Electronic trading – the future of trade execution
By Steve Hall
Electronic trading platforms are seeing acceleration in demand across a growing number of fixed income and derivatives markets. In the US and Europe, particularly, the trend towards electronic trading has been clear for some time. One example is the European government bond market, where approximately 50 percent of the dealer-to-buy-side customer volume is already traded electronically. A key reason for this growth is that electronic trading can bring fundamental benefits to market participants, while preserving the bilateral relationships between counterparties. It makes execution faster and more efficient, while offering considerable operational benefits to both the buy-side and market-makers. The growing interest in e-trading is further driven by anticipated regulatory reforms – particularly for derivative instruments.
It remains to be seen exactly how policy makers in Europe and the US, who are leading the drive towards defining regulations on trade execution, clearing and reporting, will rule, but the drive towards greater transparency is clear. For a growing number of banks, institutional investors, asset managers, hedge funds and other investors, moving the execution of their trading activities onto electronic platforms is part of the process of adapting to this changing landscape.
Yet it is the operational efficiency and effectiveness of electronic trading that is proving most compelling to investors. Indeed, those investors already trading electronically cite efficiency gains as reasons to embrace e-trading. These benefits - facilitating access to liquidity, greater price discovery and proving best execution - are compelling to firms such as asset managers and pension funds.
Efficiencies and effectiveness of e-trading
Electronic marketplaces can be fully integrated into existing workflow systems for both the buy side and the sell side (dealers). In Europe, more than 60 percent of trades executed on Tradeweb are delivered to an order management system, providing substantial efficiency gains to customers. Electronic platforms can be directly linked to clearing houses, allowing end users to fully automate their workflow without disruption, from trade execution through to clearing – reducing the operational risks involved at each stage of the process.
Buy-side customers can send each request-for-quote (RFQ) simultaneously to a chosen number of dealers from the pool of market-makers providing liquidity to the platform. Through this auction process, the buy-side can put dealers into competition to offer the best price.
Since the process is electronic, customers can track their performance and generate customized reports that help to demonstrate evidence of “best execution” and which can be used as tools to better manage their business. For example, post-trade data from previous auctions provides the ability to analyze their counterparties’ quoting performance, which may inform their choice of dealers when next sending out a request-for-quote.
The roll-call of operational efficiencies goes on. For many traders, the primary benefit is the reliability of the timing protocols around the auction process – receiving all prices back at one time eliminates the need to make numerous phone calls to find the best prices. Other traders may simply prefer the speed of the process, such as when allocating a trade to different sub-funds sitting behind the transaction. Electronic trading platforms can automate all of this, saving traders valuable time. What’s important is that during this process, existing trading relationships and information flow are fully preserved. Traders on both sides of electronically executed trades are still dealing with the same people that they would do by using other methods.
Regulatory drivers for e-trading
Of course, many of these operational benefits – such as reducing operational risk and improving price transparency – also appeal to financial market regulators. Indeed, regulators globally realise that e-trading is one mechanism that is aligned with their efforts to increase transparency in the marketplace and to reduce the build up of systemic risk. For relevant standardized derivatives, regulators are seeking to ensure that trades are centrally cleared by recognized clearing houses and that trading is executed on regulated venues – in effect that they are traded on a swap execution facility (SEF), multilateral trading facility (MTFs), multilateral organized trading facility (OTF) or an exchange.
Meanwhile, European rule makers (under MiFID II) are focussing on improving pre-trade transparency to achieve enhanced price discovery, and post-trade reporting in order to shed light on dangerous exposures or concentrations that may increase systemic risk. Regulated electronic platforms offer transparency and can facilitate post-trade analysis, and are therefore well positioned as approved venues for the trading of standardised derivatives.
As market participants adapt to market reforms and new regulation, electronic trading looks certain to have an increasingly large role to play. But even more importantly, where market participants seek improved operational reliability, efficiency, transparency (that does not undermine liquidity) and competitive pricing, electronic trading provides enormous advantages.