Fixing Fixed-Income: The Case for Better Trading Tools
While it may not be top of mind for most investors, especially those in the startup world, fixed-income markets are the lifeblood of the global economy. The ability to borrow money has played a major role in society’s evolution over the past millennia and continues to support innovation for economic and social advancement today. However, the platforms and technology powering and facilitating the fixed-income markets lack the sophistication of their equity counterparts.
While the space has seen some recent activity, with Francisco Partners' €700M acquisition of Macrobond and Clear Street’s continued expansion, abundant opportunity remains.
This piece will provide a brief background on the history of the fixed-income markets, the underpinning technology and how it’s advanced in tandem with our equity markets, and the potential opportunity for new entrants providing software to better facilitate trading.
A brief history of fixed-income
The first recorded debt systems appeared in the Sumer civilization around 3500 BCE. Not too much later, the first known bond in history dates from circa 2400 BCE in Nippur, Mesopotamia (modern-day Iraq), which guaranteed the payment of grain by the principal. While it’s safe to say we’ve come a long way since then, securitized bonds are still important in global financial markets today. The Anthropologist David Graeber contends that debt and credit historically appeared before money, which itself appeared before barter. This is the opposite of the narrative given in standard economics texts dating back to Adam Smith, which is completely irrelevant to this piece, but you never know when you need a fun finance fact I guess...
Moving on, the first securitized bond appeared in 1517 when the Dutch Republic issued them to finance debt incurred by the city of Amsterdam. On the domestic front, American colonies and the Continental Congress issued bonds to finance the Revolutionary War. After independence, Alexander Hamilton pioneered a plan involving the newly formed American government issuing bonds to redeem outdated Continental currency. The modern U.S. government bond market started about 100 years ago during World War I and has exploded in size and sophistication since then.
Modern fixed-income markets are multifaceted, with lending available in many forms (i.e., bonds, loans, and various other instruments) and via various lenders, from traditional banks to long-term investors to emerging technology companies. While the underpinnings of these markets can feel complex, understanding why they exist, how they have evolved, and how these markets operate today is crucial to ensure they remain robust and effective in the future. The size of said markets far eclipses that of equity markets. As of Q2 2022, the global fixed-income market totals about $130T in outstanding debt (per Barclays). By comparison, U.S. equities markets total about $44T (per Sifma as of Q1 2023).
As our equity markets have evolved technologically, the primary and secondary fixed-income markets have historically lagged. Talk of “equitizing” the bond markets — making bonds trade more like stocks — has been pervasive for at least the past decade. And while the bond markets have become much more electronic in recent years via natural forces, the diversity of trading mechanisms (each suited to the needs of each market and its participants) made possible by innovative workflows and technology has allowed the markets to grow and thrive. Forcing bonds to trade like stocks, primarily in anonymous centralized limit order books (CLOBs), ignores the stark differences between the two markets (and among the different fixed-income market segments), their dynamics, and their participants.
For instance, 66,000 U.S. corporate bonds are currently available to trade, which compares to about 4,500 U.S. listed stocks. So while Ford’s equity can be traded through its primary equity listing (F), trading Ford corporate bonds requires selecting among the over 200 outstanding issues. To further the point, the municipal bond market and MBS/ABS market each contain just over one million tradable bonds. Many of these corporate and municipal bonds are often bought as long-term investments and held until maturity (as opposed to being actively traded).
This lack of enabling technology severely limits trading, with many securities going months or longer without trading. This makes valuing a bond much more difficult than valuing an actively traded equity security. As a result, maintaining an order book with active prices for all bonds is difficult, if not impossible.
It is also important to note that retail investors are an important presence in equity markets. In contrast, bond market activity by retail investors is limited (with municipal bonds the only exception). Case in point, 23% of U.S. household investable assets were held directly in stocks in June 2022, compared to only 3% in bonds. This is largely attributable to a lack of access and enabling technology and prohibitively high trading costs. If you’d like to test this out, go try to buy a bond directly!
This means that most bond market transactions are between professional traders and investors, who have the wherewithal to utilize different trading mechanisms based on their unique needs. This lack of general penetration represents a unique opportunity to expand access to retail investors and smaller institutions.
The fixed-income asset class is increasingly attractive
Historically, when investors’ primary concern shifts from policy and inflation to the economy’s health, the outlook for stocks and bonds often diverges. As such, investors may be better served by exploring the fixed income landscape, as bond yields have meaningfully increased, bonds are attractively priced compared to many large-cap U.S. equities, and they offer potentially attractive capital gains as investor sentiment shifts.
Additionally, fixed-income investing offers myriad opportunities to offset capital gains taxes. Furthermore, the potential of bonds goes beyond simply asset class exposure — they provide flexible income to align with savings needs and a high degree of stability.
While individual investors and smaller institutions can build exposure to fixed-income via fixed-income ETFs, exposure to fixed-income may not be consistent with the traditional expectations of the asset class, namely predictable and redefined cash flows, return of principal, options to reinvest proceeds in potentially higher interest rate environments. While bond ETFs are diversified and thus less exposed to market and credit risk, they generally have a fixed interest rate duration, meaning that the interest rate sensitivity remains constant, whereas individual bonds have a fixed maturity date, meaning their sensitivity to interest rate changes will decline as that date approaches. This can be mitigated by different strategies (i.e., bond laddering). While a detailed discussion of the differences between the two is beyond the scope of this piece, the material differences justify the consideration of bonds as a part of a balanced portfolio.
The shift to electronic trading and the development of enabling technology
The fixed-income markets have slowly adopted modern trading practices and systems since the first electronic communication networks (ECNs) were adopted in the 1990s. The shift to electronified workflows and electronic trading shown in the data is not going away as the market returns to the office. U.S. corporate bonds have experienced strong growth in electronic trading, initially triggered by the global financial crisis and further catalyzed by the work-from-home trend brought about by the COVID pandemic. In 2022, an average of $590B of U.S. Treasury bonds were traded daily, with 65% of that volume traded electronically. On March 13, 2023, a record $1.49T of U.S. Treasury bonds were traded in a single day. (Source: Coalition Greenwich)
Roughly 40% of investment-grade and one-third of high-yield corporate bonds now trade electronically, both metrics having doubled in only the past three years. Market turnover has also grown, averaging $36B per day in 2022. As of the end of 2022, about 60% of corporate bond e-trading is executed via the RFQ protocol, most between institutional broker-dealers and large investment managers. The majority of trading for retail investors happens via a CLOB, which accounts for 7% of market volume. The electronic market’s growth overall has come less from these traditional methods of e-trading and more from trading mechanisms new to the corporate bond market, such as auction/session-based trading and portfolio trading.
In an interview, Kevin McPartland, head of market structure and technology research at Coalition Greenwich noted: “While people will find their way back to offices over time, the new tools and technology they have adopted are here to stay.” The data shows that electronic trading in all fixed-income was rising before the pandemic — COVID-19 merely accelerated the trend. The adoption of electronic trading new issue corporate bonds was no exception.
Long story short, the technology facilitating issuance, trading, and execution of fixed-income securities is on the precipice of a paradigm shift.
To provide additional color, there are three stages of market structure and associated trading protocols at each stage of a market’s structural evolution: manual, workflow electrification, and electronic trading. Trading protocols can be segmented along the illiquid and liquid securities continuum into manual, workflow electronification, brokerage, and electronic trading/ATS activities. These stages and protocols have repeated across the maturation of the equities, options, futures, and foreign exchange market structures. Now, it’s the turn of the fixed-income markets.
To give one example of data asymmetry potentially addressable by technology, details of a bond trade are often known only by the counterparties, and price or volume information is only disseminated to the wider investing public through TRACE reporting, which can be inaccurate. Due to this segmentation, the same bond could have different quotes and prices from dealers at the same exact time.
A modernized and equitized fixed-income stack
Beyond the obvious benefits of expanded access to a larger group of potential traders, there are several areas where technology can create significant value:
Better Sourcing of Liquidity: Liquidity measures the ease of executing a trade without significantly impacting the asset’s price. In the past, liquidity was readily accessible through proprietary trading desks and hedge funds willing to take the opposing side of trades made by asset managers. However, the landscape has changed, and many of these proprietary trading desks and hedge funds have disappeared. Regulated broker-dealers are now hesitant to bid on large individual bond trades that carry unique and specific risks, which are challenging to hedge. Nevertheless, they are open to buying and selling diversified bond portfolios, as they can hedge these positions using ETFs. The similarity between the portfolio trade and an ETF greatly influences the likelihood of favorable pricing. Therefore, the ability to quickly create and evaluate portfolio trades is crucial, but it requires comprehensive portfolio management and risk management systems, making it a complex task.
Better compensation to liquidity providers: The technology mentioned above can sift through market data to find interesting opportunities. During turbulent markets, liquidity challenges and investor sentiment lead to trading activity in certain sectors becoming disconnected from their underlying fundamentals. In these situations, investors looking for cash typically sell whatever assets they can, resulting in lopsided trading volumes and mispriced sectors. Integrated credit research and trading systems can help identify these mispriced sectors and corresponding opportunities. As a result, traders could purchase investment-grade bonds at yields higher than expected, simultaneously providing market liquidity. It is worth noting that market liquidity is particularly valuable and rewarded during market stress.
Market connectivity and transparency: The post-trade process is a complex domain that presents both long-standing challenges and significant opportunities for improvement. While the front-end of capital markets has undergone substantial transformations, the middle and back-office functions involved in trade processing have seen limited changes in recent decades. Astonishingly, the industry invests approximately $24B in trade processing, predominantly utilizing outdated technology that relies on legacy banking infrastructure like COBOL mainframes. With capital markets relying on multiple data sources, mishandling this data incurs various costs, such as misaligned systems of record, duplicate or incorrect schemas, disruptions in downstream applications, discrepancies in data timing and structure, loss of information, integration difficulties, and risks of non-compliance and associated fines.
More capital-efficient trading: In today’s market, clearing costs and TRACE fees meaningfully erode the unit economics of small tickets. While fixed-income transaction costs are a highly complex topic, there are a few key takeaways regarding the ability of newer platforms to take volume away from incumbents. Trade costs are a complex topic in their own right, but at a high-level consist of explicit costs (commissions, market access fees, market-making fees, clearing and settlement costs, and taxes) and implicit costs (bid-ask spreads, opportunity costs, price impacts of trades, etc.)
Trade costs could easily be half of an investor's alpha and might be impossible to avoid. As such, these transaction fees can be prohibitively high for small-ticket orders. (Source: Bloomberg)
Asset managers who solely rely on a single electronic trading platform or alternative trading solution may overlook additional sources of liquidity in the fixed-income market. Using segregated proprietary platforms for trading can impede market liquidity, hinder the achievement of best execution, and result in unnecessary costs. To address these challenges, execution management systems (EMS) come into play.
EMS serve as trading conduits, enabling traders to connect with various market participants. They empower traders to access liquidity from different sources, including alternative trade systems, direct dealer interactions, or all-to-all anonymous trading platforms, facilitating optimal execution regardless of time and location.
Employing an EMS allows asset managers to adopt a more systematic approach, enabling the automation of low-touch or no-touch trading for a larger volume of bonds. This automation frees traders to focus on more intricate and high-touch opportunities that necessitate human expertise and insights. Additionally, EMS platforms aggregate trading data, consolidating it for the user’s convenience and facilitating further analysis and evaluation of trading activities.
While many legacy EMS platforms exist, they often are cited as needing myriad improvements, chief among them better data aggregation and pre-trade analytics.
Fixed-income trading process and players
So with all of this in mind, what does the landscape of fixed-income technology look like? The below gives an overview of the high-level steps in fixed-income trading, as well as the primary parties involved and their relationships:
If that seems overly complex, that’s not surprising. I’ve shown that to illustrate best the number of parties and steps involved in even relatively straightforward transactions.
As for the players in the space, the below shows a (non-comprehensive) map, grouped by incumbents vs. challengers:
So how should VCs think about this? Software platforms that bring equity-like liquidity and other characteristics to the fixed-income market will be well-suited to capitalize on this opportunity and chip away at the market share of existing incumbents.
For example, OpenYield is building a next-generation bond ATS purpose-built to power retail and smaller investors, providing easy access for brokerages and advisors directly or via existing EMS systems.
Similarly, Multilynq provides a single API that enables all credit and municipal bond market participants to reliably access liquidity in one feed, eliminating time to market, cost, and complexity.
Overall, advancing the technology underpinning our fixed-income markets represents a highly interesting opportunity, and the current market conditions represent a unique tailwind. With that said, the space is lagging equity by a few decades, and it has a long way to go toward becoming fully modernized.
If you are building in the space, I’d love to hear from you at dave@thomvest.com!
