Innovation is coming to fixed income trading models
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16 August 2012David Easthope
The economics of fixed income dealing operations is evolving due to market structure changes, emerging regulations and disruptive technologies already in the market and on the horizon. There are a myriad of regulatory drivers and they all have teeth. The Basel III regulation (global) and the Volcker rule (US with global implications) are driving a greater appetite for capital efficiency and impacting dealer models (i.e. inventory of bond holdings) and thus liquidity in secondary markets. In the US and Europe, EMIR/Dodd Frank are mandating central clearing models for standardized swaps, inspiring new trading protocols, and creating a greater need for collateral and therefore collateral efficiency and optimization models. Finally, MiFID2 in Europe will push for more transparency in pre-trade prices, post-trade reporting and a best execution guarantee with some rules and exemptions. Most fixed income dealers have been spending the last few years responding to the financial crisis and future-proofing their business models. However, as new regulations continue to put pressure on revenue models, firms are investing in innovative new business designs. Today, this innovation is primarily in response to developments in the US and European cash fixed income markets. However, as Dodd-Frank and EMIR become more fully developed with respect to the swaps market, we expect further innovation (rather than just integration) to accelerate in the OTC markets beginning in 2013. While much of the innovation in capital markets over the last few decades has been around product, product innovation is in decline and business model/design innovation is on the move. We find this type of innovation to be inspiring and fascinating. Innovation in cash fixed income markets is occurring in trading models, price discovery, and trading technologies. From a trading model standpoint, the efforts center on concentrating liquidity with a minimum of capital and operational overhead. Price discovery innovation centers upon gathering data and building proprietary models to determine a view on price. Trading technology innovation will focus on providing the building blocks of creating a more electronic market structure, with an emphasis on connectivity, smart order routing, and algorithms. This innovation cycle will be fascinating to watch and may take longer than cycles in other asset classes (i.e. equities), but it will profoundly affect the underlying market structure in fixed income trading.