In October 2005, I wrote a commentary, "Bonds Ain't Stocks," for Wall Street and Technology on the growth (or lack there of) in electronic fixed-income trading. The gist of the article was that the products were so complex, the issues so numerous and so important, and the dealers so concentrated that it would be a cold day way south of the border before fixed-income electronic trading platforms would be successful.
That was two and a half years ago, and, for the most part, that statement still holds true today. While a few more buy- and sell-side firms are leveraging algos and dealer linkages to interact in the interdealer market, by and large the majority of fixed-income trading still is phone-based or request-for-quote-driven TradeWeb and MarketAxess transactions.
So why am I writing this if nothing has changed? Well, the time may be right for revolution.
Let's review. In the past eight to nine months, there has been a subprime meltdown, the mortgage-backed and asset-backed market has ceased, asset-backed commercial paper markets dried up, auction rate notes aren't auctioning, Bear Stearns was sold to JPMorgan for $10 a share, dealers and banks have pulled back on offering credit, and, in effect, the fixed-income markets are going haywire. If ever there was a market dislocation, this is it.
While the premise of my first commentary was that the markets wouldn't open up because it was not in the dealers' interest, this may no longer be true. The opportunity may be right to open up the fixed-income markets to alternative execution, which actually may be in the dealers' best interest to open up.
The write-off of billions of dollars by dealers will force three things to occur: Dealers will increase their investment in risk management, new risk management strategies will force dealers to reduce their proprietary trading and Value at Risk, and dealers will reduce costs in line with revenues (both personnel and technology). We are seeing this playbook role out at virtually all dealers around the globe.
But what does this mean for the thousands of fixed-income institutional investors? Are their bonds slated to stay in inventory till maturity, or will someone or something develop to facilitate greater transparency, mitigate risk and allow investors to dispose of their unwanted inventory for more appropriate product? Sounds like the market is in need of an exchange, ECN or interdealer platform open to investors, doesn't it?
I am not saying that developing an agency-exchange model is a slam dunk; however, it may be time for the dealers to think about an alternative to always being a principle. With dealers downsizing their desks, directing fewer people to cover more accounts and seeking to take less risk, and with technology getting to a point where newer and possibly more-technology-savvy and less-capitalized players (e.g., quant shops, hedge funds, etc.) perhaps more willing to step into the role of market maker, it may be time to embrace a central counterparty trading model.
While I am not calling for anarchy where the buy side trades directly with other buy-side accounts and no one manages risk, the industry may need to migrate from a traditional OTC market without a central venue to a more traditional exchange model in which there are not only liquidity providers making two-sided markets but a vibrant agency model as well. In this model, investors work with brokers on a commission-basis and trade on behalf of their clients in a more transparent and open community.
While this may seem like heresy to the fixed-income world, unfortunately that constituency is becoming smaller and the demands from the buy side are becoming greater. The big question is: Who will champion this cause -- institutional investors searching for liquidity, dealers looking to reduce risk or regulators in search of a solution? Either way, the time is right.