Electronic trading in the fixed-income market has experienced a surge as new platforms have come online in recent years. These platforms have increased efficiency in the fixed-income market by improving liquidity and reducing transaction costs.
But the rise of these platforms has not been a positive development for all market participants.
This article will review how e-trading platforms are changing the fixed income market for better or for worse.
E-trading in Fixed Income
E-trading in fixed income began its rise in the 1990s through the trading of the most liquid securities: U.S. Treasuries. Since then, e-trading has expanded to less liquid fixed-income markets including corporate and municipal bonds. There were 128 bond trading platforms online at the start of 2017.
Following the financial crisis of 2008, regulatory reform increased the capital and liquidity requirements for banks. As a result, banks could no longer hold as many bonds in their inventory, reducing the market liquidity as banks were restricted to trade in this security class. On the other hand, reduced market liquidity opened up the market for e-trading platforms.
One of the most popular platforms, MarketAxess, began offering a service known as “Open Trading,” in 2012. This service allows bond traders to transact directly through the platform rather than using a broker-dealer.
Broker-dealers have seen a reduction in the bid-ask spread they earn from trading since the e-trading platforms have reduced the need for a middleman. Many broker-dealers have shifted their focus to less liquid markets, such as municipal bonds or high-yield corporate bonds, where they can still add value since volume on e-trading platforms is high only for liquid securities. While lower transaction costs decrease the profitability of the intermediaries, this is a positive development for investors.
Be sure to check the basics of muni e-trading platforms here.
Keep our glossary of municipal bond terminologies handy to familiarize with different concepts commonly used by municipal investors.
How E-trading Platforms Are Making a Difference
The variety of features offered by e-trading platforms provide numerous benefits for fixed-income investors, including:
- Improved liquidity – Investors anonymously submit a request for quotation (RFQ) to receive an immediate bid or offer on bonds from investment managers, broker-dealers or investment banks. Rather than working with a handful of brokers, investors can deal with all entities enabled on the platform through “All-to-All” trading platforms that allow buy-side firms to transact directly with one another. For example, investment management firms such as Blackrock or Vanguard can trade anonymously with insurance companies through the platform, which would otherwise require brokers to serve as intermediaries.
- Improved price transparency – Platforms provide recent trade history, RFQ data and inventory offers in a centralized location. This helps traders with pre-and post-trade analytics to ensure they are receiving best execution.
- Increased trading efficiency – Investors trade within seconds over the platform rather than having to reach a broker by phone. Faster execution mitigates the risk of news or interest rate movements impacting pricing from the time a trade decision is made. Platform serves as a clearing system similar to an exchange for stocks.
- Reduced costs – E-trading platforms charge a small markup to the price of bonds that are traded. This cost is not seen by the buy-side client because the bid price shown on the platform has already been adjusted to include the fee. Although these embedded fees are not transparent, they are still much lower than the historical bid-ask spreads earned by broker-dealers.
Be sure to visit our Market Activity Section here to explore recent muni bond trades.
Key Considerations While Dealing With E-trading Platforms
There have also been negative impacts from e-trading platforms for the fixed-income market. The biggest con for investors is that they bear the execution risk and must ensure they are executing for the correct bond and at the right price through the platform. An error in price or trade size could cost thousands of dollars if entered incorrectly.
In less liquid markets, there is evidence e-trading platforms may be exacerbating the lack of liquidity as investors choose to trade securities with higher price transparency.
Alternative trading systems (ATS) and the use of dark pools have raised regulatory concerns, and FINRA is implementing new rules to address these issues. Platforms also allow participants to choose the counterparties with which they are enabled to trade. From a regulatory perspective, this could lead to unfair trading practices if some participants were intentionally excluded from the market.
Check out the different ways to invest in muni bonds to stay up to date with the current investment strategies.
The Bottom Line
The use of e-trading platforms is changing how bonds are being traded. Judging by their rise in popularity, market participants agree that the pros outweigh the cons and we should continue to see the use of e-trading platforms become more prevalent in fixed-income markets.
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