The fixed-income markets have changed immensely over the past decade. There have been several underlying macro-economic, political and demographic factors that have fundamentally shifted risk profiles, resulting in greater interest in fixed income at both an institutional and retail level.
According to mutual fund research consulting firm Strategic Insight, 88 percent of all fund inflows for the first half of 2012 were to bond funds, a record-setting pace rivaled only by the flight to safety witnessed after the 2007 financial crisis. Interestingly, much of the inflows have been focused on high-yield, emerging-markets and global debt.
As a result, asset managers now have more fixed-income assets to manage across disciplines and markets, increasing pressure on all phases of trade processing. Paradoxically, just as asset managers are looking to execute more fixed-income orders, brokers are finding it far more challenging to make a profit due to thinner spreads and increased regulatory and compliance demands.
These pressures have forced adjustments across buy- and sell-side firms alike, with one common solution identified: automation. In the new reality, the fixed-income markets require the ability to successfully execute and clear both domestic and global trades in a timely fashion while incurring the least amount of risk and cost. In fact, the cost of fails have been increasing with new Treasury Market Practices Group (TMPG) rules and associated levies as well as overall decreasing liquidity pools often making settlement more challenging.
As a result, firms are placing additional burdens on their middle- and back-office processes to ensure their fixed-income investments are being properly assessed and tracked across the lifecycle of the trade.
Automation is particularly helpful when it comes to eliminating risks that can stem from trade clearing. An Omgeo study found that fixed-income trades can have settlement failure rates as high as 7 percent. Automation reduces the risk of human error and ensures that trades move to clearing and settlement quickly and correctly. This is particularly relevant where trades cross languages and time zones and the error experience rate for manual communication rises sharply.
With investment firms focused on the speed of execution, it remains of paramount importance that the middle and back office keep pace. This is why, between 2010 and 2011, Omgeo saw total fixed income transaction volumes through its platforms increase by 21 percent globally, signaling market participants' growing adoption of automated trade processing solutions.
While risk reduction has always been a staple of fixed-income trade management, this is no longer just a post-settlement activity. Risk management permeates from pre-trade, to execution, to clearing and settlement, to portfolio and collateral management. While pre-trade compliance checks have been around for some time, the fixed-income market is now identifying other risk determinants: who the legal counterparty is, what the economic terms of the trade are, and with whom and where the trade will settle.
Essentially, the recent focus on shortened settlement cycles in the U.K. and U.S., coupled with the advent of central counterparties, require these determinates as agreed upon pre-conditions. While many fixed-income securities are already on shortened settlement cycles, including some on trade date, more discipline and standardized processes are needed to both reduce risk and scale to the new realities. Today, market participants are not only required to reduce their firm's risk, but to standardize to reduce systematic market risk.
A firm is only as strong as its weakest link in the trade processing life cycle. Greater community coordination and automation will be essential to keeping the markets running efficiently and allowing participants to garner the best possible risk-adjusted returns as the fixed-income landscape continues to evolve.