A New Market Structure for Bonds?

A little noticed press release came across my desk the other day that I thought was very interesting: ICAP/BrokerTec and MarketAxess were teaming up to provide institutional (buy-side and corporate) access to the interdealer broker (IDB) benchmark U.S. Treasury bond markets. In effect, this will link the BrokerTec IDB trading platform with the MarketAxess distribution network and, for the first time, institutional investors will be able to electronically buy and sell on-the-run U.S. Treasury Securities as easily as they trade U.S. Equities at the same price as the U.S. Treasury Primary Dealers.

This is a significant market structure event for the fixed-income world, as there is no centralized Bond Exchange in the United States.

Fixed-income securities trade in a dual market, the Interdealer market and the dealer to customer market. Large bond dealers find liquidity in the Interdealer (wholesale) market, in which the IDB plays the role of a virtual electronic bond exchange. Cantor Fitzgerald started this trend with their eSpeed subsidiary and others, most notable ICAP, and BrokerTec (now owned by ICAP) quickly followed. This market has traditionally been closed to institutional investors, who trade in the dealer to customer market.

This is in contrast to dealer to customer markets, such as TradeWeb and MarketAxess who offer reverse-auction or request/response trading formats. In these markets the customer sends an electronic message to multiple dealers who respond with competitive bids which can be electronically executed. In this style market, prices are not listed, buyers cannot hit or lift postings, and there are no market or limit orders.

This MarketAxess / ICAP announcement fractures this structure. First, this change enables institutions to migrate from an "inquire and deal" to an "offer and take" methodology and second, the small number of firms that dominate U.S. Treasury trading (Primary Dealers) have fought against this type of market structure for years, and now they seem to be embracing it.

Since a consortium of dealers holds a significant stake of MarketAxess we must believe that this deal was not undertaken lightly or without the backing of the largest fixed-income dealers.

Opening this market directly to institutions also implies that similar to the U.S. Equity markets, spreads in the U.S. Treasury market have become so thin that it has become unprofitable for dealers to extend capital to institutions. It appears that dealers want to move from a market-making role to an agency-based role, reducing their trading risk and increasing their fee income.

While a new market structure sounds boring, it most certainly is not. Migrating to an ECN-type format will most certainly change the way that bonds trade. This could lead to a more competitive market, increased volume, adoption of electronic and algorithmic models, new order management technology for both buy and sell side traders, as well as a centralization of the fixed income trading function on the buy-side.

How can one little change affect so much?

It begins with the way investment managers trade bonds. Since the fixed-income markets are not centralized (no central bid/offer market) and there is no single place to go to get a specific price, many firms have their portfolio managers instead of buy-side traders, trade their fixed-income securities. The development of a centralized market structure will make trading easier, enabling portfolio managers to delegate trading, allowing for creation of a buy-side bond-trading desk.

Centralization will make trading more efficient and by default facilitate better pricing. This will squeeze profits, and force brokers to look at reducing risk-based inventory positions, pushing the firm further away from market making toward a fee-based agency business.

The migration to an agency business, similar to the equity business will constrict profits further, forcing firms to both automate and eventually provide direct execution facilities to institutional clients. As firms reduce inventory and have better electronic access to liquidity, brokers and buy-side firms will develop algorithms to electronically trade these products and align the trading of these products to their trading strategies.

While these market structure change is large, and the impact great, the impact of these changes will not happen overnight.

First, the odds of success are limited, at best. Many firms, even MarketAxess themselves tried at an earlier time to implement this type of ECN structure and failed. While they did not tie this structure directly into the IDB market, they did so without the aid of the brokers, and they tried to develop this type of market structure with High Grade and High Yield Bonds rather than Sovereign Debt (three very critical mistakes), this path has been walked before without much success.

Second, if this change does occur, the technology adoption curve for success is very steep, as a significant amount of needed technology does not even exist, including a well-adopted communications protocol (FIX for Fixed Income penetration is very low), as well as a compliant order-management system (for either buy or sell sides).

However, given these challenges, a MarketAxess / ICAP/BrokerTec partnership in this area is the most valiant attempt to change the US Treasury market structure in years. Given MarketAxess, ICAP, and BrokerTec's success in this market, their industry ownership, and their distribution capabilities, this change will certainly be a well-fought battle, with much greater chance of success than any attempted in memory.

****Look for Larry Tabb's column online. He will be a regular contributor to Wallstreetnandtech.com Larry Tabb is the founder and CEO of TABB Group, the financial markets' research and strategic advisory firm focused exclusively on capital markets. Founded in 2003 and based on the interview-based research methodology of "first-person knowledge" he developed, TABB Group ... View Full Bio