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DerivSource Podcast Electronic Trading vs. Voice April 2015 Julia:
Hello and welcome to a DerivSource podcast. I’m Julia Schieffer, the founder and
editor of DerivSource.com
Since the financial crisis, regulation is pushing as many instruments as possible
onto electronic exchanges and through central clearing. It is too early however, to
call voice trading dead.
Take the recent depreciation of the Swiss franc and the sudden shutdown of the
Bloomberg terminal network - traders took to the phone. The same is true for those
thornier, less liquid trades that do need the human touch.
In this podcast we talk to Fred Ponzo, managing partner at Greyspark Consultancy
and Stu Taylor of Algomi for some insight into the changing trading landscape.
Here is DerivSource reporter, Lynn Strongin Dodds speaking to Fred Ponzo and Stu
Taylor.
Lynn:
Thank you very much to both of you for taking part in this podcast. The first
question is general, so for you Fred. Many trading desks have reconfigured their
offerings but high touch or voice is still a very important component. People turned
to voice when Switzerland depreciated its currency and the Bloomberg terminals
went down. How do you think the industry will develop in terms of voice and
electronic trading?
Fred:
There is a general misconception that electronic is there to replace voice and if you do one
you can’t do the other. The reality is that it’s always going to be a continuum of liquidity
provision and negotiation mechanisms. Now, voice and electronic are very much
complementary, so when everything is fine, there is limited volatility in the market and
there are no disruptions in them, electronic is a good way to churn a large number of
tickets. When you need a little bit more of discretion, whether it’s on price, on quantity,
whether it’s about the paper or the instruments or the counterparty you’re dealing with, you
always come back to voice. So, it’s always a balance between the two. And as I say,
thinking about electronic is there to replace voice is just a misconception.
Stu:
I absolutely agree with what Fred says there. I think the other thing we would is that we
think this is a permanent feature of the market as well. So you are going to have both
solutions, we think as long as the bond market exists in its current form. There are so
many different instruments, certainly versus other asset classes like equities, where GE
may have one or two classes of equity, but it may have fourteen or fifteen hundred
different bonds in maybe five different currencies, so as such the liquidity in this market is
very, very fragmented in a huge number of those instruments.
And you get many instruments that don’t trade, certainly not every day, but often not every
month, and in many, many cases not every year. And so the liquidity and the way that you
execute those platforms or products really requires a different approach. So ‘E’ as Fred
says, does the more liquid, the more generic, the high velocity instruments, but for the
huge proportion of instruments that don’t trade like that, we think that voice is the right way
to go forward.
Lynn:
For Fred – this is specifically to you, related to your have things changed since your
report – Trends in E-commerce 2014? I realise the method of trading depends on the
asset class, its complexity and liquidity but which instruments do you see
remaining in the realm of voice trading?
Fred:
I would actually look at the problem differently. In a sense that since the last, I would say
18 / 24 months, there is a general switch from looking at e-commerce as product-centric,
and transferring it or building the solution on the client-centric basis. What I mean is that
any e-commerce solution is targeted to a specific client, or specific types of rules or
personas. I’ll give you an example: if you’re dealing with an asset manager, the ecommerce solution will be targeted around price recovery, execution will happen on multi-
- Page 1 of 5 - Copyright for this document is retained by DerivSource and the document or any excerpts should not be republished or distributed without written notice of Julia Schieffer, of DerivSource.com. For further information please contact Julia Schieffer at Julia@derivsource.com Electronic trading versus voice Podcast April 2015 dealer platforms but will happen using voice, and a series of post-trade services would be
offered. Similarly, if your client is, say, a large corporate, the types of services and
solutions which will be offered will be different in terms of functionality and in terms of
products set.
So, thinking as ‘E’ as a clear cut threshold, above which some instruments are only
electronic and below which the instruments are only voice is, again, the wrong way to look
at the issue.
Lynn:
Sorry, just to be clear, you’re saying that the solution is more client-focused versus
instrument focus?
Fred:
Correct.
Lynn:
This question is also for you, based on your report. As for the e-commerce offering,
what constitutes a successful platform?
Fred:
Following on the definition I’ve just given, it’s very much the one that provides the right
combination of functionality across the trade lifecycle, so pre-trade, research, analysis,
price discovery to execution, to processing, all the way down to post trade services such
as portfolio valuation, portfolio rebalancing, risk indicators, confirmation and back to being
at the cycle. But that is designed to cover the needs of a specific type of client.
Those features and those products can be really divided into categories: the ones that you
need to have in order to provide a viable franchise, a useful service, and the ones which
are trade differentiating from your competitors. So, a successful platform is one that
covers the basics as well as anybody else, with enough bells and whistles to really make a
difference to their client and therefore to the provider offering it.
Lynn:
What impact do you see regulation having on both types of trading channels?
Stu:
I think the regulation is really hitting the markets in at least two ways now. In certain cases
we’re actually getting mandated methods of execution, where the regulators are trying to
push towards the creation of new types of venues in the US; we saw SEFs and we’ve
seen the attempts to try to migrate liquidity into that as the execution venue for certain
products and in that case derivatives. In Europe, we have increased regulation around the
new style of MTFs and OTFs that are coming through, and again a push towards trying to
make this the execution method.
Whilst that will have some success and some applicability to some products, I think the
more far-reaching regulation that’s actually coming in is really to do with the capital
charges, and actually the support of businesses that are OTC-traded. Traditionally, banks
have played a market-making role; they’ve put their own balance sheet to work, their own
risk to work, to support many of these products in the secondary markets.
So really what the regulations are doing are saying ‘Look, we really want banks to pull
back on the risk that they do take and in essence we will penalise excessive risk taking.’
So risky assets are penalised with capital charges. What this has clearly done is obviously
massively reduced the amount of balance sheet and risk the banks are prepared to
warehouse and put to work in support of the secondary markets, and we’ve seen
secondary market volumes drop; we’ve seen liquidity in a huge range of assets, and
certainly the less liquid ones, also suffer significantly. And that’s very well documented in
most of the financial press.
So, really, where we think the regulation has most impact is really in that secondary
approach. I think the chase for execution venues in one sense is a bit of a misnomer;
people think everything is going to go electronic, but actually what happens in reality, we
think it’s the capital charges that are really the regulation that everybody needs to keep
closest to mind.
Lynn:
Fred, what impact do you see regulation having?
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I agree with what Stu has said. The capital charges are the ones which are essentially
have the biggest impact, and I’m talking about the Basel III Accord. Now, where I slightly
disagree is on the internet. There is a general view, shared mainly by the banks, that the
regulators and the central banks to a certain extent, didn’t think through the liquidity role,
the forcing of electronic execution, the restrictions on balance sheets, as side effects of
badly drawn regulation. I don’t believe that’s the case but don’t get me wrong, I’m not
saying that regulations are as clean and simple and legible as they could and should be,
however there is a clear intent from the legislators, which are then pushing it down to the
regulators, of preventing the banks from taking principal positions. They trying to squeeze
risk taking are the banking systems. To push it out, outside of financial institutions, which
are taking deficit and extending credit, and therefore need to be bailed out if they get it
wrong.
We do see a substantial amount of anecdotal evidence where non-bank liquidity providers
are actually picking up the slack, whether it’s in FX, whether it’s in swaps, and when I say
swaps I mean interest rate swaps, but also CDS, all single name and index. And for that
type of institution, or that type of non-bank liquidity providers, obviously the ability to trade
on an electronic medium is a great enabler, because that reduces their own cost. That
doesn’t mean, again, voice is out of the question, but ultimately the legislators and the
regulators want to turn the banks into agents, into conduits to liquidity on the secondary
markets who are supposed to be providers of liquidity for the secondary markets.
Stu:
If I could pick up on some of Fred’s comments there. I agree to a certain extent, however I
do think the chasing of electronic platforms as a means of execution in certain cases is
already not providing to work effectively. Certainly in something like CDS where we see
the index product probably 90% - 95% of all volume now is electrically executed, it is a
very commoditised, very liquidity deep type of product it works really well on e-platforms
and has proved itself.
If you move into the single name part of the CDS market, we see a very different story.
And even though we’re getting the requirement to put some of those trades on a SEF and
execute there, in essence anecdotally we’re hearing that many of those trades are actually
arranged off platform and they’re basically sent through to the SEF for execution.
So, essentially what you’ve got is trade reporting by another name, really the CDS
component of that and the liquidity characteristics really look a lot like some of the much
less liquid parts of other OTC assets, and so I think that whilst we’ve got regulation that
covers electronic execution, it’s not necessarily working quite the way the regulators
intended, we believe.
Fred:
In the case of CDS, I would argue that it is because the US regulators in particular got it
the wrong way around. The mandatory condition to have a functioning electronic liquidity
provision mechanism is just central clearing. Right now, the CDS are cleared; there is a
mandate to centrally clear them. The single name are not yet onto CCPs.
My expectation is as soon as that sleeps; as soon as the exemption for central clearing for
the single name is actually wearing off and you’ve got a central counterparty to settle both
trades, the electronic execution will pick up. Because, until then, I absolutely agree with
you; when you trade there is a credit element in the sense that who you trade with does
matter on the price you’re going to be forming. Therefore you need to know your
counterparty, and the best way to know your counterparty is to negotiate and tweak the
CVA with the counterparty, is to talk to that person.
Once that goes away, I’m reasonably confident that the most traded of those single name
contracts will see their electronic parts, or a proportion of their electronic trading, pick up.
Until then, I agree it’s just not worth it.
Stu:
To develop that thought a little further: I’d agree with you on the most liquid of the single
name items, and similarly in way that I agree that the most liquid of the cash bonds also
www.derivsource.com - Page 3 of 5 - Copyright for this document is retained by DerivSource and the document or any excerpts should not be republished or distributed without written notice of Julia Schieffer, of DerivSource.com. For further information please contact Julia Schieffer at Julia@derivsource.com Electronic trading versus voice Podcast April 2015 will trade very, very well and very deeply electronically, but I think clearing itself is also not
panacea, And clearing also requires accurate pricing and valuation for all the margin
calculations and processing that is required. And unfortunately for instruments or names
that don’t trade very frequently, it’s very hard to develop accurate pricing, or pricing that
will be agreed by the market as the appropriate reference price for clearing for post-trade
purposes. Because of that we actually think that clearing of the single name CDSs, again
a huge number of the tenors and a huge number of the issues will also become something
that is a much harder reality to achieve than I think is being anticipated by the regulators.
Lynn:
Just quickly what impact do you think the Fed raising rates will have on the market
and how people trade?
Fred:
The divergence in monetary policy and the fact that we will go back to normal in terms of
interest rates policy hopefully within the near future, will create more activity, at least
during the transition time and hopefully will be back into the a functioning markets in time,
maybe another five years. So, is that going to dramatically change the way people are
trading, I don’t think so. However, what it will create are spikes of volatility and bursts of
volatility and market dislocation so movement where people will be reverting back to voice
primarily during those day or two of bursts of activity.
Lynn:
Stu, what are your thoughts?
Stu:
I agree with that. I think when we see moments of volatility, even recently, people very
quickly pick up the phone again to try and get trades done. Electronics are great when
they work, and most of the time they do, but when things go bad, and that could be any
aspect of a trade or market conditions, then I think relationships, having somebody to lean
on, somebody to help out and maybe fix a trade, that’s really when relationships and voice
really come to the fore.
I think an interest rate adjustment, which may be severe, or perceived as severe, when it
first starts to come through to market, I think may be one of those events.
Lynn:
The last question for both of you is really about the initiatives that we’re seeing in
the markets such as SIX trading corporate bonds, Bondcube, Algomic of course
which we will get to later and the Emerging Market Bond Exchange. Fred, last
question for you: do you foresee other platforms emerging and what are the drivers
of the market and is there enough?
Fred:
There are a lot of new platforms launched, or being launched. In the last count we did
between 1st January 2014 to the end of this year (31st December 2015), we counted 80
new platforms. What’s happening is that the corporate bond market is broken for all
intents and purposes, and this is a direct consequence of the balance sheet reduction
triggered by the Basel III Capital Regulations. The old model doesn't work any more, or
doesn’t work efficiently any more, and everybody is trying a new trading model, a new way
of gathering liquidity, forming prices, protecting investor anonymity, and no one knows
which one is going to work.
So, you’ve got a flurry of innovation, it’s kind of everybody is throwing everything at the
wall to see what sticks. Have we got enough platforms? We’ve got more than enough.
Have we got the right one, or two, or three really useful platforms? I don’t know yet. Will
we see more trials and more attempts before we convert to the right trading model?
Probably.
Lynn:
Thank you very much for your time Fred.
For Stu - Algomi has continued to gain momentum over the last year - you’ve
doubled staff numbers, opening up shop across the Atlantic as well as Asia and
signing up leading banks and asset managers. I’m going to ask you about the
drivers behind that and to this question before about the competition and how you
see your business developing?
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I think how Algomi sets ourself apart is we don’t see ourselves as an electronic platform,
inasmuch that we don’t do electronic execution. What we do is we digitise the data and
we digitise the workflow, but we then allow the individuals concerned, who’ve maybe had
connections made for them, to essentially get the trade done in whatever way they see fit;
over the phone, over a chat mechanism etc. And I think this plays to the less liquid part of
the market that we’ve discussed; it plays to the bifurcation that’s clearly gone on in many
of the assets that we trade as well, where you have a liquid component and a much less
liquid component sitting side by side using very different execution mechanisms. So we
play for that part. So voice is a big part of how trades happen over the Algomi network. I
think the growth of the company is testament to the fact that we are doing at least some
things right as you say we are over 120 staff in about 2.5 years since forming the
company, so very rapid growth. We have over 10 major banks signed with the platform,
and over 50 buy-side investors now. And clearly our aim for this year is to continue to
grow that.
In terms of competition, just to your last point, we’re not really tied to any platform as such,
and so we’re very happy for all the e-platforms and all the innovation that Fred describes
to come to the fore. We are big believers in e-execution for the right product and we think
we’ve got more than enough flavours in the market for at least some of those to get it right.
What we’re here to do is really focus on the less liquid part where we think it’s still a people
business, a person-based execution and really just to join the dots around that and help
people get the trades done.
Lynn:
Thank you both very much for your time, we certainly appreciate it.
Julia:
DerivSource listeners, if you would like more information on this topic you can find
links related articles on the podcasts notes page available on DerivSource.com and
via our app.
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