books model) and Dealer to Customer (RFQ based) platforms This model remains very much the dominant one in the Nordic countries: In some asset classes ( Swaps in particular) we are hardly at this stage. 5
The mid- 2000s… Voice D2D brokers platforms Voice interactions Electronic interactions Dealer Dealer D2C SDP SDP Customer Customer Dealers started introducing Single Dealer Platforms FX was the primary objective. But some offered Bonds and Interest Rates Derivatives…with various fortunes. This is yet to happen in the Nordic region and given the lack of success of Single Dealer Platforms in the Fixed Income space so far, other than on some very specific asset classes (structured products ?), it may never materialise. 6
Where we are now Prop trading Voice Interactions firms Voice D2D Electronic Interactions brokers platforms Dark Pools Dealer Dealer D2C SDP SDP Customer Customer In the G4 currencies, the last few years have seen the arrival of new types of liquidity providers. They are targeting the highly liquid instruments space (Vanilla Swaps and Benchmarks Bonds) Their business model is heavily biased towards electronic A new type of ”venue” has emerged: the dark pools. 7
In short… Electronification has already happened. At a different pace in each asset class Certainly at a slower pace in the Nordic countries than in the wider G4 Markets. P ockets of “voice business” remain Primary market, various illiquid asset classes… The dealer to dealer interactions in Bonds, remain voice based (if not “chat”) as opposed to the highly electronic FX world (bilateral links) and derivatives (D2D, “SEF”, D2C). In fact volumes traded on European dealer-to-dealer platforms in the recent years have been depressed. Importantly, none of the past transformations of the Fixed Income market structure were induced by regulatory changes This is about to change dramatically After these initial waves of electronification, market players who have missed the first turn will face the difficult challenge of a rushed transformation . The others will move on to the next stage: Automation. 8
The forces behind the changes
Regulation, regulation, regulation… MiFiD framework in place since November 2007 It scared a few at the time, but hardly affected the Fixed Income market structure. For Fixed Income it was mostly a lot of paperwork: execution policies, client classification, suitability and appropriateness… The post-crisis regulation: Dodd-Frank, MiFiD II, Basel III, NSFR, TLAC, BRRD…and coming soon FRTB Prevent tax-payers bail-outs of failing banks by: Separating prop-trading from other more traditional market making activities Discouraging Banks from taking excessive risks on financial markets These will impact the Fixed Income market structure, as they will directly affect Banks. Reducing costs and capital consumption while maintaining profitability is the new grail . This can only be achieved one way: automation. 10
MiFiD II: trading on venue obligation ESMA will confirm the scope of the “Trading Obligation”. But there is already a pattern : EUR plain vanilla swaps will be caught: Buy-side and sell-side players still need to make the necessary investments. In the Nordic countries, SEK could be caught on the most liquid part of the curve. NOK, DKK will be spared. Even if Scandy swaps were left aside, the electronic transformation could still happen: The extra investment on top of what is necessary for EUR swaps is very small. The temptation to re-use the infrastructure will be strong. If Banks do not make the move, the mandatory clearing (SEK,NOK) could allow for new participants to fill the void. The Nordic Swaps industry is late on the electronification curve . At least on EUR, it will have to catch-up. But we could see a two-speed market. 11
MiFiD II: pre- trade transparency…a game changer for the dealers In the Nordics the following bonds will be deemed to have a liquid market: Sovereign bonds: all of the Government and most of the SSA bonds Covered Bonds: All of the Swedish Mortgages (except 5) in stage 1, all of them by 2020 Half of the Danish mortgages bonds in Stage 1 and almost all of them by 2020. Then it is all about the SSTIs: Sovereign Bonds: 900 k € in stage 1 all the way up to 5 M € by 2020 Credit, from 250 k € to 722 k € by 2020 Derivatives still under discussion Pre-trade transparency and systematic internalization rules: Make dealing on own account below these levels a risky and expensive business. Offer easy waivers for transactions done on OTFs, MTFs and Regulated Markets. Will be the new rule for transactions below SSTIs…and not so small ones 12
MiFiD II: Best Execution Migrating to electronic venues offers the best alternative to both buy-side and sell-side. The multi- dealer RFQ model remains sufficient from a regulatory point of view, but… The compliance cost for Banks to maintain too large lists of customers, The multiplication of price providers (including non Banks dealers), The greater independence of brokers towards dealers over platforms’ access, Will like facilitate the emergence of new models or the renewed success of old ones: One to all RFQs, Dark pools (when not executing client orders !), The return of the CLOB pushed by some OTFs/MTFs The next two years: multiplication of platforms, protocols and players all pushing in different directions. 13
Beyond the regulation, other influencing factors (1/2) The costs problem Low yields and increased competition are forcing market participants to reduce costs. Some may pull out of dealing activities as the rewards do not seem to outweigh the costs anymore. Others will try to adapt via greater automation of the trading process. Technology in not just a way to reduce cost: On its own, it can also be a source of ”new businesses” for the industry. High Frequency Trading firms are the best example of it. With increased competition in Equities and FX, Fixed Income will be their next target. The Nordic markets will not be totally immune to this change. Whatever the reason, expect more of its kind. 14
Beyond the regulation, other influencing factors (2/2) The monetary policies: The prolonged low interest rates environment is impacting the market structure: Buy and hold approach of FI investors has been reinforced by the low yields High level of new issues in the last 8 years, have spread the liquidity even thinner The buy side is looking for alternatives to dealers’ balance sheets Despite Central Banks policies (or because of ?), the velocity of newly printed money has been reduced. Adverse market conditions could easily derail the electronification trend…for a short period of time Stressed markets are showing how fragile the electronic liquidity is. The pace of the market structure evolution will be decided by how smooth the rates normalization process will be. 15
The changes
Tomorrow’s platform landscape The diversity of the platforms should remain but with a clear separation between liquid and illiquid instruments: RFQ type of MTFs are here to stay in the least liquid assets classes In liquid instruments (vanilla swaps, government bonds, some SSAs…) we will likely see a resurrection of the Central Order book model, as brokers allow more and more participants on their platforms The Nordic markets will follow this evolution: it is imposed by regulation, not driven by markets specificities. Large size Phone-Dealers/Brokers Dark OTFs Pools - CLOB MTFs MTFs - - Liquid Illiquid RFQs RFQs MTFs - One Regulated to all Exchanges RFQs CLOB Small size 17
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