Sell-side institutions have long been advocating direct connectivity for fixed income as a means to sidestepping the major venues that hold a monopoly over execution in these markets.
The process of direct connectivity or single dealer platforms (SDP) allows a buy-side institution to directly connect to a smaller handful or even one sell-side broker. Many argue the process reduces impact as firms are not revealing their hand to the wider market. The argument can also be made that it reduces costs firstly by removing the need for firms to pay fees to trading venues and secondly because it gives them greater control over their valuable transaction data.
The issue has come to a boil in the last 12 months as the cost of data and platform fees have risen. In the cost-driven recession-pending environment the markets find themselves within, every penny counts. Despite multi-dealer platforms being markedly more costly, there has historically been little evidence to imply that buy-side traders are pushing for bilateral connections as aggressively as their sell-side counterparts. While information leakage and data control are definite pain points for the buy-side, costs incurred through trading on venues are often absorbed by liquidity providers.
In other words, it wasn’t buy-side’s problem. However, this lack of appetite from the buy-side could be set to change thanks to a combination in circumstantial changes in the market.
What’s an MTF?
A key hurdle to the adoption of direct connectivity for the buy-side was the looming threat of their EMS potentially being classed as a multilateral trading facility (MTF) and subsequently being charged as one.
Regulators in both Europe and the UK launched consultations last year to firm up their individual definitions of what is classed as an MTF in a bid to level the playing field, bringing what they claimed were grey market areas including RFQ systems, execution management systems (EMS), and pre-arranged transactions under the spotlight.
ESMA has since published the findings of its consultation – much to the relief of EMS providers – finding that so long as a system does not facilitate the interaction of third-party interests related to financial instruments, they should not be considered multilateral. To summarise, if a system is gathering quotes from multiple players that are able to interact with one another, that is a multilateral trading venue and should be charged as such.
The industry is now awaiting the findings of the FCA consultation. Should it result in a similar finding, the buy-side could be in a position to re-examine whether bilateral connectivity for them is favourable to trading on a venue.
“We were waiting for 18 months for the regulator to decide and ESMA have now come out with a paper. I expect you’ll now see more interest in direct connectivity,” head of trading at BlueBay Asset Management, Stuart Campbell, told The TRADE.
Reliable data at a reasonable price
In the background, the growing problem of data costs being too high has continued to simmer. Buy- and sell-side institutions resent having to pay high fees to reclaim the data that is collected on MTFs when they trade. The frustration around who owns data and how much it costs to acquire it has sparked the launch of several industry initiatives including buy-side focused bonds data pooling network Glimpse Markets, in a bid to give control of data back to the institutions responsible for generating it.
The reliability and cost of essential market data is another key item now on the agenda of regulators on either side of the channel. The FCA launched a three-pronged investigation into competition concerns early last year, bringing the first stage to a close last week with the conclusion that competition in the wholesale data markets was not working.
“The pricing we see in fixed income is often indicative so direct connectivity could be one way of ensuring that the prices that are being streamed are more tradable,” added Campbell. “It’s click to trade directly with better cleaner pricing and its more transparent with better TCA.”
With the threat of being classed as a venue now gone and with the issue of competition around the cost of data now a harsh reality, institutions are likely to begin reassessing investment into direct connectivity technology as a means of reducing costs on the sell-side and regaining ownership of reliable data on the buy-side. Whatever the result, direct connectivity requires a huge amount of development work around order management technology and data aggregation and so it’ll by no means be a rapid transformation.