Deja Vu for Bond Exchanges

From the Jan-Feb 2006 issue of Advanced Trading

With Archipelago announcing in October that it's going to trade listed corporate bonds on its electronic trading system, electronic bond trading systems providers might be a little nervous. After all, Archipelago is merging with the New York Stock Exchange, and the Big Board already has an automated bond system (ABS) that CEO Jerry Putnam says needs an upgrade. If any market has the clout, technology, connectivity and customer base to revamp the bond trading system, Arca/NYSE is it. But, in the fragmented world of bond trading - where each sector (e.g., Treasuries, corporate bonds, high yield, mortgage back securities, European government bonds, etc.) has access to its own sources of dealer liquidity - it's going to be difficult for an exchange model to win critical mass without some incentives.

So, are the leading fixed-income trading systems worried that the Big Board will encroach on their turf? Not at all. Speaking at a bond conference in December on a panel with Archipelago President Mike Cormack, CEOs of the two major electronic bond trading systems - TradeWeb and MarketAxess - reminded the industry that previous attempts to experiment with an exchange model in fixed income - namely BondBook and Trading Edge - failed.

While the mood on the panel mostly was cordial, the message was clear: TradeWeb and MarketAxess are not feeling threatened by the NYSE's and Archipelago's plans to expand into corporate bonds. "There have been many attempts to push the fixed-income markets into an exchange world - it hasn't worked," said Richard McVey, CEO of MarketAxess. "This is not a market that has continuous liquidity," he added, noting that only about 500 bonds are actively traded. Further, McVey pointed out that Archipelago's new partner, the NYSE, has had ABS as a model since 1976, but it still represents less than 1 percent of the volume in corporate bonds today.

Despite these warnings, Archipelago officials are giving the bond exchange model another whirl. Archipelago's Cormack joked that he hadn't felt this way since he sat on a panel with market makers in over-the-counter stocks during the early days of Archipelago's emergence as an ECN in equity trading. Of course, the rest is history. Archipelago, Instinet and Island captured half of the market share in stock trading from Nasdaq, which has spent the past five years trying to win it back. So perhaps the bond systems should sell Archipelago short?

"There is healthy skepticism as to whether an exchange can work in the bond market," said Jim Toffey, CEO of Thomson TradeWeb, at the conference. "BondBook had all the healthy ingredients to make that happen." Whereas the current electronic bond trading systems have had success with a request-for-quote model - in which the buy side requests bids and offers from several dealers and the dealers know the identities of buy-side customers - in an exchange model, trading is anonymous and both the buy and sell sides need to act as liquidity providers. The problem with BondBook, Toffey explained, is that "The buy side traditionally liked to be liquidity takers and not providers, and that's a fundamental hurdle in a marketplace where it takes both to get legs."

However, Archipelago's agenda for the listed corporate bond space differs from BondBook's approach, which was to offer anonymity to the buy side and increase price transparency. Arca/NYSE's motive seems to revolve around earning listing fees from corporations and diversifying the range of asset classes. "We have a few clients who are significant players in the equity and fixed-income space," Archipelago's Cormack told conference attendees. "It is a technology pricing solution for at least these clients." But, while Cormack is betting that technology becomes an enabler and will lower the barriers to entry, the CEOs of TradeWeb and MarketAxess remain unfazed. That's because they're focused on competing with each other.

Ivy Schmerken is a 20-year WS&T veteran. As Editor-at-Large, she covers trading for both Wall Street & Technology and Advanced Trading. [email protected]