Rise of electronic trading in fixed income markets and its implications

Morten Linnemann Bech, Anamaria Illes, Ulf Lewrick and Andreas Schrimpf have a nice piece in latest BIS quarterly.

The authors show how the bond market (fixed income is such a misnomer actually) has moved from phone driven to electronic driven:

This article explores drivers and implications of the rising use of electronic and automated trading in fixed income markets – a process we refer to as “electronification”. We take stock of the current state of electronic trading and how it has changed the market ecosystem, its resilience and its overall functioning. We argue that the impact of electronic and automated trading is visible in a number of dimensions of market liquidity and price efficiency. With market participants adjusting to the new market structure, several new challenges have emerged that warrant attention from policymakers.

…..

Trading in fixed income markets is becoming more automated as electronic platforms explore new ways to bring buyers and sellers together. In the most liquid markets, traditional dealers are increasingly competing with new market participants whose trading strategies rely exclusively on sophisticated computer algorithms and speed. Some dealers, in turn, have embraced automated trading to provide liquidity to customers at lower costs and with limited balance sheet exposure.

To some extent, these trends resemble those witnessed in other markets, where electronic and automated trading have long become the prevailing market standard. Indeed, much of the innovation in trading protocols and (HFT) algorithms is based on importing technology initially developed for equities that has subsequently spilled over to foreign exchange markets (Markets Committee (2011)). This suggests that many of the market implications – and the associated policy challenges – will increasingly shape trading in fixed income markets as well.

As discussed in Markets Committee (2016) and CGFS (2016), there are several areas that may warrant further policy attention. First, the impact of electronic trading needs to be appropriately monitored. The above discussion highlights how standard liquidity metrics need to be supplemented by alternative measures to reflect the changes in liquidity provision. Second, more research is needed to inform policymakers about the impact of automated trading on market quality and how to address any associated market failures. Third, with trading activity increasingly gravitating towards platforms, ensuring their robustness as well as their capacity to deal with market stress becomes a key financial stability issue. With dealers closing down traditional trading desks (“hanging up their phones”), while their e-trading desk algorithms connect to an expanding set of multilateral platforms, the fallback option of returning to voice trading may no longer be viable. Finally, regulation and best practice guidelines need to adapt as markets evolve. This could include assessing the scope and capacity of existing supervision as well as the effectiveness of existing mechanisms to deal with market stress episodes.

The authors get into the tech side of it. What would be more interesting is the sociology of the whole transition. Is information reaching out better? Are people trading better?

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