There has been much discussion about the inevitability of moving fixed income trading to an electronic platform and the difficulties of making this a reality.
Kenneth Hoffman
Let’s set the scene.
Currently ~80% of equity trades are done electronically while only 20% of fixed income trades that way. Why the gap? Fixed income instruments are customized products, which makes them difficult to price, less transparent and much less liquid. In addition most equities are traded on an exchange (e.g., NYSE, NASDAQ) making them much more transparent as to the time, price and amount of each trade. Of course some fixed income instruments are liquid and trade regularly like US government bonds, and the percentage of these securities that trade electronically is much greater (over 40%). In contrast the corporate bond market is made up of a large number of unique issues that trade infrequently and when they do trade the face amounts are usually large.
The challenge.
Regulators in both the US and Europe have tried to improve the transparency of the fixed income market by introducing TRACE in the US and MIFID 2 in Europe. This requires some bond trades to be recorded in a similar fashion as equity trades. However, recording and verifying the integrity of this information is costly for both the market participants and the regulators. Even with the introduction of TRACE and MIFID 2 electronic trading has flatlined. Current platforms have proved ineffectual – the bond market is overdue for a technological shake up.
So, how do we fix it?
- Blockchain: First, in order to verify the integrity of information, a new bond trading platform needs to embrace the blockchain. Blockchain technology can be used to verify information on a distributed basis. Not just the details of each trade but information about the cover price and number of inquiries related to that security.
- Artificial Intelligence: Next the platform needs to utilize intelligent agents in order to ascertain all the holders of a bond globally as well as an approximation of the price at which those bonds might trade.
- Incentives: Finally in order to encourage participants to utilize the new platform users will be “paid” in cryptocurrency every time they utilize the platform to offer to sell or bid to buy a security. The amount they will be paid will be a fraction based on the nominal amount of the security they are offering to buy or sell. They will then have to pay in cryptocurrency every time they complete a trade. This transaction fee will also be based on the nominal amount of the trade but will be a larger percentage amount then the inquiry fee. The trading platform will provide bids and offers in the cryptocurrency so that participants can buy the cryptocurrency they need to pay the fee on completed trades if they have not accumulated enough from their previous activity. This should reduce the cost of trading since they are both receiving and paying cryptocurrency to and from the platform.
Expected Benefits
This approach solves a number of issues that currently plague the fixed income market. Utilizing blockchain technology makes the recording and verification of trades cheaper, easier and more secure. The use of artificial intelligence will increase the likelihood of trades actually taking place as the system will operate in much the same way as the bond market currently functions but instead of humans reaching out to likely counterparties by phone the platform will do that electronically. Artificial intelligence will also improve the pricing of securities. Finally by using a cryptocurrency based inquiry and transaction fee system users will be more likely to use the system as it can potentially reduce the costs associated with trading securities. For the electronic trading platform the advantage is twofold. First it earns fee income on completed trades and second as a market maker in that cryptocurrency it earns the bid ask spread on trades in the cryptocurrency. The biggest issue with utilizing a cryptocurrency based system is that some fixed income investors may be prohibited from holding these instruments in their portfolio. For those investors a USD transaction fee can be implemented.
The Result?
By combining the latest innovations in blockchain technology, machine learning and cryptocurrency a new electronic bond trading platform can finally achieve the goals investors and regulators have long sought. A more liquid, transparent, and efficient bond market.