By Li Renn Tsai, Head of Asia, Tradeweb
Over the past two decades, asset class after asset class has gone digital. The transparency and liquidity benefits are well documented, but fixed income, with pricing largely driven by inventory, remained a last stronghold of voice trading until recently. This year, amid the volatility associated with COVID-19 and the arrival of new trading technologies, has seen a surge in uptake of electronic workflows generally, and portfolio trading in particular.
Portfolio trading is the latest arrival on the electronic bond execution scene. It gives asset managers the ability to put together a basket of bonds to buy or sell, and trade them all together as a single package deal. Bonds within a portfolio trade will typically encompass both liquid and illiquid instruments with varying credit quality and durations. The basket is typically sent to a limited number of dealers for negotiation, and once the deal is done with a single counterparty, each line item is fed back to the client’s order management system, while benefitting from straight-through processing and reporting efficiencies.
The idea behind portfolio trading is that buyers and sellers can access aggregate liquidity more effectively. By including illiquid bonds alongside more easily traded securities, sellers are able to get liquidity across all their desired trades where it would be difficult to achieve on a bond-by-bond basis. On the sell-side, dealers have access to sophisticated analysis, underpinned by machine learning, which enables them to assess the risk profile of the basket as a whole and take on the less liquid instruments within their pre-set risk parameters.
Like all electronification of markets, these developments have been facilitated by advances in technology. The complex machine learning and algorithmic analysis underpinning this real-time pricing and trading a much broader range of debt instruments has only become possible in the last few years. Previously, a portfolio trade of the type that can be made in a few minutes on a digital venue, would have taken weeks to analyse and price on both sides of the deal. In the new e-trading platform world, each fixed income instrument in electronic format already contains information on all its variables, and quantitative algorithmic analysis can easily be applied as bonds are grouped together ready for a portfolio trade.
Despite the obvious speed, ease and cost benefits of such an approach, a wholesale move to electronic trading in bonds is hardly a foregone conclusion. In contrast to government bond trading, voice execution is still the norm in the more opaque and complex world of corporate debt, particularly in the U.S. And outside the U.S., without the consolidated tape (TRACE) that provides pricing information, pricing for illiquid bonds in particular is more difficult to extrapolate. Nevertheless, portfolio trading continues to surge. A key factor in this is ETFs.
The relentless rise in popularity of fixed income ETFs has driven demand for more frequent trading of underlying securities to support the creation and redemption process. Here portfolio trading demonstrates clear benefits as access to underlying inventory is faster and more efficient. Timing is critical in ETFs, and trading portfolios in one go ensures trades can be executed quickly, in order to reflect the on-market quoted price in the creation/redemption basket.
Regulation is playing a part as well. MiFID II rules around proof of best execution and post-trade transparency favour electronic execution, even in markets not specifically governed by these regulations, as leading firms benchmark themselves to meet these client-friendly requirements as a point of competitive advantage. The compliance materials that flow from electronic portfolio trading – such as FIX messaging, a dedicated compliance PDF document, a time-stamped audit trail and post-trade analytics – are very useful both for this type of regulatory and client reporting, as well as benchmarking trading performance.
And finally, the unexpected health crisis of 2020 saw bond traders working from home en masse, away from their teams and data feeds. This gave a huge boost to electronic trading platforms, which proved critical in providing institutions access to markets during the hugely volatile first quarter of the year, but also in informing their trading decisions. Much of the trading that moved from voice to platforms during this year is likely to stick once the crisis recedes. In this year of so much uncertainty, it seems that electronic- trading is one constant that is going to be here to stay.