By Carl James, Global Head of Fixed Income Trading, Pictet Asset Management
Applying equities methodology to measure transaction costs is unsuitable for diverse fixed income markets, and instead the focus should be on process and dealer expertise.
The launch of Markets in Financial Instruments Directive (MiFID) II will herald wholesale, revolutionary changes for fixed income trading. Yet, few dealing desks and even fewer portfolio managers realise the extent of the tectonic shift that will soon re-shape their familiar landscape.
An important tenet of MifID II is the unbundling of research and dealing commissions: fund managers will pay directly for the data and analysis they receive from the sell-side, rather than indirectly through channelling orders to brokerage as a reward for their service. Achieving provable best execution will become a key responsibility for the buy-side dealer. The problem is that there is not a clear convention for valuing sell-side fixed income research or how to measure the best transaction price at any given time, which means it is difficult to verify that unbundling has occurred. And it is naïve to think that practices in equities markets can simply be replicated by bond fund managers.
Yet, most transaction cost analysis (TCA) service providers are offering systems that attempt to do just that, and hence they fall into a classic error. Generally, they apply variations of an equity metric such as volume weighted average price or implementation shortfall. They are simply supplanting an equity methodology to fixed income trade analysis. Instead of obsessing about price, TCA should focus on the process to demonstrate that a best execution methodology has been achieved. This is exactly what MiFID II describes as best execution. Checks should be made on the steps taken by the dealer from when they receive an order from the portfolio manager to when they complete it in the marketplace. The process requires judgment based on data analysis and skill derived from experience, not on simply ticking boxes to satisfy a simplistic and narrow view that equity TCA delivers, for example, obsessing about price to the detriment of all other decisions.
The fixed income process also follows a logical sequence: a dealer determines whether to trade principal or agency depending on broker axes available; a request for a multiple or single price quote might be conditional on the liquidity of a particular bond issue and the risk that information leakage could disturb the market and distort the price; and a dealer must decide how to incorporate best “hit-and-miss ratios” in counterparty selection.
Fixed income is in fact multiple asset classes, whereas equity is a single asset class. Of all bonds a tiny minority trade more than once a day. Therefore, a different style of trade analysis is required, as it is impossible to be certain that a trade was transacted at the best possible price at a specific time. (This is true in any market in the world). There are many different price-reference benchmarks, but none are perfect or universally used.
Instead, validating each stage of the trade order and execution process will provide better analysis for dealers to adapt their trading strategy, and clients can be shown substantive evidence of best execution.
Dealers embedded in portfolio process
The fixed income dealer’s role is changing and, after implementation of MiFID II will become even more central to the investment process. In pre-trade, they provide metrics such as axes, hit and miss ratios and market understanding to help with decision-making. In post-trade, they have a monitoring duty, ensuring that execution is successfully completed, and shining a diagnostic warning light if something goes wrong.
Crucially, the dealer also acts as a liquidity consultant, in constant dialogue with the portfolio managers using data analysis to identify liquidity, which brokers have good hit ratios or close miss-ratios and how to transact an order appropriate to an individual portfolio manager’s investment style. In fact, increasingly the dealing desk is integrated with portfolio managers’ strategies: it is embedded rather than reactive.
Moreover, the buy-side should become a price-maker as well as a price-taker. It can post its interests or axes on one of several dealing platforms, improving the opportunities to meet a broker or another buy-side participant and hence find alternative sources of liquidity.
The financial industry in general and fixed income, in particular, is developing at a rapid pace, and is currently going through a classic maturing phase: increased automation; more regulation; lower margins; less people; and potentially a better product or outcome.
The equity markets evolved many years ago and do offer a map or set of guidelines, but not a blueprint for bond trading. The fixed income market is diverse in types of instruments and how they trade. Therefore, participants can learn from the mistakes and inadequacies of the equity markets and deliver their own specific solutions, such as a best execution methodology. Yet whatever way the landscape shifts, the effectiveness of the dealer will be critical over the next few years.
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