Fixed Income Meets the Black Box
The universe of fixed income securities - with more than 3 million names in the U.S. alone - dwarfs the global equities market, which only has about 15,000 stocks from which to choose. As the dot-com bust has consolidated more than 100 bond-trading platforms to just a few entities with meaningful liquidity, the fixed income market would seem to be ripe for algorithmic trading, and in the fast-moving, deeply liquid interdealer market in government bonds, this certainly is the case. But it may be quite some time before algorithmic trading becomes commonplace for institutional asset managers and mutual fund managers, due to structural issues with the dealer-to-customer marketplace that result in a lack of transparency and navigability for automated trading patterns.
In the interdealer market, an active arbitrage business has developed between the two giants of electronic U.S. Treasury trading - eSpeed and Icap - and between these two platforms and the futures market. Opportunistic traders attempt to gain small profits by purchasing bonds on one platform and immediately selling them on the other, which requires lightning-fast connectivity and firm quotes - and it certainly doesn't hurt to have a computer with built-in parameters doing the work. According to David Rutter, CEO of electronic brokerage at London-based Icap, the vast majority of this trading is conducted by "less than 10" quantitative trading firms, most of which have been spun off of Chicago-based futures commission merchants (FCMs) to lay off risk against bond-based futures contracts traded on the Chicago Board of Trade (CBOT).
"Algorithmic trading is the fastest-growing customer segment that we have, and there has been a dramatic change in the last year - more than 50 percent of our bids and offers are now black-box-oriented," Rutter says. "[Black-box traders] have become a very important source of liquidity, which was traditionally the domain of dealers."
Rutter notes that relatively few transactions result from black-box postings, but they have helped reduce price discrepancies in the Treasury market. He adds that Icap now is experimenting with creating a volume weighted average price (VWAP) benchmark for its most active securities - a hallmark of the equities market and a harbinger of more algorithmic trading to come.
New York-based eSpeed also is considering creating a VWAP for "on the run" (i.e., most recently issued) Treasuries, officials say, and the broker is making preparations for more-automated trading. Over the past year and a half, the platform has been increasing its message-rate capacity so as to pave the way for active black-box customers.
"We have a group of people really dedicated to helping our clients operate programmatically with us," says Matt Claus, eSpeed's CTO. "Program trading, in our environment, is customers who have developed software that interacts with our API [application programming interface] without human intervention." Though he cannot provide specific figures, Claus estimates that algorithmic trading on eSpeed will grow tenfold in the next five years.
The attitude toward algorithmic trading, however, is much more conservative at dealer-to-customer venues such as TradeWeb, the predominant trading platform for government securities, and MarketAxess, the predominant corporate-debt trading platform. According to a spokesperson, TradeWeb is not actively pursuing algorithmic trading capacity.
For its part, MarketAxess is making improvements to its API to support faster trading, according to John Dean, the company's head of connectivity. But, he says, the algorithm bug probably will require 12 months to 18 months to take form in the fixed income dealer-to-customer marketplace, starting with Treasuries and moving to the recently launched credit default swap (CDS) index market, and finally on to the most-active corporate securities.