Sell-side firms are increasingly seeking bilateral connections in more liquid fixed-income markets with their buy-side counterparts, as bank trading margins are hit by the costs of execution on electronic venues, sources tell WatersTechnology. Now, while more liquidity providers are keen to shift their trading volumes away from venues, the challenge they face is convincing the buy side to commit to the tech lift of these connections.

A trader at one UK-based asset manager says banks are starting to push for direct connections with the buy side, as execution fees and other market structure trends compress already thin margins. “They are being very vocal in telling their clients, such as us, that the costs are unsustainable, that the cost will be passed on to us. And then at the end of the day, it’s the end-client that suffers,” he says.

Automation in slower-to-electronify fixed-income markets is generally welcomed by most participants, at least in concept. And the electronic venues—such as Tradeweb, MarketAxess and Bloomberg—have become rich sources of liquidity, and other value-added services. “They are not just focused on matching the buyer and seller anymore. There is a tremendous amount of data and analytics they do underneath to help the users of those platforms understand what their interactions are like per counterparty, who tend to respond faster and who is good in certain sectors,” says Kevin McPartland, head of market structure and technology research at Coalition Greenwich.

However, these venues charge fixed fees and commissions, and liquidity providers bear most of these costs. “As more trade volume flows through, that means more fees to pay, which again can go straight to the profit margins of some of those trading desks,” McPartland says.

A report by McPartland’s firm says market structure trends, such as the transition from voice to fully electronic execution, are making the economics of executing fixed income on multi-dealer platforms increasingly unsustainable. The venues can counteract margin erosion by charging fees and are capturing a wider share of the value generated by fixed-income execution, the report says. Plus, they can charge for data generated by their activities. The sell side, however, bears the brunt of costs without being able to remediate them.

McPartland says both liquidity providers and buy-side firms are increasingly interested in alternatives to current request-for-quote trading models; for the banks, a popular suggestion is to interact with clients directly, streaming prices into the execution management systems (EMS) and order management systems (OMS) of asset managers via APIs.

“In recent months, over the past year or so, there has been a lot more talk—not just in Treasuries, but in corporate bonds as well—about whether dealers can do those connections directly to clients without a middleman—into their order or execution management system—to allow them to interact with those clients directly without anybody having to pay a toll,” McPartland says.

For the buy side, there are potential benefits to aggregating direct connections to the major liquidity providers, as well as venue connections.

“If I requested a quote from 20 banks, the price I get back from a JP Morgan won’t be as good as if I had just gone to them directly and asked for a price,” says the trader. “I am not fulfilling my best execution requirement if I just go to JP Morgan. If anything, I am probably leaking information to them that I am looking to do something they can’t help me with. So, the problem at the moment is being able to disseminate that information of what a JP Morgan wants to do at any point in time to the clients who want to see that.”

To build or not to build

McPartland says the buy-side firms that have built these connections so far are the largest ones, “who have the staff and the wherewithal to do that. I think over the long run, a lot of it will not be sustainable, because it will be onerous to manage all those direct connections.”

Jim Switzer, senior vice president and global head of fixed-income trading at AllianceBernstein, says his firm built connections to two dealers around the end of 2019, and will be going live with three more in the coming months.

Others, however, say they are aware of interest from the sell side but haven’t built anything at this point. Stuart Campbell, head of trading at BlueBay Asset Management, says most of the major Wall Street banks have asked him if his firm would connect with them bilaterally. However, he says, he would prefer to have his firm’s OMS provider, Charles River, supply connections.

“Rather than me having to build something myself, which could take a lot of development work and maintenance, I’d much rather it’s built for me by a vendor that I’m already using, such as Charles River. Once they show me a solution that may work, then perhaps I’ll take those direct feeds in from the banks,” he says.

Campbell says BlueBay is working with Charles River, “to help me consolidate those prices and see them pre-trade.”

One of the main benefits of the incumbent platforms is that they offer multi-party RFQ functionality, which is one of the easiest ways to prove best execution

Joram Siegel, Cowen

Sharon Ruffles, head of fixed-income dealing at State Street Global Advisors (SSGA), says her firm has discussed direct connectivity with some banks. She says the interest is confined to mature markets like US Treasuries, which are more liquid and transparent. “As a buy-side firm, I would have to be pretty sure that the price I am going to get is the best price available,” she says. “To some extent, the less liquid the security is, the more chance of variance in that price.”

Joram Siegel, managing director and head of fixed-income outsourced trading at Cowen, says his firm is exploring direct connectivity. “We are consuming most dealer prices and axes through close to a dozen third-party providers and evaluating liquidity in a highly systematic way. We are also talking to dealers about streaming prices and executing directly, but this is still in the early stages of its evolution,” he says.

Cowen uses Tora for its OEMS. Siegel says the firm would gladly connect to the banks through Tora, but adds that the necessary capabilities on the sell side are not yet fully developed.

Siegel adds that direct connections will never entirely replace the multi-dealer platforms. “One of the main benefits of the incumbent platforms is that they offer multi-party RFQ functionality, which is one of the easiest ways to prove best execution,” he says.

“While direct connectivity has great efficiency benefits for both sides of the trade, it requires a more robust market dataset and technology infrastructure to satisfy this requirement.”

Heavy lifting

McPartland points to the spot FX market, which has long been electronic, as an object lesson in understanding how venues might be disintermediated. Unlike the fixed-income markets, where most electronic flow is executed by a few multi-dealer platforms, FX market participants interact with liquidity providers on single- and multi-dealer platforms, as well as via APIs into EMS, with a range of execution protocols.

But in fixed income, where automation has lagged, neither buy- nor sell-side firms may be set up to easily enable direct connections and streaming quotes.

SSGA’s Ruffles says if her firm were to directly connect with banks, she would encourage SSGA’s OMS provider to set up Fix connections with the sell side. The firm would also need a repository into which it could receive prices streamed from multiple banks in real time, and from where it could evaluate those prices.  

“That would work well for developed government bond markets,” she adds.

Ruffles says firms need to consider whether their OMS provider is sophisticated enough to stream pricing data in real time from multiple banks and can run analytics on that data and make decisions based on it.

Susan Joyce, a trader and head of fixed income trading market structure at AllianceBernstein, agrees the build is not a light piece of work. “First, we have to come to an agreement. Then we set up a user acceptance testing connection and a production connection. And depending on where we host that and how we set that up, there may be a monthly cost associated with that hosting. Then it’s about agreeing the trading protocols,” she says.

AllianceBernstein has compiled trading protocols necessary for direct connectivity, Joyce says. “We have a book that, essentially, we wrote on what we think the trading protocol should be. And sometimes we provide that to the dealer, and they can use that when they code up to it.”

The bank sometimes has its own protocols, “so there’s some tweaking involved,” she adds.

“Ultimately, we agree on those, we code up to it, we do some testing—all in, it’s usually about three weeks of development work, and then two weeks of testing.”

AllianceBernstein built its OMS and EMS in-house. Switzer says none of the EMSs on the market quite fit the bill for the firm. “For us, it was build versus buy, and there was nothing to buy out of the box. So, for us, it was, ‘Let’s build it all.”

The in-house EMS can route to multiple venues and dealers simultaneously. Switzer says the firm is connecting to dealers that offer the widest range of fixed-income instruments.

“If you are a very specialized dealer in just one asset class, you are going to be at the back of the line, because we are going to code up to those with impact in every class so that we can use that Fix feed,” he says. He wants to ultimately connect AllianceBernstein with eight to 10 dealers.

Vendors step in

Some buy-side firms are looking to tech vendors to address inefficiencies they see in fixed-income market structures. Fidelity and some 20 other buy-side firms (as well as 18 sell-side firms) have backed LedgerEdge, a new corporate bond trading platform. LedgerEdge wants to launch as a multilateral trading facility in the EU this year, and as an alternative trading system in 2022.

The vendor uses distributed ledger technology and privacy-enhancing technologies to prevent information leakage when an investor reveals their trading intention and other investors profit from that by buying or selling an asset ahead of them.

“When we first went to the market with this idea last year to 18 sell-side firms in a working group, one of the first things they raised was a desire for direct connectivity,” says David Nicol, co-founder and CEO at LedgerEdge.

“They said that in connecting directly to customers, they are looking to control the flow of data to these customers on an individual basis. They are looking to have a disclosed, known relationship with those clients, and they are looking for a reduction in the cost of the overall trade.”

LedgerEdge plans to use DLT to give users control over their information and to whom they can reveal it.

When we first went to the market with this idea last year to 18 sell-side firms in a working group, one of the first things they raised was a desire for direct connectivity

David Nicol, LedgerEdge

“Our hypothesis is that market participants are reluctant to put orders into a market when those orders will be visible to other parties,” Nicol says. “They would rather control exactly who gets to see their information, either based on the name of a counterparty or based on what their counterparty is showing into the market.”

The vendor is currently integrating the platform with some major OMS and EMS providers.

SSGA’s Ruffles says the concept behind LedgerEdge is very interesting. “Each client will have a node [in a blockchain], and the sell side will be able to connect directly to the client via that node. So, they can send different prices to different people. If I am a predominantly index-based long-only asset manager, I might get one price from the counterparty; a high-turnover hedge fund would get a different price,” she says.

A vendor solution would be desirable, says AllianceBernstein’s Switzer, but it would need to have broad-based support among both the buy- and the sell side. It should also be administered by a neutral third party.

“If you have the top 25 dealers, and dealers 10 through 25 say, ‘This is a great idea! We are in!’ And dealers one through to five are out, it isn’t going to work. You need broad acceptance by the top guys. An industry solution is going to come from the market leaders.”

Switzer says he hopes that as fixed income evolves, an industry-wide commercial solution could emerge to create an economy of scale of these connections. He calls it the “creation of an interstate highway or network that will allow this connectivity to happen.”