Treasury Trading 2011: Automating the Yield Curve

While algorithmic trading in the liquid fixed income (FI) market has been discussed for years, a group of dealers are launching a new generation of trading functionality aimed at bringing a greater amount of automation and sophistication to the buy side. While dealer-to-client (D2C) electronic trading has been around in the form of single- and multi-dealer platforms for over a decade, the solutions being marketed today aim to streamline the execution process.

The initial source of demand for algorithmic functionality is coming from trades (such as switches, curves and basis) that depend on the efficient execution of two or more securities, and is limited to Treasuries for now. The new functionality allows the trader to pinpoint the amount of risk exposure they are willing to take on in order to get filled. A trader can take on more risk in order to put the trade on more quickly or only accept a narrow range of exposure.

At the same time as the sell side is rolling out client-facing trading tools, there is substantial work being done to liquidity-provisioning technology. Nearly all of the major FI shops have aggregated internal cash treasury liquidity into a single pool. Most shops automatically execute small-sized orders. In addition, automated responses to RFQs are becoming the norm. But only a few have taken the next steps: (1) pushing top-level data from the internal pool out to clients, and (2) executing algorithmic orders against that internal pool.

While the cash market is taking incremental steps toward increased automation, the rates product facing the most upheaval is swaps. Vanilla interest rate swaps will be required to trade through a Swaps Execution Facility (SEF) with the exception of block trades (still undefined) and end users. Furthermore, SEFs will be required to grant access to a variety of market participants (who meet some minimum requirements) and enable trading between multiple counterparties. In addition, post-trade reporting requirements and the eventual dissemination of quotes, will also drive significant change. These concepts have significant implications for the rates business.

Allowing open access to major swaps participants will change the dynamic of the tiered market structure (inter-dealer brokers, dealer-to-client platforms and single-dealer platforms). This is not to say that there will be a single platform for all swaps participants, but that the current segmentation is likely to shift as the existing platforms attempt to encroach on each other’s territory.

In a sense, the rates market is about to enter a competitive landscape that is similar to what is occurring in digital distribution. While movie studios are still funding the creative process, the way in which the product is disseminated is undergoing radical change. The same is true for the dealers. Despite efforts to pull some of the business away from the dealers, the dealers will still be the ones who need to provide a significant amount of the liquidity in the market for at least the next several years. But the way that the liquidity is being distributed and how clients want to interact with the liquidity are changing.

Treasury Trading 2011: Automating the Yield Curve

In this Vision note, TABB Group examines recent trends in Treasury e-trading. The report is based on conversations with primary dealers, brokers, interdealer brokers, proprietary trading groups, hedge funds and long-only asset managers. The report covers topics such as liquidity aggregation, autoquoting, algorithmic spread trading, buy-side attitudes toward electronic trading, the impact of Swaps Execution Facilities (SEFs) on the cash market, and the recent product announcements from a number of dealers. The report also sizes the portion of Treasury trading that occurs electronically versus the phone and how much market making is fully automated.