Fixed Income Leaders Summit EU 2021

EUROPEAN MARKET STRUCTURE CONTINUES TO EVOLVE

Introduction

Though pandemic-related uncertainty continues, fixed income industry professionals were keen to gather both in person as well as virtually for the recent European Fixed Income Leaders Summit (FILS). While seeing humans physically networking in an actual exhibit hall felt a bit odd, the overall tone was positive. Investors were eager to hear each other’s insights and learn about new trends in the market. Against this backdrop, Aite-Novarica Group analysts report the top themes discussed at FILS and their implications for investors. Among a litany of topics, including growth of portfolio trading, the adoption of execution management systems (EMSs), and ongoing market volatility, the potential for sustainable investing and all things related to environmental, social, and governance (ESG) to further shape the fixed income market emerged as dominant concepts.

Methodology

Aite-Novarica Group analysts used a series of live polling questions during the FILS symposium, held on October 5 and 6, 2021, to gauge market sentiment and unearth prevailing trends in the financial services industry. Insights gained from speakers on various panels highlighted European as well as global trends and are also discussed.

ESG continues to shape fixed income investment

One key theme to emerge from FILS was the importance of sustainable investing and ESG. Sustainable investing has risen in importance over the past few years, driven by social influence and other factors, with more flows into ESG funds (Figure 1). This shift is influencing the way firms invest in the fixed income markets (Figure 2). For instance, market participants are increasingly looking at becoming involved in ESG and dedicating resources to it—something that clients, policymakers, and regulators are noting and discussing. The European Union Sustainable Finance Disclosure Regulation (SFDR) aims to create a sustainability profile of funds that investors can use as a comparison tool to guide where they’re putting their money. However, establishing rules for transparency in funds and a related reporting framework are taking a lot of time—a signal that it’s still early in the game.

FIGURE 1: SUSTAINABLE INVESTING IS ON THE RISE

FIGURE 2: GREEN BOND ISSUANCE IS ON THE RISE

While the buy-side acknowledges that ESG is a “huge” focus from the investment side, its impact in trading has been slower to materialize. Many believe that ESG in trading will continue to evolve in response to client demands. At some point, clients will (and should) demand a view into the sustainability footprint in trading, and the buy-side will need to be ready to respond. If issuance is any indication of the direction of travel, it is noteworthy to mention that 25% of European investment-grade bonds being issued are now ESG-related. A late September gilt issue was 10 times oversubscribed as venues continue to focus more on green bonds.

As data becomes more consumable, it’s likely market participants will see more funds going green, and the demand for more strategies and firms focused on sustainable investing will steadily increase over the next three to five years. Of course, nothing worthwhile ever comes without challenges. On the portfolio-management side, the mixing and matching of different scores and risk metrics (e.g., climate and ESG scores) linked to a simple new issue have fostered the need for aggregation tools to aid credit and sustainable investment analysts. Better workflows upstream and downstream are also necessary, and enhancements to flows going into compliance and pre-trade systems are developing. Despite strong demand for new issues, secondary market liquidity is often lackluster. Finally, questions arise when evaluating ESG and sustainable investing versus return on investment. Investment firms must carefully consider the right balance and focus on both. While some clients may be willing to bypass the alpha to meet the social impact of the funds, a sharp decline in markets could test this view.

Portfolio trading is impacting European markets

The COVID-19 pandemic increased the adoption of more electronic trading, pushing fixed income markets to a significant inflection point, and a wave of new and exciting trends is impacting European trading. These include the rise of algos in European investment-grade bonds; new protocols such as firm prices, live markets, and request-for-market functionality; and an uptick in portfolio trading. The majority of market participants pointed to portfolio trading as the most innovative trend set to create meaningful impact to the markets in the next six to 12 months (Figure 3).

FIGURE 3: PORTFOLIO TRADING CONTINUES TO EXCITE

Portfolio trading—which has grown to 5% to 6% of the total market, is catching up with U.S. adoption figures. Roughly 14 billion euros in portfolio trading are transacted per month in European trading, with emerging markets and high yield accounting for the fastest-growing portion of the total.

While this is all very good news, Portfolio trading remains nascent in Europe. Investors view the protocol as one tool in a growing toolkit that is deployed in a measured manner and hasn’t become overused. The need for dealers to support the liquidity provision remains, and there has been significant building of the tech stack for pricing these deals. Managers are expected to continue using portfolio trading for flow-driven volume, asset reallocation, large transitions, and liquidation/ramping up.

The overarching benefits of portfolio trading are the time it takes to trade the package with certainty and the cost. Reducing operational efforts and trading illiquid bonds when baskets are well-diversified is key. When baskets become less diversified—and possibly concentrated in a maturity or sector—portfolio trades are harder to price. Additionally, while portfolio trading guarantees execution, it still does not guarantee delivery, as some funds have waited for weeks for bonds. However, the continued entry of new participants in the market is set to improve pricing, liquidity, and delivery snags in the near term.

To EMS or not to EMS?

Over one-quarter (27%) of fixed income market participants (Figure 3) believe fixed income EMSs are set to experience exceptional growth and create meaningful impact in the markets in the next six to 12 months. While EMS shares many functionality overlays with an order management system (OMS), EMSs add value because they better handle complex workflows in the fixed income space. There is a wider range of available connectivity, which is important as traders consider sending a request for quote (RFQ) or engaging in open-to-all trading, auctions, or single-dealer connectivity.

The ingestion of data—including pre-trade analytics, which 41% of market participants believe will be driven by artificial intelligence and a key innovation in the market—will create demand for more customization of workflows and aggregation of data from different points. An EMS may make this process smoother. However, many traders are still employing workarounds as a clunky means of finding liquidity and providing best execution. Table A compares some pros and cons of EMS adoption.

TABLE A: FIXED INCOME EMS PROS AND CONS

While there are many upsides to choosing an EMS, the value isn’t constant for everyone. It depends on the amount of asset classes being traded and other ways the firm is set up. For example, if investment managers are engaged in many liquid securities, they can use more smart order routing tech and netting/aggregation tools built into their workflow. Although some very good pre-trade analytics still support less liquid securities, those traders rely on more traditional transaction methods and wouldn’t get a lot of mileage from an EMS. Implementation cost is another hurdle to fixed income EMS adoption. While there are running costs to any system, implementation is never simple and may create complex workflows. In the case of an EMS, integrating back with an OMS could be tricky. There is usually a period in which things don’t go well until users settle into the system. SaaS deployments have an advantage, as they bring down implementation time and complexity. Another “big help” is the standardization of protocols, which aids in interoperability efforts. But ultimately, the market needs more user-friendly, intuitive solutions. These will appear as more OMS and EMS providers partner on solutions.

More mifid, more problems?

In July 2021, the U.K.’s HM Treasury launched a review of its financial transparency regime, looking across multiple asset classes, including fixed income, and considering a number of changes as it has to work in a post-Brexit U.K. world. This is welcome, as market participants have criticized the current transparency regime. Greater weight has, however, been given to post-trade transparency, which is important since much of the market is RFQ- and dealer-based. Less focus will be spent on pre-trade transparency since the fixed income market is “fundamentally bespoke and nonstandard.” Thank goodness.

There is a strong desire to recalibrate the liquid market determination from its present state, in which current calculations under the EU’s Markets in Financial Instruments Directive (MiFID II) aren’t producing reliable statistics, creating false liquidity flags for illiquid securities. As a result, HM Treasury is seeking industry opinion, with the likely goal of using a different methodology combining qualitative and quantitative factors. There will be a consultation with the Financial Conduct Authority early next year to ensure regulations work well for U.K. markets. Many European buy-side investors don’t believe the market should go from the current transparency rules to something more simplistic. In the U.S., fixed income is viewed as a collection of markets and is, in itself, multi-asset class. The Financial Industry Regulatory Authority’s (FINRA) Trade Reporting and Compliance Engine (TRACE) divides bonds so users can distinguish between liquid corporate bonds and illiquid off-the-runs. While European fixed income markets may glean some benefits from TRACE, most fixed income managers believe ultimately, it’s about finding the balance between high levels of transparency and keeping the market structure and ecosystem alive. The sell-side may carry illiquid bonds for over 30 days on balance sheets—the burden of any risk book. As a result, many are calling for compromise. Enter the consolidated tape debate. Although there are clear advantages to a real-time consolidated tape, competitive forces appear to be pushing for multiple consolidated tape providers (CTPs), a matter HM Treasury is exploring. The big question is whether or not there will be data alignment. Trading venues, approved publication arrangements (APAs), and those self-trading connect to multiple CTPs. However, it’s likely investors will connect to only one. While, in theory, all CTPs should have the same data, is it sensible to believe that will happen in practice? For those that recall, it was initially difficult to get access to all APAs born out of MiFID II in 2018. Talks of multiple CTPs awaken similar concerns. Easing monopoly fears may require European regulators to implement a single CTP and grow an industry around it, similar to the development of analytics and other data originating from TRACE-reported statistics like price and yield. The goal of enhanced transparency will come from one of the CTP models as well as regulatory effort to monitor data quality. The development of analytics that aggregate this information by third-party providers may well be what it takes to level the playing field.

Economics and geopolitics strike again

Markets are at an interesting inflection point, perhaps akin to the period following the 2008 financial crisis. There is evidence the world economy is going through tensions exposed by the COVID-19 pandemic. Growth and supply are out of balance. For the first time in many years, there are legitimate inflation concerns, too. Central bankers and market participants are left scratching their heads and wondering: Where do we go from here?

It seems likely that U.S. Federal Reserve Fed Chair Jerome Powell will not be reconfirmed, and some believe the Fed may fall behind the curve if they aren’t careful. Meanwhile, the European Central Bank (ECB) has a steady staff, but its asset program is a question mark. There is less pressure to raise rates compared to the U.S. While shorter-term developments dominate the tape, the cumulative impact of quantitative easing for over a decade has created long-lasting distortions. For instance, the supply of safe-haven assets like Japanese government bonds and European sovereigns have dwindled, leaving U.S. Treasury securities as a standout, risk-free asset. China’s influence also remains a key part of the investment story. Although many investors believe there is a strong case for putting money to work in China, recent Evergrande news created shockwaves. Chinese authorities want to clamp down on speculative leverage, but there may still be some contagion to the rest of the Asian markets. Additionally, China may run afoul of ESG and sustainable investing goals. It is stunning to see policies in the big three economies of the U.S., Europe, and China diverge, whereas they mostly aligned in the wake of the financial crisis. Welcome to today’s markets. The COVID-19 pandemic was incredibly destructive and motivated the expenditure of capital in the U.S. China is attempting to maintain the status quo. In Europe, it’s more about social aspects like climate change. It will be interesting to see what happens when each country converges to a new normal, as some will surely be less interested in creative destruction. Which direction will investors turn?