[ M A R K E T
How is the rise of passive invest-
ment vehicles changing the fixed
income market?
JS: The growing size and presence
of ETFs has created an ‘arb-
able’ event. Ever since the crisis,
there has been speculation about
the potential role of alternative
liquidity providers. Compared to
the pre-crisis environment, today
we no longer have sell-side prop
desks, dealer inventory is substan-
tially reduced, and hedge funds
use less leverage. But now we
have an arb-able opportunity, with
dealers using their balance sheet
to support diversified risk trans-
fers, which offer us an important
way of sourcing beta.
Because they have insight
into the ETFs’ create/
redeem process and
can hedge their risk,
the sell-side can
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facilitate riskless transfers, acting as intermediary
between active and passive managers. This market
was still fairly sketchy only a couple of years ago,
but we’re now able to transact in it very consistently
today. In parallel with this change from a princi-
pal-based market-making model to a riskless transfer
model, the bigger change is how the sell-side engage
with us as clients. Rather than telling us what they’re
trying to get done, they ask us what we’re trying to
get done.
How are you using transaction cost analysis (TCA) and
related tools to achieve best execution in the fixed in-
come markets and how do these tools and capabilities
need to further develop?
MB: TCA is becoming a more important topic, both
through the mandate of MiFID II and the develop-
ment of analytics in a wide range of fixed income
asset classes. Electronification of these markets
will help their further development. As traders, we
know which strategies we believe will achieve best
execution, but we need to be able to quantitatively
measure and verify outcomes that either confirm our
expectations or, over time, help us to achieve better
outcomes.
Whether we’re talking about the most liquid or
most difficult markets, TCA in fixed income has
already come a long way in the past few years – and
still has a long way to go. That doesn’t mean we
should not be using it yet. As long as you understand
the limitations and assumptions inherent in the pro-
cess, you can understand where there may be some
margin for error in the results. That said, I’m still
looking for industry developments to improve the
process. It has evolved very quickly and I expect this
to continue as more asset managers become focused
on it.
DV: TCA is an area where fixed income trading
should take the lead from equity trading, at the same
time accounting for the fact that fixed income is
primarily an OTC market. As transparency and data
quality increase and become more available, TCA
should evolve to measure statistically versus a whole
host of benchmarks, including mid at time of execu-
tion, mid at time of order raise, etc. This is a non-triv-
ial exercise, especially across fixed income sectors
that are more opaque, such as mortgage pools, for-
ward swaps, etc. With the evolution of fixed income
TCA, the buy-side will better be able to measure
costs and trends to make more informed investment
decisions, and adjust trading tactics accordingly.
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