Bilateral Trading Finds Momentum Across Multiple Asset Classes

With the rise of electronic liquidity providers, bilateral trading is moving across multiple asset classes, prompting conversations about direct connectivity and the technology that is needed to tie trading in all the asset classes together.

While bilateral trading has existed in foreign exchange for decades, it has gained traction in European equities under MiFID II’s regulation where non-bank liquidity providers have turned into systematic internalizers (SIs), providing executable prices directly to the buy side.

Now there are signs that bilateral trading is expanding to fixed income in rates trading and in corporate credit where electronic liquidity providers (ELPs) have begun to stream executable prices directly to the buy side through execution management systems (EMSs).

Citing the efficiency of trading bilaterally with counterparties in FX, buy-side firms are having conversations with ELPs about connecting with bilateral streams in fixed income, emphasizing this would be “complementary” to the existing market structure.

“There is a balance to be struck in having the ability to connect with liquidity providers as well as maintaining a healthy relationship with the intermediary execution venues,” said Paul Cable, Head of International Fixed-Income Trading at T Rowe Price in London.  

While the trend of bilateral trading in fixed income is in its infancy, there is demand from the buy side for bespoke pricing from their counterparties, and the potential for better prices and cost savings. It’s also possible that different asset classes can learn from each other.

Commenting on the potential for bilateral trading in corporate credit, Lynn Challenger, Global Head of Trading and Order Generation at UBS Asset Management in London, said: “If there was a market maker streaming quotes into an EMS order pad, it would improve efficiency and reduce the potential for information leakage.”

In 2022, UBS Asset Management executed the first bilateral electronic trade with JP Morgan’s systematic internalizer with direct connectivity facilitated by FlexTrade’s FlexFI system, reported The Desk.

But the hurdle with fixed income “is that liquidity is episodic, and to ensure the best outcome for our clients, it’s important that we are focused on accessing liquidity wherever its available, directly or indirectly,” said Cable. Dealers are in the risk and liquidity transfer business, and we welcome the conversation on improving access, efficiency, and transparency,” he added.

As market structures evolve and proliferate, global firms that trade across FX and equities, futures, and fixed income are taking a holistic view of the various asset classes.

Hugh Spencer, Global Head of Global Trading at Janus Henderson Investors, said he looks through the lens of equities and foreign exchange to inform his perspective on fixed income. “I believe conceptually, there’s potential for decentralization away from known marketplaces in the fixed-income world, to move toward an EMS model, which creates the potential to trade bilaterally,” said Spencer.

The Role of ELPs

Despite the challenges, the trend toward bilateral trading is expected to grow as high-speed electronic market makers are making two-way prices in different asset classes and then unwind the risk on exchanges.

In August, Bloomberg News reported that global market making has boomed into a $260 billion business for Wall Street, with a select group of high-speed market makers, “where they offer prices for thousands of securities to keep trades flowing on exchanges.”

This also reflects the role that non-bank liquidity providers play in liquidity provision since the 2008 financial crisis, when banks pulled back on their risk taking. That opened a void for hedge funds and market makers to step in and provide liquidity.

“In many cases, the market maker is the end risk taker, so it is natural for them to want to bypass any intermediary and show their prices directly to the natural buyer or seller,” said Challenger of UBS Asset Management.

Although traditional asset managers may have been hesitant to interact directly with market makers in the past, there is interest in bespoke bilateral prices and in executing at a better price.

From the buy-side trader’s view, Challenger said, “The only reason to trade on the [firm] price is that it’s inside the bid/asked spread and you’re filled immediately, so there’s a duration risk component and an immediacy component if it’s better.”

From a technological standpoint, this was not possible until recently, said Andy Mahoney, Managing Director of FlexTrade EMEA. “In the past, many electronic liquidity providers sat at the end of a smart order routing table; they didn’t face the buy side directly. They faced sell-side counterparts who have done the smart order routing or internalization themselves,” he explained.

However, LPs recognized that under the appropriate regulatory structure, they can provide a price directly to the client and they can execute against the back of it, said Mahoney. “This is a big change because it cuts out the extra step of having to route to a sell side directly to access these liquidity providers.”

On the other hand, this move to bilateral trading means that complexity is increasing. “One could argue that the FX market is efficient, but it does require the buy side to maintain connections to many counterparties,” said Mahoney. “There is a technological advantage to having a multi-asset class system that is able to cater to the FX markets or built for more complex markets than just routing down a pipe to a broker,” he said.

EMEA Equities: New Rules of Engagement

Currently, bilateral liquidity is most prevalent in European equities, where it has changed the status quo in order routing and brought competition to traditional exchanges and MTFs.

According to Rebecca Healey, Managing Partner at Redlap Consulting in London: “Historically, in Europe, you had buy side reach out to sell side and the sell side reach out to venues. And that might be an ELP or not. But ELPs have moved themselves between the buy side and the sell side, and it’s changed the rules of the game. They provide streaming liquidity using “fill or kill”. If an order hits their order pad, it will get routed directly and see if there is liquidity with an ELP,” explained Healey.

However, industry participants maintain that bilateral trading is fundamentally not new.

Banks have provided bilateral liquidity for some time through their smart order routers into their internal central risk books (CRBs), or in other areas, such as through their Delta One products or high-touch risk positions.  

“Bilateral liquidity offered by market makers is becoming more accepted in the European trading landscape,” said Anish Puaar, Optiver’s Head of European Equity Market Structure, who is based in Amsterdam. Before, “there was a lot of explaining to do about how market makers fit into buy-side workflows and improve execution performance,” said Puaar.

In European equities, Optiver streams its liquidity directly through EMSs, but the firm now reports as a systematic internalizer, whereas previously it reported its trades as off-book/on-exchange transactions.

Drawing on its experience as a supplier of bilateral liquidity to European ETFs, Optiver initiated a new style of trading in cash equities, providing consistent, two-sided liquidity direct to the EMS or to an algo wheel. “This increases competition and improves the execution to the end investor,” said Sjors Kole, a senior cash equity trader at Optiver in Amsterdam.

“Our focus is on providing liquidity for benign order flows, like cash flows, rebalances and hedging flow, typically up to 10% ADV per order, which is generally larger than sizes traded on block,” said Kole.

According to Puaar, “the interest in bilateral liquidity centers around the ability to trade in decent size at the prevailing price with no market impact vs. going through a participation-based algo which will always have some market impact.”

Since markets are evolving with bilateral trading in equities and FX, global asset managers are looking at how similar market structures could proliferate in fixed income trading.

Bilateral Expands to Fixed Income

“In credit trading today, the buy side mainly uses the request-for-quote (RFQ) protocol to ask for prices from several brokers, which is then advertising their intent”, said Challenger. “You are telling the market you are interested in a specific bond. That is information leakage and that could drive prices a lot,” he said.

However, “if market makers in fixed income were streaming quotes into us, it would impact efficiency; it would affect a lot of aspects of the trade,” he continued.

Challenger predicts the buy-side will start to see streaming quotes in US Treasuries because the technology is there. “There’s not a tremendous amount of ISINs in the Treasury market like there is in the corporate bond market, so it’s a definable set of instruments that they’re going to have to stream,” he said. “It’s a super deep and liquid market, so the potential for trades to get picked off in that market is harder because prices are so transparent, so institutions can run lots of secure checks of where the prices should be,” he said.

“Having a stream with prices so that information is pushed to you, so the buy side doesn’t need to RFQ and tell anybody they are going to trade, then the trader could pick the best price and trade it. That’s my utopia in credit,” said Challenger.

Data & Connectivity: The Missing Piece

Although the conversation around bilateral liquidity for fixed income has been around for several years, it has been slowed down by the need for data dissemination and direct connectivity.

Unlike equities, where hub-and-spoke networks, and smart order routers connected to EMSs existed for decades, “direct connectivity between the buy side and sell side in fixed income through an OMS and EMS is in a nascent stage,” said Matt Coupe, who joined the fixed-income trading team recently at Susquehanna International Group (SIG) in London.

But Coupe predicts that bilateral liquidity is at “the take-off point” now that tech stacks have gone through several cycles of upgrades, adding that connectivity is progressing and it’s going to grow further in the next 18-24 months.

In addition, “the dissemination within fixed income of more systematic data over the last three years has dramatically increased, and this includes pricing (firm or indicative), axes, and positions,” explained Coupe.

While there has been a dramatic shift in terms of the flow being traded electronically on a venue, with most small-to-medium trades traded on platforms, the medium-to-large orders are not traded on-platform, he said.

In terms of how fixed income trading is evolving, SIG’s Coupe said: “Bilateral connectivity is about the electronification of the OTC activity, which the buy side currently executes manually through voice or messaging.”

“Fixed income trading is about bilateral interactions and risk-transfer between the two counterparties,” said Coupe. “When firms go up the size and risk scale, that is not done on a platform. They are engaging with their partners who are going into the market on a risk basis,” he added.

In the future, Coupe predicts that direct pricing will evolve on the voice side, and that traders “will want systematic information to be ingested in their systems to start running analysis and look at positional information and streaming prices, said Coupe. If the buy side has a voice conversation to discuss a large trade, the market maker might send the axe or RFQ and capture that information with systems running under it.

However, Cable at T. Rowe Price said initially, the firm is engaging with counterparties around the ability to execute any size, but it’s most likely small size orders so that everyone can see how it works and where it is more efficient. “In the future, bilateral can grow to bigger size, or the ability to view central limit order books or CLOBs where the bilateral counterparty is making available different sizes at different levels for immediate execution,” he said.

According to Janus Henderson’s Spencer, looking at markets holistically, the trend in fixed income is more toward direct connectivity and decentralization, which will create competition, and is positive for pricing and for the end investor.

“Based on current models, the introduction of more direct connectivity in the fixed income world will create competition, and economically, it should be better for both parties with bilateral execution,” said Spencer. “As a secondary, knock-on effect, the industry will probably see the RFQ space become more competitive in pricing terms, and innovate further, leading to more EMS integration. This is the natural evolution,” said Spencer.

Wider Impact on Markets

In Europe, some have raised concerns that bilateral trading has removed equities volume from the lit continuous markets which is where price formation occurs. But the scale of the problem may be overestimated due to a lack of clarity in the trade reporting data. One example relates to off-book/on-exchange data, which previously did not distinguish between price forming and non-price forming trades. According to analysis from Optiver and BMLL, off-book/on-exchange volumes that’s been filtered to exclude non-price forming trades represent around 7% of market-wide volume rather than the 23% that’s been commonly cited over the past years.

Some market participants have called for a special flag mapping bilateral liquidity so that the non-addressable liquidity is not included in the bilateral bucket. “There is no specific trade flag for it, so firms are estimating some portion of pure OTC and some portion of off-book/on-exchange is bilateral,” explained Puaar.  

Puaar asserts that “equities trading is highly unlikely to suddenly move to an FX-style market where the majority of trading is done bilaterally. It’s much more of a complementary liquidity source alongside venues, bank risk, or whatever else is already out there,” he said.

Future of Bilateral Trading

Nevertheless, many expect bilateral trading to become more prevalent across asset classes. In U.S. equities, bilateral trading has surfaced in so-called hosted pools within ATSs where the buy side’s orders can execute against a market maker’s bespoke stream and invite other counterparties to participate.

Still, it remains to be seen how bilateral trading in equities and FX could transform fixed-income trading.

When comparing fixed income to FX, which is very liquid, Cable said the asset classes are very different. He noted that FX and equities are more similar in that they have CLOB-like structures with depth of book and lit prices. “That is a good example of something that works well in the FX space, and if the technology works, there can be lessons applied to fixed income,” he said.

One of the challenges facing market participants is preparing for a future where bilateral trading and other market structures proliferate across different asset classes.

“While each asset class has its own nuances, and can set up their own streams, they are coalescing from a technical perspective,” said FlexTrade’s Mahoney referring to the EMS consolidating the different feeds. “There’s a benefit to having an EMS that’s able to cope with FX market structure, or equities and futures as easily as any other market structure,” said Mahoney.  “Whatever ends up evolving in each space, whether it be bilateral, traditional venue, or MTF, or combinations of those three, firms with multi-asset class trading technology will have an advantage as the market structure evolves,” he said.