How much is too much? This is the question that traders grapple with on a daily basis when buying or selling bonds. While equities markets have enjoyed near-instant pricing for decades, bond markets have lagged behind – slower to electronify, less liquid and traded over the counter – the historic lack of accurate and consistent price formation has been a headache for traders.
This however is changing. Driven by the influx of data, rapid electronification and greater regulation, we have experienced a bond pricing revolution that has changed the game in the pursuit of best execution. As a result, we have seen mass movement from the arduous process of clients manually calling their contacts to gather pricing to using AI and advanced analytics to form prices in a blink of eye. Yet, while the process of gathering bond pricing has improved immeasurably, we are only just scratching the surface.
TCA: An Imperfect Solution
Regulators have been integral in harnessing the fixed income data revolution to increase market transparency, promote fairness and improve outcomes for end savers’ pensions. To achieve this, a key weapon in their armouries has been Transaction Cost Analysis (TCA) – ensuring that participants strive for the lowest possible trading costs as part of best execution requirements. TCA works by using composite benchmarks to predict the average price at which a bond can be transacted, based on an aggregate of all the quotes available at the time of execution. The concept is simple – beat the benchmark and you’re getting a good price – or so the theory goes.
There is however a fundamental problem. In its current form, TCA only gives traders a crude yardstick from which to measure trade costs. While helpful, benchmarks are not truly reflective of the market as they cherry pick certain datasets and omit others. Dealer selection and liquidity provisioning data, for example, are important components in fixed income trading but are not covered by composite benchmarks. Another problem lies in aggressive pricing on some benchmarks that can negatively impact smaller trading firms that do not have the scale to compete with such tight bid/ask spreads.
Together, these factors have made it difficult for traders to assess what qualifies as a good price for their order as well as the liquidity landscape at the point at which they want to execute their order. TCA has therefore become a tick box exercise for many – an unglamourous and inconvenient post-trade process – rather than a useful tool critical to the efficient functioning of the market.
This is a missed opportunity. While TCA has been a good start, it could do so much more – using available data and powerful technology to paint a more holistic picture of the bond market to improve human traders’ decision-making process.
The Move to Transaction Cost Liquidity Analysis TCLA
Every trade is different, requiring traders to decide the best dealer, time to trade, protocol and order size. Just knowing whether they are beating an imperfect benchmark is not enough to aid these decisions – understanding the state of market liquidity is a critical missing piece of the puzzle. A new and improved TCA regime needs to reflect this by looking beyond benchmarks to give a better view of market liquidity. TCA therefore needs to become Transaction Cost Liquidity Analysis (TCLA) – offering even greater depth to materially improve trading outcomes while driving down costs.
To do this, we need to leverage the other rich sources of data we have at our disposal. Scoring dealers, ranking historic trade performance and bid/ask spreads are part of this – offering actionable insights beyond what can be derived from a benchmark. Based on trading data, we can also examine whether approaching a certain dealer or increasing the number of dealers a trader approached for quotes results in price deterioration, helping them to decide which trading protocol will deliver the best price improvement. More data points mean a greater number of variables that can be anaylzed, giving a more detailed view of the market and helping traders make critical decisions.
In fixed income markets, we now have access to data and technology we could only have dreamed of a few years ago. While the pace of change has been astounding, there is still more to be done. Market participants and regulators need to understand the data and technology that we have at our fingertips for the mass migration to TCLA. TCLA is the future, which is why we are already rolling it out for our clients – increasing transparency but also helping to improve their trade decision making and the overall market function.