Building Electronic Bond Markets & The Role of Exchanges ... · • Trades reported to the BSE –...

Thapelo Tsheole

Deputy - CEO

11 Sep 2014

Building Electronic Bond Markets &

The Role of Exchanges in Bond Markets

1. What are e-bond markets and the forms

2. Evolution of e- bond markets

3. Pre-requisites for e-bond markets

4. Evolution of e-bond markets

5. Arguments for e-bond markets

6. Challenges facing e-trading of bonds

7. Pros and Cons of e-bond bond markets

8. The role of Exchanges in e-bond markets

9. Botswana’s migration to automation

10. Key considerations and success factors

11. Conclusion

• The contention of this paper is that the advent of e-trading may be slow, but indications are that

the evolution to e-trading could present far-reaching benefits for bond markets

• Especially given the regulatory reforms following the financial crisis and the increased pressure

on dealers/banks to minimize inventory levels

• The paradigm shift from the inventory-driven model, pre-crisis, due to regulation such as Basel

III mandates a refreshed set of skills and technological infrastructure consistent with a “capital-

light” world

• The proliferation of several e-trading platforms has thrived on the need to promote

interconnectedness in the market but has also resulted in fragmentation of the market

• The forms of such platforms, the evolution, pre-requisites, advantages of migrating to e-markets,

the role of the stock exchange and the key success factors in this transition are discussed in

this session

• Quotes from the buy side

• Predominantly dealer-to-dealer (D2D) trading

• And not customer –to-customer (C2C) trading

Multi-Dealer RFQ

Platform

• Matches orders off exchange

• Without first routing it to any public market

• Provides anonymity and low cost Crossing Systems

• Fully transparent, real-time, anonymous and low cost in execution • C2C & D2D direct trading • Customers can make markets themselves

Central Limit

Order Book (CLOB)

The emulation of the equities-style e-trading platforms in bond market is faced with several

challenges that have to be addressed:

1. Dealers

Align the organization

Centralize the trading infrastructure

Harness the data opportunity

Transform the sales force

Reduce cost per trade

2. Institutional Investors

Would have to collectively change their behavior in several ways

Such as providing firm tradable quotes in the system

Investors who trade small lots could potentially increase trade frequency

Need to diversify their pool of investment strategies to support 2-way markets

3. Issuers

Need to standardize their products

Match-based e-trading requires a high degree of standardization

But the cost implications of standardization have to be reasonable – should be a gradual

effort

4. Regulators

Regulation can ultimately break the bottleneck

If the current reforms are an impediment in the bond market

E.g. Basel III capital requirements

Regulators need to incentivize creation of market-making and defragmentation

And also need to optimize listing use by creating user-friendly requirements, and promoting

surveillance to instill confidence in e-trading platforms

5. Infrastructure:

• that provides a conducive environment for securities transactions

• ensures legal title to securities and settlement of transactions

• and provides price discovery information and pre & post trade information

6. Product Type and Availability

• high penetration in plain vanilla debt versus structured products

• broader maturity spectrums – a good mix of short, medium and long term debt

7. Parameters for success

• involvement of the central bank in migration of gov’t securities to the Exchange's e-platform

• soundness of the banking sector in supporting cash settlement

• 100% dematerialization of bonds and centralized depository

Source: Celent

Source: McKinsey & Company (2013)

Source: Celent

• Hybrid trading system comprising OTC and ATS

• Treasury bills will also trade OTC

• Mobile phones used primarily for retail distribution of government bonds

• Automated Trading System implemented in 2012

• Bond trading in the ATS not commissioned

• Government bonds trade OTC

• Trades reported to the BSE – at EOD

• Bonds are traded in the Inter-Dealer-Broker OTC system

• JSE operates the Nutron trade reporting system for trade reporting, booking and

trade matching

• All trades reported within 30mins

• Hybrid trading system comprising OTC and ATS

• Brokers permitted to match orders off the ATS

• Trades are then reported to LuSE

• Unmatched orders are loaded into the ATS

• By far the most transparent in SSA

• PD system maintained to promote liquidity – underwriting and market making

• ATS eliminates concerns about price distortion, price discovery and

post information dissemination

• Inefficient price discovery and opaqueness

• Unsystematic pricing – with varying conventions and formulae

• Untradeable quotes and late trade reporting

• Poor price discovery

• By far the deepest and broadest – but highly opaque

• Greater reliance of IDBs and greater confidentiality

• Trades only visible post execution

• High potential for market manipulation – a difficult market to survey

• Pre trade information inhibited by the OTC setup

• ATS usage is sub-optimal as brokers can pre-match orders manually

Efficient market controls

Fairer Competition

Cost Reduction & Improving Efficiencies

Pre & Post -Trade Transparency

Promotes Quality of Liquidity

Greater Market Depth &

Less Fragmentation

Stricter capital requirements

Lack of product standardization

Requires coordinated effort

Challenges presented by

unregular liquidity

Fragmentation hampers

standardization

Regulatory shift feared to add

another cost layer

Leading U.S.

corporate bond

e-trading

Leading U.S.

Treasury trading

Has the largest market

share across Europe

and Asia

Developed In-house

Country Trading System

Botswana Millennium IT ATS

Egypt OMX X-stream

Ghana Ghana Automated Trading System (GATS)

Kenya Millennium IT, moving onto Securities and Trading Technology(STT)

Mauritius Millennium IT ATS

Nigeria Nasdaq OMX

South Africa Nutron Trade Reporting System & Millennium IT ATS

Tanzania Securities and Trading Technology(STT)

Zambia Securities and Trading Technology(STT)

Reduce costs for investors

Electronic system can aggregate a

greater number of bids

Solves the shortfall in the liquidity

Contributes to transparency

Provides more counterparties

Increased transparency can cut profits

Standardization is impossible

Single dealer platform model

poses a challenge

Requires a coordinated effort between

Many banks and investors

ADVANTAGES DISADVANTAGES

Exchanges can leverage on their expertise from the equities market to develop

centralized electronic trading platforms

Their strong links with issuers and economies of experience in regulation can

minimize regulatory costs for both the sell and buy sides

As a revenue diversification avenue, Exchanges can capitalize of banks’ and buy side reluctance to develop all inclusive electronic platforms

Exchanges need to step in and address the fundamental problem inherent in fixed income markets that inhibits liquidity e.g. formation of Bond Market Associations as lobby groups

Exchanges could tap into passive “bought & held” inventory by promoting SBL to inject liquidity

Since exchanges are valued for their independent conflict-free model, they can reach their full potential when they innovate exchange-like ways of matching buyers and sellers of bonds

IOSCO Principles for the Secondary Market

The establishment of trading systems including securities exchanges should be subject to regulatory authorization and oversight

There should be ongoing regulatory supervision of exchanges and trading systems

Systems should be designed to ensure that they are fair, effective and efficient and that they reduce systemic risk.

End –to-end surveillance to minimize systemic risk and market manipulation

Regulation should:

Promote transparency of trading.

Be designed to detect and deter manipulation and other unfair trading practices.

Aim to ensure the proper management of large exposures, default risk and market disruption.

Key Aspects of MiFID

Authorization, Regulation & Passporting

Less Fragmentation

Pre & Post Trade Transparency

Better Execution & Fairer Competition

Efficient Market Control

Harmonized Legal Framework

Why should the African Regional Markets establish legislations such as the EU’s Markets

in Financial Instruments Directive (MiFID)?

Revolutionary Impacts of MiFID

1. MiFID expressively recognizes 3 categories of execution venues:

a) The traditional exchange

b) Multilateral Trading Facillity (MTF)

c) Systematic Internalizer (SI)

2. MiFID abolished the “concentration rule” – the rules required investment firms to route orders to

the national exchange. Now firm have can use any platforms as long as they can demonstrate that

they have achieved best execution for their clients

3. This diminished the privileged position of traditional stock exchanges in Europe and the immediate

consequence has been the proliferation of exchange -independent execution venues across Europe

• eSpeed Nasdaq OMX

• Bonds.com LSE Group

• Vega-Chi Liquidnet

• Bondcube Deutsche

Borse

• The rise of alternative execution venues

( ECNs, ATS) has brought competition to

stock exchanges

• These platform have, since MiFID, been

free-riding the exchanges' role of market and

company regulation

• Acquisition of technology driven companies is

seen as a strategic tool

1. Cultivates diversity in liquidity:

Multi-dealer venues build an interconnected fixed income marketplace,

providing both buy-side and sell-side participants with opportunities to

access each other and form a valuable ecosystem for transactions.

2. Provides access to voluminous data:

To maximize liquidity and minimize execution costs, market participants

will leverage the plethora of data available in the market to make more

intelligent portfolio and trading decisions.

3. Benefits dealers:

With fresh pressures on balance sheets, bond dealers can no longer

hold large inventories without either regulatory or capital penalty.

Dealers will now be rewarded to help clients access liquidity on behalf of

a client and not necessarily trading against the client.

In order to drive success in electronic trading, stock exchanges need to create a

Multi-dealer platform. WHY?

Envisioned Situation: Transparent Markets Centralized Exchange Trading Robust Information Dissemination Price Discovery Increased Liquidity Central Clearing Counterparty

Current Situation: Opaque Fragmented Market Over-The-Counter(OTC) Inefficiencies in price discovery Poor information dissemination Illiquidity Bilateral Counterparty Risk

•Primary

Dealers

•Clients •Brokers

The “sweet

spot” of

liquidity

Centralized Trading, Clearing & Settlement of Bonds

SECTOR 2010 2011 2012 2013 2014

Market Cap (P’ Bn) Gov’t

3.5

5.3

5.0

6.1

6.4

Corporate

3.3

3.0

3.2

3.2

3.2

TOTAL

6.8

8.3

8.2

9.3

9.6

Turnover ( P’ Mn) Gov’t

747.1

283.7

314.2

94.7

359.6

Corporate

10.7

41.4

18.0

-

-

TOTAL

757.7

325.1

332.2

94.7

359.6

Liquidity Ratio (%) 12% 4% 4% 1% 1%

Listed Bonds Gov’t

5

7

6

6

6

Corporate

31

28

29

29

29

TOTAL

36

35

35

35

35

2010

• Bond Market Association conceived – a Bond Market development lobby group

• Bond Market Development Strategy established and BSE commenced implementation

2011

• Research published to create awareness about structural impediments in the Bond Market and propose the solutions

2012

• Bond Market conventions established and adopted

• Began construction of bond indices in consultation with market participants

2013

• Launched 3 Bond Indices in April: CorpI, GovI and BBI

• Botswana Bond Market Association launched in September

2014 • Bonds (including Government bonds) earmarked to trade in the ATS

With each of these achievements, consultation was undertaken between the BSE,

System Providers and Market Participants

Aggression has to give

way to diplomacy

Efficient regulatory

framework

End-to-end surveillance to

manage systemic risk

Development of multi-dealer

systems

Markets and systems cannot be

forced onto market participants

Debt Markets

CLOB model can enhance the e-trading of bonds as opposed to the current RFQ model. The markets

are however, far from ready for CLOB

Electronic trading offers more benefits even though there are some challenges that need to be

addressed for the trading platforms to be fully functional

Stock exchanges need to leverage on their expertise from the equities market in creating a central

platform to trade bonds

Development and ultimate success of e-trading of bonds should be underpinned by sound legal

framework, systems and processes that work efficiently

In developing markets, efficiencies can be better realised by harmonising or centralising the depository

with the trading system

Botswana’s migration to automation has progressed significantly, currently the bonds are earmarked to

trade in the ATS.

Building Electronic Bond Markets & The Role of Exchanges ... · • Trades reported to the BSE –...

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