How an EMS helps firms navigate a fragmented fixed income market

Fragmentation in fixed income is nothing new. However, the situation has been exacerbated by a series of events including Covid-19, geopolitical tensions, and a shifting macro-economic landscape.  The dynamics have changed and finding the most efficient way to source liquidity has never been more important.

Ironically, the rise in electronic trading has been a double-edged sword. It has enhanced efficiencies, but as a recent report by Coalition Greenwich points out, it has also made markets even more splintered and diverse. The consultancy attributed this to the plethora of new trading venues and protocols, as well as increased volumes of data.

The challenges are not only in the opaquer end of the fixed income universe, but also in the roughly $26 trillion US Treasury market. Often dubbed the most liquid in the world, the market has suffered serious bouts of disruptions following the pandemic and the mini banking crisis over the past three years. Larger orders, which in the not-too-distant past were seamlessly executed, are now often broken up into smaller chunks. A portion is sent through the electronic pipes and the rest is traded by phone over the course of a day.

Volatility, which made a comeback after the pandemic, has caused market makers to widen their bid-ask spreads and post less depth at any given price to mitigate the increased risk of taking on positions. As the stalwarts withdrew, an influx of newer participants — such as hedge funds and high-speed traders — stepped in to provide much-needed liquidity. However, this cohort is less regulated and behaves differently to primary dealers.

For example, they are thought to have intensified the market crisis in March 2020. As panicked investors sold treasuries, hedge funds in leveraged bets known as the basis trade were forced to unwind their positions, accelerating the sell-off.

Europe has similar issues to the US, although trading is more fragmented given the heterogenous nature of the region. They are experiencing the same liquidity issues as traders adjust to the new world order of higher interest rates. This caused them to whittle down their significant bond holdings and play it relatively safe with smaller positions until there is a clearer picture over the European Central Bank’s next move.

This is supported by a recent report from the International Capital Markets Association. It found that median trade sizes fell around 50% in Germany and 58% in Italy during the first half of this year compared to the same period in 2022, while average trade size slid 37% and 22% respectively.

Against this backdrop, it’s no wonder that the tried and tested methods of corralling prices and effectively executing trades are no longer seen as fit for purpose. In the past, as the Coalition Greenwich report notes, order management systems (OMS) and trading venue front-ends would provide the broadest possible view of the market. These approaches were viable due to the dearth of available data and a smaller number of liquidity sources.

Fast forward to today and market participants need technology that can enhance trader capabilities as market structure evolves. The number of data-producing channels has expanded over the past five years and now includes a multitude of execution protocols, dealer prices, evaluated prices, liquidity scores, a plethora of communication pipes, and enhanced post-trade regulatory reporting, according to the Coalition Greenwich report. In addition, legacy methods are witnessing an increasingly smaller fragment of the overall market, limiting the liquidity picture and pre-trade transparency.

However, buy- and sell-side firms do not have to look far for the solutions. The execution management system (EMS) may have been around for a while, but the newer, more sophisticated version that can digitize the entire dealer-to-customer (D2C) trading process is the ideal response.

Fragmented sources of liquidity are aggregated with real-time prices and aligned with orders to help identify when to trade, how it should price, and where it should trade. These insights are captured, maintained, and combined with historical trading activity, which produces a pre-trade decision support tool that can ultimately be used to drive automation.

The Coalition Greenwich report highlights the many benefits, including improved speed, access to information, compliance, and scale. Moreover, combined transaction costs are reduced, plus buy-side firms can meet their fiduciary responsibilities, particularly at a time when markets are increasingly more complicated and the volumes of data continue to mushroom.

Equally as important, an EMS can be instrumental in achieving best execution across different bond asset classes. This is not easy in the fixed income world. However, the platform not only ensures optimal pricing for the buy-side among various D2C markets and retail venue, but also provides buy-side capabilities to sell-side traders through direct execution, along with pre-trade and post-trade hedging. It also fulfills regulatory requirements by providing a comprehensive audit trail of all execution steps.

Given the changing dynamics of the fixed income markets, it’s easy to see why the EMS should no longer be seen as an accessory but a crucial, must-have piece of technology.