Outfoxing the fixed income fracas
Fixed income is a bit like the tortoise of Aesop’s fables, while equities is unquestionably the rambunctious hare. While equities finished the race towards an agency trading model many years ago, fixed income is just plodding onto the starting lines now. But a little outsourcing may provide the rocket boost the industry needs to push ahead, according to Carl James, managing director of dealing services UK at BNP Paribas.
“Inventory levels are at historic lows with investment banks ever since the financial crisis, when the fixed income market broke down,” James told Banking Technology. “Investment firms have found it increasingly difficult to execute business in this agency driven model. The reality is the landscape of fixed income has changed.”
Possible solutions include Aladdin, an enterprise investment system run by BlackRock, which essentially allows other buy-side firms to match against its flow, and attempts by Goldman Sachs to organise trading in a specific class of bonds at a set time and place with the rest of the market. However, James suggests that Aladdin’s success has been limited due to concerns among the buy-side community about doing business with a potential rival.
Alternative attempts to meet the need for liquidity include a range of various bond platforms such as Euronext’s BondMatch, an MTF that uses a central order book for euro-denominated bond trading. There are at least 20 of these platforms in existence, and they are based on the need to replace agency skills that have not been actively exercised in the fixed income market since the 1980s, according to BNP Paribas.
“It’s a complex market to navigate,” said James. “The costs are high, both for people and technology. A London-based buy-side dealer might cost you £300,000 fully loaded, based on independent research. Most houses will use a minimum of three dealers. This takes you up to £1 million per year of costs for just personnel. On top of that are technology and data costs. Some firms don’t even know how much their trading desk costs, nor do they have TCA infrastructure in place to measure its performance. But if you did outsource the trading desk you could save half this cost.”
BNP Paribas’ solution is to run an outsourced dealing services desk, which covers various asset classes including cash equities and fixed income as well as FX and derivatives. The bank signs an SLA with its buy-side customers, which is agreed bilaterally on a customised basis. In effect, the asset management firm exchanges the fixed cost of the dealers and associated technology for a ‘pay as you go’ model based on trading needs.
“To ensure the best outcome for the client we build a trading strategy based upon several factors that include; the frequency of flow, the assets being traded, the geography, volatility; spread; liquidity,” said James. “Technology has had a dramatic role in the evolution of the market. The dealer is now playing more of an oversight role, letting the technology do the heavy lifting. To ensure the client gets the trading outcome they wanted we ensure there is a definite agreed benchmark that we can be measured against, post-trade.”
Such deals are becoming increasingly common across different business areas in capital markets. The concept has some aspects in common with cloud outsourcing deals, in the sense that the potential benefits are a reduction in manpower, infrastructure and maintenance costs, and the ability to scale up and down quickly whenever needed. Whereas in the recent past, each institution would have its own back and middle office, those processes have increasingly come to be provided by outsourced providers.
BNP Paribas is not the only bank to offer a similar service. However, it does claim to have been the first. According to James, there was nobody else on the sell-side providing outsourced dealing in fixed income when the business started in Paris in 2005. Since then, it has grown – notably in 2008, when BNP Paribas acquired Fortis Investment Management. The deal gained it dealing desks in London, New York, Hong Kong and Tokyo. But the main difference between BNP Paribas and its rivals in the outsourcing game is that many of the competitors are brokers, which the French bank is not.
“A decision was taken not to become a broker, because dealing services thought that being broker neutral was a cleaner, more transparent model,” said James. “We make it clear how we will be paid – we invoice per trade, completely separately from the any broker charges. The end client can easily see whom is charging what, and for what service.”
BNP Paribas warned that broker competitors may switch orders to a DMA-only service, forcing buy-side customers to pay more or execute the orders themselves.
Fixed income is a different world from equities in terms of liquidity and transparency. Transaction cost analysis is well evolved in equities, but in fixed income results are complicated by competing definitions and a relative lack of standards. It can be a difficult job, added James, because four different brokers may offer four different results. As a result, asset managers can in theory simply report using whichever TCA benchmark makes them appear in the most favourable light possible. BNP Paribas sources its TCA from one provider, but does admit that an industry standard to allow ‘apples to be compared with apples’ would be useful.
The bank is also currently exploring technology that would allow orders to be executed automatically in some cases, freeing up the trader for more intellectually demanding trades and cutting away at the inefficiency caused by delay between an order being sent and it being entered into the market.