In a speech before the Economic Club of New York on Friday, June 20, SEC Chair Mary Jo White said that the Commission is looking into ways to apply more technology to the fixed income market to enhance benefits (presumably for investors). Although broker-dealers have been applying more technology to their fixed income trading operations over the past few years, most of the upgrades have focused on enhancing their existing dealer-centric trading model. For example, some dealers have been happy to post bids and offers from their own inventories on their proprietary systems, but reluctant to include those of other dealers. Likewise, bond trading prices are only shared internally or with their best customers.
The SEC wants to see some changes. First, it wants pre-trade price quotes made available more generally to investors. It also wants to see historical trading prices more widely disseminated to help better inform investors. (Investors can readily access fixed income trade data on individual bonds through the TRACE system at FINRA, and the same data is available on the fixed income research platforms of most online broker-dealers, but it is cumbersome to work with this data, especially when trying to compare trade prices with more than one bond or across fixed income sectors.)
The SEC has also directed FINRA and the MSRB, respectively the self regulatory organizations for the corporate and municipal bond markets, to implement a "best execution" rule in the fixed income sector. Similar to existing practice for equity securities, this would presumably require brokers to scour the market on behalf of their customers to ensure that they receive the best market price available on their trades.
In addition, the SEC wants to require dealers who execute riskless transactions - where customer buy and sell orders are matched and executed simultaneously - to disclose the markups that they earn. This, presumably, is an attempt to ensure that customers are not gouged by their brokers.
Current Bond Trading Systems. Although I do not profess to be an expert on the current state of affairs in the electronic bond trading universe, I believe that I can make a few reasonable observations:
1. There is currently no single central marketplace for all bond trading.
2. There are two types of electronic bond trading platforms:
a. Single dealer: Individual broker-dealers or investment firms have developed their own trading platforms to support their fixed income trading operations.
b. Wholesale or multiple-dealer: There are a few multi-dealer systems which allow many broker-dealers to post bids and offers.
Examples of single-dealer platforms include Bonds.com, Blackrock's Aladdin, Goldman's GSessions, Morgan Stanley's BondPool and UBS's Price Improvement Network (PIN). After pushing to recruit other broker-dealers to its GSessions platform, Goldman Sachs recently put its development plans for GSessions on hold, because it was not able to generate sufficient trading volume. Greenwich Associates has compiled data showing that these single-dealer platforms account for only 1% of bond trading.
The current multi-dealer platforms include MarketAxess (NASDAQ:MKTX), Tradeweb and Bloomberg. These collect and list the best bids and offers from many dealers and other market participants, including hedge funds and other institutional investors, on one platform. They also serve as the primary bond trading platforms for some online brokers, such as E-Trade, TD Ameritrade and Fidelity.
Personal Observations. I have personally experienced these platforms through two online brokers, TD Ameritrade and Fidelity. A couple of years ago, corporate bond offerings on these platforms were pretty skimpy, especially in lower-quality corporate bonds.
The number of bonds for which two-way markets are offered has increased markedly since then. It is much easier today to get active price quotes on these platforms, even for distressed bonds in small quantities (i.e. 10 bonds equal to $10,000 in par value or less).
There still are, however, too many bonds for which no market is offered. Some of this may be due differences in the scope of the offerings by brokers. (For example, I have found that Fidelity offers two-way markets in more bonds than TD Ameritrade.) Sometimes, these online brokers do not provide bids and offers even on actively traded bonds. (In this case, I define an actively traded bond as one that trades at least once every trading day.) This is probably due to the market-making practices and other idiosyncrasies of the participants on their platforms.
However, I still find myself, in some cases, wanting to bid on bonds for which there are no market quotes, but I cannot. These online broker fixed income trading platforms do not allow individual investors to place an order for a bond that does not have a current quote (either a bid or offer or both). I do not know whether institutional investors face similar restrictions. Although it can be argued that this policy protects individual investors from being exploited, it seems to me that it also restricts market-making, potentially making the market in any given bond less liquid than it otherwise would be.
Where do we go from here? As a result of the 2008 financial crisis, recent regulations (i.e. Dodd-Frank and the Volcker rule) and the prospect of rising interest rates, investment banks have reduced significantly the amount of capital that they devote to fixed income market-making activities. As a result, market-making in many of these corporate and municipal bonds is much thinner than it has ever been.
The surprisingly sharp rise in volatility that the fixed income markets experienced in the spring of 2013 may have been due in part to the reduced capacities (or willingness) of broker-dealers to bid for bonds. Consequently, the growth and development of electronic bond trading platforms is important to help fill this gap. There will probably be fewer bids from the major broker-dealers going forward, but improved direct access to the bids and offers from other investors can help to make up for part of this shortfall.
Ms. White opened her speech last Friday with a quick discussion of the rise of high-frequency trading. Her main point: Many market professionals blame the SEC's Regulation NMS and, specifically, its best execution rule for the growth of HFT. (In response, she suggested that the rise in HFT may be due to other factors. For example, high-frequency trading accounts for a substantial portion of the trades in the E-mini S&P 500 futures contract, which is not subject to Regulation NMS. But, in my view, E-mini HFT trading may, in fact, be an indirect consequence of Regulation NMS, since HFT firms may hedge some of their books by trading futures.)
By forcing a best execution overlay on to the fixed income markets, the SEC may be inviting more program trading firms into the (currently fragmented) fixed income markets. By mandating special disclosure for "riskless" trades, the SEC may, in effect, cede a large portion of market-making activities to program traders. (These program traders can, in theory, earn wide spreads even on best execution riskless trades in the relatively illiquid fixed income markets without any disclosure requirements.) If this happens, these new rules could crimp profits even more for broker-dealers, and further reduce the depth of fixed income market-making.
If so, then what's the solution? I'm not exactly sure, but it seems to me that the SEC should be trying to provide incentives (or at least, not trying to reduce them) for market maker participation. While it may be necessary to provide some policing in actively traded bonds to ensure that investors are not gouged, most investors know very well the principle of "buyer beware", especially in illiquid high-yield and distressed corporate bonds. Market makers should have the ability to earn a wide spread on illiquid bonds to justify their commitment of manpower and capital. Since active market participants probably know, in most cases, which broker-dealers are gouging their customers; it might be better to provide a public forum that would allow them to identify (and shame) egregious offenders as a way of letting the fixed income market police itself. In any event, I hope that the SEC pays careful attention to the unique needs of these often thinly-traded markets in designing new rules for electronic fixed income trading.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.