Historically, a large percentage of OTC fixed income derivative trades have been bilateral deals arranged via a sell-side broker. The recently passed US Dodd Frank Act looks set to bring significant change in fixed income, shifting a considerable volume of such deals on to regulated trading venues. 
These venues, known as Swap Execution Facilities (SEFs), are defined in the act as a “facility, trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by other participants that are open to multiple participants in the facility or system, through any means of interstate commerce”.

Although the new US legislation is still in process and the rulemaking is not yet complete, the Dodd Frank Act is already making an impact in the world of fixed income. Critically, it has provided an opportunity for start-up trading facilities to take some of the liquidity that must inevitably migrate to the new trading platforms. The industry is already responding to the stimulus created by regulation, with Eris, Javelin and Tradition being just a few of the examples of venues seeking to become SEFs.

Connectivity
The creation of the SEFs raises, amongst other matters, the issue of connectivity. In particular, it poses the question of how market participants are able to link up to the new breed of trading venue in a speedy and cost effective way. Indeed, there is a growing feeling among large sell-side institutions that the introduction of a standardised means of communication, based on open industry standards such as FIX, would play a valuable role in reducing the time, effort and cost needed to plug into the emergent SEFs.
Major sell-side banks are especially eager to see greater efficiency in this area as, at present, they often link to existing fixed income trading sites using APIs based on proprietary protocols. A large bank can have over a hundred different “gateways” across its fixed income suite (although the fixed income suite will include bonds as well as derivative contracts such as interest rate swaps or credit default swaps).
Often, each of these connections is constructed using proprietary technology or based on a gateway solution purchased from a software vendor. For firms maintaining links with a plethora of different trading venues, this entails a great deal of expense. Considerable time and effort are necessary, and it is also costly to hire the specialised IT personnel required to develop and support the complex technology involved.

Lack of standardisation
Some explanation is required as to why the fixed income markets – unlike the equity markets – have not made greater use, to date, of open industry connectivity standards such as FIX.
Firstly, a great deal of fixed income trading has been carried out over voice. Secondly, where automation has occurred, frequently trading venues have chosen to put in place proprietary protocols as both the workflows and the instruments involved have been more complex than in equities.
FIX, which started life as a specification for equities trading in 1992, has now been widely adopted across the equities markets, with the majority of exchanges having a FIX interface. Adoption within the fixed income markets is growing but there is still significant potential for expansion.
Thirdly, and importantly, the drive towards standardised connectivity in the fixed income derivatives markets has, thus far, focused almost exclusively on post-trade processes. In the pre-trade area, the march towards standardisation has seen far less progress.

Improvements in post-trade
The credit crunch and the collapse of firms such as Lehman Brothers exposed a huge backlog of unprocessed trades, causing regulators globally to push for a move from manual to automated processing of swaps trades.
As a result, ECNs and exchanges have been obliged to reconsider their post-trade processes. They have had to search for effective ways of connecting to the new swap data repositories (SDRs) demanded by regulators and have also had to invest technology budgets in developing the common instrument identifiers and common legal entity identifiers which will allow regulatory authorities to monitor trading activity with precision and efficiency.
In addition, the derivative specific e-commerce language FpML has been adopted by trading venues as the post-trade language for deals, thereby introducing a much greater degree of standardisation. On the negative side, intense regulatory scrutiny of post-trade aspects of fixed income derivative trading has meant that industry attention has been deflected from pre-trade processes.

An opportunity for change
The Dodd Frank Act creates an important opportunity for the fixed income community to improve efficiency in pre-trade and, in particular, to make the process of connecting to trading venues speedier and less costly. Indeed, with the number of SEFs likely to grow significantly in the future, it is imperative that market participants find a more effective way of integrating with them. This end is served best by embracing a standard, industry-wide means of connectivity, based on the FIX Protocol and FpML.
A move to FIX-based connectivity will benefit the fixed income community in a number of ways. For the sell-side, it will lessen the need to build and deploy custom connectivity solutions to trading venues. This will facilitate faster and easier connectivity integration between market participants. The cost of ownership of technology is likely to be reduced. It makes sound economic sense for the fixed income community to adopt open industry standards such as FIX, which will bring down the high cost of connectivity associated with the prevalence of proprietary protocols.
Sell-side participants will benefit from a variety of other advantages. For example, faster time to market for new features and products will be possible, as will greater vendor choice and technical flexibility. Leveraging and re-using IT infrastructure across multiple asset classes should also become easier. The supportability of trading platforms across asset classes will also be improved.

Benefits across the market
While a move towards the use of open industry standards has clear advantages for the sell-side, such a shift will create benefits for other market participants, including the buy-side. Recent years have witnessed a demand from the buy-side – generally met by trading venues – for a switch to FIX connectivity.
The use of FIX has not, unfortunately, occurred in a standard manner. At present, the buy-side uses a variety of different versions of FIX. In addition, trading venues have many different options as to how they implement FIX. As a result, complexity abounds.
Standardisation would allow a consistent set of best practice guidelines for the use of FIX to be introduced, initially in relation to IRS and CDS instruments, and to all fixed income products in the longer term. Such an approach would reduce complexity and allow the FIX Protocol to be enhanced, as and where gaps in the current functionality are identified.
Trading venues – whether new or existing – that support a standardized FIX approach are likely benefit from increased liquidity, with more participants being attracted through the lowered cost of connectivity. Importantly, the cost of technology ownership should, in the medium term, be decreased.
Standardisation of connectivity should also assist software vendors. Existing vendors will be able to reduce their expenditure on maintenance whilst new vendors in adjoining markets – for example, those selling connectivity solutions in equities – will be able to enter the market more easily by leveraging existing products and know-how.

Achieving standardisation
Standardised connectivity can best be achieved if all market participants work in concert with each other. Interestingly, members of the fixed income community are already taking steps towards this end. At present, a group of major sell-side banks is currently engaging with SEFs and existing trading venues, as well as software vendors and FIX Protocol (FPL), the industry association that owns and develops FIX, to promote the global use of FIX and other industry standards.
The working group’s short-term priority is standardised connectivity for interest rate swaps and credit default swaps, with a special focus on connectivity to SEFs. The group hopes that through early engagement with the SEFs, these newly emergent organisations will adopt open industry standards, rather than pursuing the traditional route of proprietary workflows and technology.
FPL has agreed to work with the group to ensure that the free and open FIX messaging standard fully supports the needs of the fixed income market. It has also agreed to assist in the preparation of best practice guidelines to encourage those trading venues seeking to adopt the protocol to do so in a standardised manner.
Last month FPL welcomed the working group’s decision to engage with existing and emerging fixed income market venues and independent software vendors to promote the increased use of the FIX Protocol and other non-proprietary standards such as FpML.

Implications for incumbents
The working group has engaged with existing trading venues to ensure that a change to harmonised open industry standards occurs without excessive expense or disruption. Major sell-side institutions are seeking a planned migration to open industry standards over the next few years – they are not looking to carry out an immediate wholesale switch-over to FIX and FpML which, as the banks themselves acknowledge, could prove extremely costly. Importantly, a gradual move will also dramatically lower costs as the switch-over can be implemented as part of a planned IT update investment.
Critically, a phased migration will allow existing trading venues the option to maintain proprietary APIs whilst, at the same time, adding new FIX APIs. Running old channels in parallel will ensure that no market participant is forced to move abruptly from a legacy connection, although the new FIX APIs will need to be seen as being sufficiently functional to ensure there is no barrier to their take-up. New functionality may, however, be introduced gradually to the FIX APIs only.

Dodd Frank: not just a US matter
Clearly, at this point, some readers may ask themselves why the global fixed income community should be responding to what, after all, is US legislation. Yet the implications of the Dodd Frank Act are unlikely to concern the US alone. Indeed, Dodd Frank is very much a global matter, with both European and Asian regulators looking set to follow the example of US legislators.
European regulators are already considering migrating derivative trading from bilateral private deals to electronic venues. An EU lawmakers’ committee recently voted in favour of a draft law to standardise derivatives so that they can be cleared through central clearing houses, thereby reducing risk and improving transparency. European pre-trade practices will be addressed – most probably in the autumn – as part of the Markets in Financial Instruments Directive (MiFID).
While electronic trading in the fixed income markets is less mature in Asia than in the US and Europe, it seems probable that Asia will adopt best practice from Western markets. Asian regulators are currently considering rules for the clearing, although not for trading of OTC derivatives, but appear likely to emulate the US example.
The Dodd Frank Act, and the creation of SEFs, represents an important opportunity to introduce standardised connectivity within the fixed income derivative trading area.
Standardised connectivity has advantages for the fixed income community as a whole and sell-side firms recognise that the most beneficial way ahead for all is a move carried out with the consensus of other industry participants.
While the focus of the current sell-side initiative is derivative trading it is hoped that standardised connectivity will be extended to all fixed income products, including cash trading, thereby creating a double benefit for the fixed income community.
Finally, it is essential that the fixed income community acts as a whole in order to ensure that efforts towards standardisation in the pre-trade arena dovetail with, and are consistent with, developments in the post-trade area. Only by taking this approach can post-trade standardization be leveraged in a way that will benefit fully the pre-trade area.

Note about the authors:
Sassan Danesh and Murray Reid are founding partners of ETrading Software Ltd, a capital markets IT consultancy. The company’s particular expertise is in front office trading systems. ETrading Software Ltd is currently working with a group of major sell-side banks engaging with ECNs, exchanges and ISVs to promote the global use of FIX and other industry standards across all fixed income products.

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