Trading over-the-counter (OTC) derivatives poses fewer burdens that ever before, but buy-side support can accelerate progress.
The FILS Daily hears the pace of electronification in fixed income derivatives trading is greater than ever, giving buy-side firms better execution. Nicolas Koechlin, CEO of OTCX, tells us that digitalisation will enable lower costs and greater margins, if psychological barriers can be overcome.
FILS Daily: Is the electronification of derivatives trading in lockstep with that of cash bonds?
Nicolas Koechlin: There has been huge progress in digitisation of trading traditional cash bonds across different types of market participants. From 10 to 15 years ago with the wide adoption of OMS systems, and in more recent years the translation of processes in the EMS space for fixed income, some big players like FlexTrade, TradingScreen and others have made a great effort to connect traders to different venues that offer trading protocols for bonds. Yet there is still more to be done. The big venues acknowledge that.
Choice of digital platform tools has never been better. Yet if we look at the choice of tools that are available to you to trade fixed income derivatives, it collapses very quickly. That’s really mind boggling. Bond markets are going through huge transformation, but interest rate derivatives and some aspects of other fixed incomes derivatives remain manual in many scenarios. That marketplace is dominated by one or two incumbents in the dealer-to-client space for interest rate derivatives.
How do you see that changing?
As more buy-side trading desks create sophisticated etrading capabilities across most of their asset classes, they are now turning their attention to the smaller volumes of trades that for one reason or another remain largely manual. it’s starting to annoy them that smaller volume of their business – in terms of quantity of trades not notional – remain largely manual. To execute 10 manual trades a day can consume an extraordinary amount of manpower, in addition to operational issues and lack of efficiency.
Fixed income digitisation is focusing on parts that are still challenging to digitise. Market participants have for many years been very sensitive about opening up and digitising these markets. If efficiency means that instead of the buy-side putting three people in competition they can put ten, that crushes sell-side margins. That was where resistance came from in the early days.
Change has been in waves, and it’s been a long journey. But we see a tipping point because heads of trading at big and small buy side firms are being judged on the robustness and efficiency of the trading environment they create, especially in the long only world. They have to create resilient environments with zero errors, and one of the things they will always be looking for is to have that digital connection and low to no manual entries. So there are drivers for change from several angles and the buy side is reacting to that. Many asset managers are fed up with years of operational errors, the cost associated with them. They are judged when marketing to raise funds. They have to evidence that they have controls in their processes.
One of the sub texts in this MiFID II best execution discussions were the ability to do trade reconstructions. At any point in time a regulator, an investment consultant, an auditor or management might ask the history behind a trade, and they want to press a button and retrieve the whole audit trail. From ESMA to the CFTC to the SEC, authorities want to understand how trades are being negotiated, why they are on voice or venue, where does the venue start and stop and what constitutes a venue. This big debate is coming back to the buy side so they need to future proof their environment. They need to make very careful decisions on how they are building the architecture, and the technology that is going to support that.
They want more versatility from the vendors and the providers of digital solutions, to all talk to each other. More interoperability between systems is vital to the buy side, because they don’t want to be left with one part solved only to then step back into a manual process on the back end of that negotiation.
What might overcome sell-side resistance to change?
There are aspects of the market that lend themselves to digitisation; from the standardisation of products to established standards in communication protocols. That gives you a basis to expand upon. If I am building an EMS in FX I can reasonably expect to connect to bank A, B, C and D who now have standardised protocols on how to connect. Then if you look at banks in the derivative space, voice is still huge. and even for non-derivatives sometimes it’s still a huge activity.
How are you solving this problem?
Given the type of trades, the liquidity of those trades and how they are traded, the range can be so wide that often the head of trading wants a human at the other end, because it’s too difficult to put it into an electronic message.
We have tried to bridge that gap which will be important for a full solution in the fixed income derivative space. The ability to cater for pure e-channels via proper APIs, where there is no human at the other end such as from liquidity providers. Queries and quotes can be fully automated and whether fast or slow can be properly assimilated as a pure electronic channel while still interacting with voice.
The next evolution of fixed income derivatives digitisation will happen step-by-step. Not all liquidity providers have the means to provide electronic pricing in markets on a repeatable and sustained basis. We have had many conversations with leading liquidity providers who have huge capability, but when people take off the layers, their capabilities appear very specific. The trade works for a small size, but larger size trades need somebody to look at them more closely.
There are all sorts of hurdles to create a pure e-environment, but if we start building the bridges to link up the services that voice desks can offer, and also have those voice desks move away from just using chat systems, we have hybrid tools that potentially link to their credit systems, and booking systems but still allow them sight of the negotiations so, that they can interact with the trader or another price maker within the bank and aggregate those seamlessly to then offer the buy side the ultimate trading environment.
What sort of recommendations might you make to a buy side head of trading to support this change?
Firstly education is needed; we have spoken to traders who were left in this manual stage because we they didn’t realise there were solutions. They can really bring efficiencies or at least a step forward in digitisation, and in that discussion with the buy side I would first go over the awareness. Heads of trading sometimes don’t have the bandwidth, a problem that can be 1% of your trading volume, might consume 10%-15% of your colleagues’ manpower. There are probably solutions that can help you mitigate that. Finally the buy side can make a big difference if they identify a partner that can help them achieve the digitisation especially in fixed income derivatives. If they bring everybody to the table especially the liquidity provider, draw out the road map and ask for commitment to support, they can make significant changes in their operational trading processes. Tools need to be as much plug and play as possible, easy to onboard and deploy. Solutions need to be competitive, innovative and collaborative.
©Markets Media Europe, 2022
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