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New perspectives for electronic fixed income trading in Europe Back  
The European electronic fixed income trading market is experiencing fundamental strategic shifts, as continued efforts to standardise the market is leading to electronic trading and voice assisted trading being brought together, writes Frank Gast, in this summary of BearingPoint's latest white paper into the sector.
BearingPoint, the global management and technology consulting firm, has recently published its white paper The Electronic Bond Market with the support of over 40 of the major players in the European fixed income community. It builds on previous surveys conducted by BearingPoint and focuses on the latest developments in the European inter-dealer (B2B) fixed income market.
Frank Gast

The report highlights a number of key trends:

• Change of ownership with electronic platform providers increases pressure on profitability: Platform providers, which were previously owned by the banking community, have now been sold to other institutions such as exchanges (e.g. MTS/ EuroMTS), brokerage companies (e.g. BrokerTec) and data and news vendors (e.g. TradeWeb). These large institutions demand a return on their investment so that the electronic platform providers are under pressure to increase their market share and profitability. This is a major challenge for the provider given that the government bond business - as the largest segment in the B2B space - is largely a commoditised product. Increased returns on investment will come from cost savings and the development of new markets and ancillary activities like the sale of value-added data.

• Continued reduction of trading costs: Our research and consultation with electronic platforms indicate that the annual trading fees which banks pay have fallen by approximately €550 million a year since 2000, but the pace of this decline in costs will slow in the future. Since the introduction of the Euro and the expansion of electronic platforms, brokerage costs have decreased from an average of €75 per million traded in 2000 to an average cost of €12-15 per million in 2006. We further see cost savings in the future coming primarily from increased electronic volume and improved straight-through-processing (STP).

• Cost of supporting the trading infrastructure is increasing: The electronic cash bond market, although efficient, is costly for the participating banks to keep up with the latest developments and release changes. For example, some of our participants estimated that maintaining 'end to end connectivity' with just one electronic platform can cost up to €200,000 a year. This represents a very significant investment in situations where the organisation is connected to multiple electronic platforms across different asset classes (although naturally the connectivity costs vary across platforms). One larger bank we consulted noted that they maintained in excess of 60 connectivities to the various electronic markets. In addition, testing and other related costs for supporting the electronic platforms mean that participating institutions have to rigorously evaluate the business case before signing up to an electronic market.

• Banks recognise the importance of the government bond business for cross-selling opportunities: In the primary market, government bond auctions trigger intense competition between dealers. Primary dealers have a quasi-monopoly on access to the auctions and therefore obtain privileged access to investor demand. In response, Debt Management Offices (DMOs) have implemented measures to avoid 'overbidding' by banks.
Nevertheless, dealers stated that they derive value from their government bond business not only because of the syndicated deals and derivatives business originated by DMOs, but because banks leverage their DMO rankings to demonstrate their expertise for a range of other highly-profitable fixed-income businesses.

• Imbalance between spreads in the B2B and B2C (client) markets: Different trading strategies have been caused by an imbalance between spreads in the B2B and B2C markets, the former being much wider than the latter. One major reason for this imbalance is the increased competition in the dealer community who are defending their market share in the different sovereignties and subsidising the B2C markets.

• Size of the voice broker market remains constant: Our survey estimates the volume of the voice broker market excluding the future of a basis trade to be €17 billion. Four major voice brokers play a dominant role in the voice-assisted trading environment. An estimated €15 billion is split across four major voice brokerage companies: Cantor/BGC (which owns ETC Pollak), Tullett/Preborn, ICAP and Tradition (which owns Finacor) with the remaining volume split across more specialised brokers such as CIMD (20 per cent owned by ICAP).1

• Voice brokers provide spread advantages: Key players have confirmed the main reason for using a voice broker in these markets are the more favourable spreads offered by the over-the-counter (OTC) market over the electronic platforms. Here voice brokers were even able to win back some market share from the electronic platforms. Survey participants stated that they do not believe, that electronic trading will gain further market share in the inter-dealer segment.

• Voice brokers continue to play an important role in the inter-banking market: By combining the voice brokerage arm (for cash and basis trading), ICAP/BrokerTec play a dominant role in this segment followed by Tullet thereby generating revenues of about €100 million on euro governments only according to market experts.

Market responses
These trends in the European government bond market have caused banks and platform providers - as well as voice brokers - to refine their strategies. With decreasing profit margins and increased infrastructure cost, banks now look for ways to reduce their operational costs and increase efficiency. Voice brokers are equally responding through a reviewed focus on operational cost reduction. Finally, due to relatively sluggish growth in market volumes, electronic inter-dealer platforms are looking for new ways to build market share, all things being equal, in electronic rim.

Table 1 summarises the responses of the different wholesale industry participants.
Assuming that we will see an increasing demand by banks to cut the cost in trading fixed income securities, we should soon see a new model emerging. We believe that the next step for trading European benchmarks and repos is to combine electronic trading and OTC trading in a more efficient way than the existing models. Based on the Swapswire experience for derivatives, we believe that the most advantageous model is a technical infrastructure that provides an efficient post trading flow to OTC inter-banking trades executed in the OTC space. In this model, banks would route all their transactions electronically while they continue to be able to execute their transactions either electronically or OTC, depending on the nature of the trades.

Over the short term we believe that the trend will continue to move towards increased standardisation of the fixed income market. With standardised interfaces and straight-through-processing already implemented in the organisations, the different market participants must find new ways to reduce cost. Currently, we see a short term trend towards voice-assisted trading, but this trend will diminish as the electronic market and post-trade settlement infrastructure in Europe becomes more efficient. Existing platform providers like MTS, EUREX Bonds and HDAT (and - to some extent SENAF) and their market models have to evolve to facilitate larger trading volumes. By reformulating the market and bringing together electronic trading and voice assisted trading, the market should move towards a higher degree of standardisation, which could result in the development and adoption of an 'exchange-like' model.

In the longer term, the challenge of the European government market is to compete with its U.S. counterpart for the benefits of all the parties involved in the market. The Euro government bond market is quite fragmented compared to the U.S. market (e.g. no dedicated Euro government bond benchmark). Daily volumes in the Euro-Zone account to 20 per cent of the ones in the U.S. ($90 billion equivalent at the prevailing exchange rate versus $500 billion). In addition, according to market participants, the swap spread in euros is constantly undervalued compared to its U.S. counterpart. This implies an increased cost of funding to all euro issuers including the biggest and best respected ones.

However, two major developments could positively impact the daily turnover in Europe's secondary markets:

• Banks should assess the advantages of algorithmic trading for the euro government bond market. This could involve a re-assessment of the definition of the inter-banking space.

• Issuers should work towards the creation of a Single Debt Agency that will act in the market on behalf of the 12 existing euro-issuers. This could tackle the most important remaining fragmented feature of the euro government bond market. These structural changes could bring outstanding beneficial externalities to the global Euro fixed income market.

Table 1: Industry participants' responses

Banks' responses

- Further reduce cost
of electronic and OTC trading
- Increase the speed
of execution
- Improve STP levels

Voice brokers' responses
- Increase STP offerings
- Increase price competition
- Streamline their post-trade infrastructure

Electronic platforms' responses
- Enter new product segments
- Enter new markets
- Integrate OTC business

1According to annual financial statements and publications from brokerage houses.

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