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JANUARY/FEBRUARY 2012

MARKETAXESS STREAMLINES CORPORATE BOND TRADING

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SPECIAL FEATURE

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FEATURE

Credit QualityMarketAxess blazes a trail in the electronic trading of corporate bonds

FEATURE

discern what bonds were available, and at what price.“Getting 80 dealers on one system to aggregate inven-

tory and prices and compete for order flow is a radi-cal departure from the way the market worked before 2000,” McVey said.

The global bond market has an estimated aggregate value of $95 trillion, so it comes as no surprise that the business of electronically trading bonds is highly com-petitive. MarketAxess’ competitors include broker-dealers who trade with each other and with institutional investors, as well as other multi-dealer trading firms such as Bloomberg, Tradeweb, FXall, and Creditex.

“Client to multi-dealer electronic trading is now well-established in fixed income and other less-liquid asset classes,” said McVey.

Regulators have proposed conflict of interest rules governing SEFs (swap execution facilities), SDRs (swap

The dot-com bust of more than a decade ago left countless casualties, but survivors such as Amazon, eBay and Yahoo! have managed to not only stick around, but also change the rules of their respective games.

A comparable success story in the financial space is MarketAxess, whose client-to-multi-dealer trading platform allows institutional investors to request bids and offers on corporate bonds from broker-dealers, and then pick and choose who to trade with.

“We are promoting price discovery, transparency and trading efficiency for the institutional credit markets,” said Richard McVey, chief executive of MarketAxess.

Corporate bonds have never been the most efficiently traded securities on Wall Street, as liquidity is comparatively low for all but the biggest names such as General Electric and Bank of America.

“In an OTC market where we operate, you need to think of what’s going to drive investors to use the trading system and what will motivate dealers to make markets,” McVey told Markets Media. “On the investor side, the value proposition was always to create a central trading place to promote transparency, competition and straight-through processing, while on the dealer side it’s about promoting broad client reach, greater inventory turnover in trading books, and lower cost.”

Prior to founding MarketAxess in 2000, McVey was managing director and head of fixed income sales in North America at J.P. Morgan. In that role, he was responsible for developing and maintaining client relationships across all asset classes.

GOING ELECTRONICAs the 21st century dawned, bond dealers were concerned that the Internet would disrupt their core business, i.e. squeeze bid-ask spreads and profit margins. But rather than resist the trend, some dealers moved to incubate and harness the tech-nology to launch new businesses.

MarketAxess is a classic example. “At J.P. Morgan, we saw that fixed-income trad-ing would increasingly move electronic, and there was a strategic objective to use technology to expand client reach in a cost-effective way,” said McVey. “There were 30 or 40 examples of companies incubated by the dealer community, and a handful of them turned out to be successes.”

In 2000, there was no meaningful electronic trading in corporate bonds. Trading took place bilaterally between dealers using telephone, e-mails and faxes to transmit inventory and indicative prices; clients had to expend considerable manual effort to

Auction-based systems promote transparency, competition, and openness in the swaps markets, which are the overriding objectives of the Dodd-Frank Act.

We are promoting price discovery, transparency and trading efficiency for the institutional credit markets.

data repositories) and CCPs (central counterparties) that will require independent governance. This puts MarketAx-ess on a favorable footing vis-à-vis its competition, according to McVey.

“Clients like the fact that we’re independent, that we are a public company that can act objectively with respect to the best interests of both investors and dealers,” said McVey. “Regulators like independence too. We already have that. We went public in 2004, we have a fully independent board, and our financials are public. Today, some of our competitors are not independent, and that will be a differentiating factor in the trading space going forward.”

Today’s fixed-income market is largely segmented by client focus: inter-dealer brokers such as BGC, ICAP and GFI operate trading venues within the dealer-to-dealer segment, while other entities cater primarily to retail traders and investors.

MarketAxess is firmly planted in the institutional customer-to-multi-dealer segment, as most of its revenue is derived from commissions for trades executed on its platform that are billed to broker-dealer clients.

“The core of our business is electronic execution,” said McVey. “Most trading we do is RFQ or auction-based, where

clients initiate electronic orders and send them to dealers of their choice, who then compete for those orders.”

The process is tailored for corporate bonds that may trade just a few times per day. “Whereas it’s impossible for dealers to make live markets on tens of thousands of securities that trade infre-quently, we provide liquidity on demand with our auction-based system,” McVey said. “Cli-ents and dealers have both shown a preference for auction-based technology because it allows them to cope with fragmentation in the corpo-rate-bond market. The forward-looking oppor-

tunity is that a large part of the market is still trading on the phone.”

MARKET SHAREMarketAxess has 900 active institutional investor clients and 80 dealers making markets. In the fourth quarter of 2011, MarketAxess’s share as a percentage of Finra's high-grade Trace trading volume was 12.2%, up from 9.6% in the year-earlier period. MarketAxess' clientele includes investment advisers, mutual funds, insurance companies, pension funds, banks, and hedge funds. "Trading electronically on MarketAxess is an efficient way to access the corporate bond markets and eas-ily reach a broader group of dealers," said Kerry Gawne, CFA, vice president at investment manager Payden & Rygel. "The price transparency available through e-trading also helps us get a clearer view of the market while helping with our com-pliance requirements, and supporting measurement of best execution." Fragmentation in the corporate-bond market has under-pinned MarketAxess' expansion. Primary dealer hold-ings, as calculated

Client to multi-dealer electronic trading is now well-established in fixed income and other less-liquid asset classes.

FEATURE

TWO-TIER MARKET LANDSCAPE: SELECT PARTICIPANTS

MULTIDEALER TO CLIENT (MD2C) USING RFQ AND/OR CLOB

SINGLE DEALERS (D2C)

Examples Dodd-Frank and MiFID Impact § Tradeweb § Bloomberg § MarketAxess § Thomson Reuters § Javelin § TeraExchange § Eris SwapBook § CrediEx § ICE OTC energy § TrueSEF § Others

§ Highly diverse group with divergent product experience and knowledge.

§ Intend to register as SEFs and/ or OTF where appropriate as soon as possible.

§ Some to experiment with multiple models, including combined RFQ and CLOB over time.

§ More announced players over time. § List is not exhaustive.

Examples Dodd-Frank and MiFID Impact § UBS § Credit Suisse § Morgan Stanley § Barclay’s § Deutsche Bank § RBS § Others

§ SEF status uncertain. § Could become SEFs but more focused on SEF facilitation and aggregation.

by the Federal Reserve Bank of New York, fell from $218 billion at the end of 2007 — just as the credit crisis was gathering force — to $46.6 billion by the end of 2011, requiring investors to source liquidity from a broader group of dealers.

“The reduction in dealer inventory for corporate-bond market making is fuel-ing demand for clients to expand their trading counterparties in order to have more choices for liquidity,” said McVey.

The cornerstones of MarketAxess’ strategy are adding functionality and additional product segments within fixed-income markets, doing more

business with existing clients, and expanding its client base.

“Investors need new sources of liquidity because of the de-risking and de-lever-aging that’s taking place within the large dealer community, and investors want to access that liquidity through electronic trading channels,” McVey said. “Institu-tions have a clear preference for multi-dealer trading platforms because they get the benefit of competition, transparency and efficiency in one place.”

MarketAxess’s bond-trading products span the front office (live, executable prices and indicative levels for trading and market-depth analysis), middle

office (market-data feeds for risk man-agers), and back office (pricing, STP connectivity and compliance-report-ing tools).

“Our objective is to provide the lead-ing global electronic trading platform for fixed-income securities, connect-ing institutional investors and broker-dealers more easily and efficiently, while offering a broad array of informa-tion, trading and technology services,” said McVey.

While some bond-trading platforms focus on the more liquid sectors within fixed income, MarketAxess works with all securities. This includes the stuff

kept in the proverbial dresser drawer, such as high yield and emerging-market bonds, agency debt, eurobonds, and credit default swaps. Just last year, MarketAxess launched an institutional credit-trading system to enhance the functionality of CDS trading.

MarketAxess’s core trading technology complies with the proposed rules under Dodd-Frank and allows clients maximum flexibility in trading CDS indices and single names. A recent analysis of CDS transac-tions published by the Federal Reserve Bank of New York showed that the most active of single-name CDS contracts traded about 20 times a day, and some index CDS contracts traded over 100 times a day. However, the majority of single-name CDS contracts trade less than once daily, but in large blocks.

“The CDS market operates very differently than exchange-traded products, which have hundreds of thousands of trades per day,” McVey said. “The CDS market is more similar to the corporate-bond market than equities or exchange-traded futures.”

Derivatives exchanges such as ICE, Eurex, and CME have launched clearing services for credit and interest-rate OTC swaps, and could conceivably offer trading in swaps as well, with exchange-like features such as central limit-order books. That’s fine with MarketAxess, so long as regulators don’t try to force CLOBs on the market.

“We are not opposed to CLOBs,” McVey said. “We have offered them in the past, and may offer them again in the future. However, we don’t believe that an auction-based system should be required to offer CLOBs.”

The applicability of central limit order books to swaps trading is a hotly debated topic among market participants as the SEC and CFTC wade through the complexities of the Dodd-Frank rule-making and imple-mentation process. The CFTC’s proposed rules require SEFs to allow market partici-pants to leave executable bids or offers that can be seen by the entire marketplace, i.e., a CLOB.

“We are perfectly happy to compete with any entrant, but we think that the deter-mination on trading protocols that we offer should be made by our clients, not by highly prescriptive rules,” said McVey. “Auction-based systems promote transparency,

competition, and openness in the swaps markets, which are the overriding objec-tives of the Dodd-Frank Act.”

SEC + CFTCMarketAxess has been regulated by the U.S. Securities and Exchange Commission since its inception, and it will soon be subject to regulation by the Commodity Futures Trad-ing Commission as well. “The SEC has always been a proponent of creating more elec-tronic trading in fixed-income markets,” McVey said. “We are now working closely with both the SEC and the CFTC because of their involvement in implementing rules for derivatives trading.”

Regulatory oversight of credit derivatives will be split, with CDS indices falling under the CFTC and single-name CDS falling under the SEC.

“This makes it more challenging for us and others who are active in CDS, because the same market participants trade both CDS indices and single names,” McVey said. “We will end up with two different sets of rules, and the need to register with both the SEC and the CFTC.”

The objective of U.S. regulatory reform is to promote greater market transparency, execution on centralized and regulated marketplaces, and centralized clearing for standardized swaps. “The overarching prin-ciple of the Dodd-Frank Act is that trading should take place on venues that promote transparency and competition, and the mar-ket should decide what protocols work best depending on what swaps they’re trading,” said McVey.

“The CFTC has been more prescriptive on proposed rules with some significant changes versus the way swaps get traded today,” he continued. “While the OTC mar-ket needs fundamental change, there is a risk of negatively impacting market liquid-ity or moving swaps trading offshore.”

Divergent market-structure standards for derivatives trading between Europe and the U.S. present opportunities for regulatory arbitrage. “Clarification is required” regard-ing how the rules will be promulgated on both continents and how cross-border mar-ket participants will be affected, said McVey.

As with many young companies, growth has been nonlinear at MarketAxess, and the

credit crisis of 2008-09 provided an extreme test of the company’s staying power.

“We have had attractive and consistent growth, but there have been periods...where liquidity became very challenging in the credit markets as primary dealers were going through active de-leveraging,” McVey said. “Our strategy was to expand the market-making community and open up the credit market to alternative sources of liquidity.”

McVey drew a parallel between MarketAx-ess and Markit, a provider of market data and (via its MarkitSERV subsidiary) post-trade processing for OTC derivatives.

“Markit’s businesses are highly comple-mentary with MarketAxess,” McVey said. “They are primarily in data, trade process-ing, and clearing, and we are primarily in trade execution.”

Since 2000, the companies have taken very different growth paths. “They have been very acquisitive, whereas our growth has been primarily organic,” said McVey. “In total we’ve only done three acquisitions and the two that we have done since 2001 have not been large.”

In 2007, MarketAxess Technologies acquired Trade West Systems, a provider of gateway adapters for connecting order-management systems and trading systems to fixed-income trading venues. In 2008, it acquired Greenline Financial Technologies, a provider of integration, testing and man-agement solutions for proprietary and FIX Protocol related products and services.

The acquisitions have enabled MarketAx-ess’ electronic trading platform to integrate with the work flow of its clients, McVey said, and also allowed clients to achieve a fully automated straight-through process-ing (STP) solution from trade initiation to settlement.

“STP is making the world of bond trad-ing more efficient for the middle and back offices,” said McVey. “For most of our deal-ers and large institutional clients, we are fully integrated into their order-manage-ment or trade-capture systems. Once a trade is completed on MarketAxess, we send electronic messages through APIs to the back offices of both the client and dealer, and that allows them to process trades more efficiently than a phone trade.”

© 2012 Markets Media, LLC. Issued under license to MarketAxess 2/22/2012 marketsmediaonline.com