The TRADE 60 | Page 75

[ 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 R E V I E W | F I X E D I N C O M E ] 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. Issue 60 // TheTradeNews.com // 75