Draft: June 8, 2003 Developing Efficient Market Infrastructure and Secondary Market of Government Bonds in Developing Countries

Electronic trading systems (ETSs)

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5.3Electronic trading systems (ETSs)

ETSs have been rapidly accepted in certain segments of fixed income markets in developed countries thanks to their efficiency. However, the realities of successful and unsuccessful ETSs in the US market suggests that it is essential to implement the principles of the market infrastructure, the supply-side and the demand side for market liquidity in the first place in developing countries before aggressively eliminating human intermediary functions.

5.3.1Limited roles of an ETS in trading

An ETS makes a significant difference in efficiency and reliability of securities trading. However, it stops short of completing the whole trading process. The part of the process that an ETS cannot fulfill is critical in generating trades.

To understand the roles of electronic trading system in trading, it is useful to see trading activities as an action circle consisting of “Do” for implementation of a planned action, “See” for monitoring the result of the implementation, and “Plan” for feeding back of the results and planning of the next action (see Figure 5). Repeated activities like securities trading normally require the actor to go round the circle of the three steps to improve the activities or keep them relevant to changing environments. An ETS undertakes activities mainly from the moment the strategy for a trade has been established until the trade settles. Subsequently, it also helps part of monitoring. It covers from a substantial part of “Do” up to a part of “See” in the action circle. This portion of the action circle may be termed the “operational part of a trading action circle”. Roughly the half of the circle from “See” to the beginning of “Do” with the entire “Plan” in between, which may be called the “strategic part of a trading action circle”, is left outside the functionalities of an ETS.

Figure 5: Trading Action Circle

Figure 6: Components of Broking

Conventional broking of securities transactions can be broken down into three functions: order transmission and execution, executed order processing, and investment advice (see Figure 6). An ETS replaces human roles of the first and second functions, but not the third one. The first two functions are operational in nature. Hence, efficiency and reliability matter. By contrast, the last one is subjective and the effectiveness on the investor’s mind, rather than efficiency, counts. The investment advisory function is, in fact, consultation or decision facilitation for the investor.

The strategic part of securities trading, which corresponds more or less to consultation or decision facilitation of broking, is eventually the engine of trading activities. It generates trades. Intermediaries facilitate this process leading to actual trades. Therefore, market liquidity can be enhanced by properly addressing policy issues surrounding this process in the first place, rather than by hastily installing an ETS.

5.3.2Five major types of ETSs

The Bond Market Association, a trade association in the United States, classifies electronic trading systems into five major types: auction, cross-matching, inter-dealer, multi-dear and single-dealer systems. Auction systems enable participants to conduct electronic auctions of securities offerings in the primary or secondary market. Cross-matching systems generally bring both dealers and institutional investors together in electronic trading networks that provide real-time or periodic cross-matching sessions. Inter-dealer systems allow dealers to execute transactions electronically with other dealers through the fully anonymous services of brokers' brokers. Multi-dealer systems provide customers with consolidated orders from two or more dealers and provide customers with the ability to execute from among multiple quotes. Single dealer systems allow investors to execute transactions directly with a specific dealer of choice, with the dealer acting as principal in each transaction14.

Appendix 1 tabulates ETSs in the United States and Europe that the Bond Market Association surveyed in late 2001, by ETS type and fixed-income product type. Commercial attempts to electronized fixed-income trading have been made for every type of systems and products. According to market sources, commercially successful ETSs are found only in multi-dealer and interdealer systems. The two types are not exclusive to each other in the marketplace. They serve different needs of the market and are conceivably complimentary with each other. Electronic trading has not been successful in generating direct trading among institutional investors.

This indicates that electronic trading has not fundamentally changed established market infrastructure principles of a liquid market of fixed income securities: quote-driven auction, well capitalized market makers, and anonymity among investors and dealers. The advent of ETSs has raised the efficiency of already liquid fixed income markets, through increased transparency of market prices as well as integration of trading with back-office operations. The introduction of an ETS packaged with self-regulatory market rules designed for the enhancement of liquidity has proved to be effective in vitalizing government bond markets in some European countries.

5.3.3Market and product suitability to an ETS

ETSs for treasury bonds have been far more successful than those for corporate or other illiquid bonds. This fact also evidences that the demand- and supply-side principles for market liquidity – sizable, regular, stable (predictable), transparent and market-based supply of bonds of high quality, and uniform characteristics, and, many, incessant, competitive, and diversified demands for the bonds – hold good. Furthermore, the fact that screen-broked trades are a minority outside dealers’ community suggests that most of screen-broked trades are those of commoditized products that are of a simple nature.

In other words, the less the strategic part of a trading action circle is required, the more likely to be suitable for ETSs a product, a trade type, or a market is. The extent of the strategic part is also a function of sophistication of investors and market intermediaries15.

Conversely, the strategic part is more needed in most of developing countries, for example, due to large price volatility or less sophistication of market participants. Therefore, human broking is likely to be essential in generating liquidity in developing country environments.

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