Man or mouse: Voice broking versus e-trading

When market turmoil was at its peak in late 2008 and the first quarter of this year, the voice broking model returned to prominence at the expense of electronic trading platforms. But with the markets returning to stability in recent months, has this trend been reversed?

The use of electronic platforms to trade credit and other fixed income products in the interbank market has always been less widespread than in the buy-side market. With activity concentrated among a limited number of market participants, using telephone and email has been the preferred method of communication. Investors, on the other hand, generally have relationships with numerous dealers and the use of a one-stop trading platform has more obvious benefits.

Nevertheless, the interbank community has been affected by the rollercoaster trajectory of the credit market in the past couple of years just as much as the buy-side. “At the start of the year when spreads had widened massively, traders were looking for more market colour from their brokers and this caused electronic trading to suffer,” says Dean Salmon, European head of e-commerce at interdealer broker BGC Partners. “Since the start of the second quarter, we have seen a steady return to electronic trading as spreads have returned to near normal levels.”

At interdealer broker Icap, electronic broking of fixed income products, which includes government bonds and repo as well as cash corporate bonds and credit default swaps, fell from an average daily volume of around $600 billon before the collapse of Lehman Brothers in September 2008 to a low of $400 billion at the end of that year. “Since then, volumes have recovered to $500 billion in September 2009,” says Mark Yallop, group chief operating officer.

Cash is king

One noticeable trend in 2009 has been a migration back to the cash bond market, traditionally a voice broking business. This, coupled with the decline in CDS volumes, led to the use of electronic platforms falling substantially when market uncertainty was at its peak.

“This migration [from derivatives to cash bonds] is chiefly attributable to the funding requirements of corporates, which have issued record levels of new bonds, while in the CDS market, uncertainties surrounding regulatory requirements in the OTC derivatives space prevail,” says David Perkins, head of electronic broking for Europe, the Middle East and Africa at Tullett Prebon.

However, Salmon says in recent months the trend has started to reverse and confidence in the derivatives market is growing again, potentially prompting an increase in electronic trading. “One of our big successes has been the growth in electronic trading in our CDS business in North America,” he says. “We are confident that the growth we’ve seen over the last six months in electronic trading will continue in 2010.”

With the credit markets rebounding strongly since the first quarter, brokers and their trading platforms have become more important, according to Perkins. “They are increasingly regarded as a natural extension of a bank’s sales force,” he says. “The main objective of many traders has been to move risk off their books as rapidly as possible, especially in relation to difficult or illiquid positions. An interdealer broker’s electronic platform is considered a powerful distribution tool.”

The crisis highlighted the valuable role IDBs can play in facilitating the banks’ efforts to reduce and hedge risk. “The banks’ concerns regarding credit exposure, and the regulatory pressures related to it, are not going to go away, so the ability of IDBs to help improve liquidity and transparency in the market is vital,” says Perkins.

Nevertheless, while IDB platforms have become more valuable, the longer-term scope for electronic trading to expand in the interbank market is limited. Even the most ambitious of IDBs, such as Icap, aim only to derive half of their profit from electronic broking. “There will always be a role for high quality voice brokers because the credit market is innovative and, as such, requires the solution-based support only a voice broker can provide,” says Perkins.

Consequently, all IDBs operate a hybrid model offering both voice and electronic trading, where the balance between the two constantly changes depending on the product and market circumstances, according to Chris Giancarlo, head of corporate development at GFI Group.

The great unknown

In the period since the collapse of Lehman Brothers and the onset of the most volatile period of the financial crisis, the debate surrounding the reform of the financial sector and the OTC derivatives market in particular has changed substantially.

“Twelve months ago, most observers were forecasting a huge regulatory overhaul and a forced transfer of OTC markets onto exchanges,” says Yallop at Icap. “Now many, but not all, of the key decisions about a new more robust market infrastructure have been made.”

Proposals to forcibly migrate CDS onto exchanges were criticised by both the buy-side and sell-side community. And despite regulators’ ambitions to do that initially, a compromise solution whereby standardised contracts will be centrally cleared and all trades reported to repositories appears to have settled regulatory concerns.

“There is a low degree of commoditisation in many single-name CDS products and fairly small pools of liquidity,” says GFI’s Giancarlo. “Single-name CDS is not an ideal product for exchange trading. A major difference between an exchange and an interdealer broker is the human element. It’s not necessary to have a human to execute an equity transaction in the most liquid stocks. But in order to find the other side to a complex hedge against a specific issuer’s bond, a hybrid broking model has value.”

However, while it seems likely credit derivatives will not become mandatory exchange-traded instruments, they will “be pushed, pulled and dragged to clearing platforms”, according to Andy Nybo, principal and head of derivatives at financial markets research and strategic advisory firm TABB Group.

To date, IntercontinentalExchange and Eurex have launched CDS clearing platforms, with CME Group also planning its own offering. Most of the initial focus has been on clearing interdealer trades, but the Operations Management Group, an industry body whose members include dealers, investors and industry associations, has committed to achieve market-wide access to clearing platforms by December 15.

These efforts, coupled with the move towards standardised contracts, has led some market participants to predict the CDS market will become larger than ever, as long as regulators do not attempt to enforce additional changes. But not everyone is confident market growth is a certainty.

“Why would anyone commit significant capital to a market in which there is a degree of fear until the writing on the wall is clear? A year ago some Congressmen had wanted to ban derivatives,” says Giancarlo.

Current discussions are centred on the type and scale of transparency that will be imposed on the market. “It is important to define what is meant by transparency,” notes Giancarlo. It can be divided into pre-trade transparency (where the most transparent asset class is equities), post-trade, such as the fixed income data reported through Trace, and regulatory transparency, where information is sent to a central trade repository.

“The most likely outcome of the current debate is regulatory transparency with some degree of post-trade transparency, similar to what you see in the real estate market where offered prices are listed, negotiation is private and there is a lag before the final price is released,” says Giancarlo. “Pre-trade transparency is deemed negative by the credit market because it is likely to chase away liquidity.”

It is essential to remember that regulatory reforms and increased electronic trading of credit derivatives are not synonymous. “Some elements of CDS, such as indices, will increasingly be traded electronically while less liquid single-name products will require voice broking,” says Giancarlo.

Nybo says there need to be sound benefits in terms of efficiency and transparency for credit derivatives to migrate to electronic platforms. “At the moment, a limited number of participants do much of the business and any new solution will require their support,” he notes. “It remains to be seen if that support is there. It is far from inevitable that increased regulatory scrutiny will ultimately result in more electronic trading.”