By Kevin Kulling, J.D.
Although automation in the fixed income markets has lagged behind that of the equities markets, FINRA’s chief economist and senior vice president said that electronic trading in the corporate and municipal bond markets is gaining traction, “like a slow train gathering speed.” As the electronic transformation continues, he said that it was imperative that regulators and the industry continue to work to strengthen programs that minimize the impact of market volatility and to limit market disruption.
Current state of electronic trading. In remarks to the North American Electronic Bond Trading Forum, Jonathan Sokobin said that while nearly all stock markets are electronic, on the fixed income side, trading and markets are a dramatically different story and electronic trading platforms have not yet been as transformative. The reasons are varied, he said. One reason may be the inherent value of voice trades in maintaining discretion in thinly traded markets. Another reason often cited is the large number of unique assets and infrequent trading of many corporate bond markets.
Regardless, he noted that today there are 19 electronic bond trading platforms operating, up from 5 in 2008. The platforms have evolved in response to the differing demands of participants and to increase participation.
He also said that electronic trading is dominant in the fixed income futures and the U.S. Treasury markets. There is also a general uptick in electronic trading in the corporate market, he said, and the number of corporate bond trading protocols that have been structured to address the differing demands of market participants has more than doubled since 2013.
Increased electronic trading factors. One factor driving the creation of electronic platforms in fixed income is the significant shift in the balance sheets of traditional liquidity providers such as banks and broker-dealers, in contrast to non-traditional liquidity providers, such as asset managers and proprietary trading firms. Since the financial crisis, regulatory reforms have resulted in greater capital and liquidity requirements for banks. In turn, the traditional liquidity providers have offloaded a significant amount of inventory.
Sokobin said that there is likely a change in the demand for liquidity services, led by market participants who demand liquidity because they may need to adjust their portfolios quickly to meet inflows and outflows. Additionally, as traditional liquidity providers move back toward more agency-like models, it takes more time and more work to identify counterparties and more opportunities for asset managers to selectively provide liquidity.
Regulatory concerns. Electronic trading, in particular automated and high-frequency trading, pose a number of challenges to regulators, including a lack of transparency regarding alternative trading systems, or ATSs. This is a concern to regulators generally, he said.
On the fixed income side, FINRA is seeing increased trading of TRACE-eligible securities in dark pools, greater use of request-for-quote processes, and more executions of customer orders by firms that participate as both broker and as dealer. As a result, FINRA will begin requiring firms to report additional information to TRACE.
He said that regulators are also concerned about some of the protocols within the platforms. For example, some protocols allow participants to filter out participants with whom they do not wish to trade. Because participants may not wish to trade with certain counterparties, this may create an uneven playing field.