November 2012 - sponsored by: MarketAxess, MTS
Fixing Fixed Income
With the world still recovering from a drawn-out financial crisis, it's easy to forget that the initial catalyst for this economic collapse was the credit crunch, and that the inability to accurately value and price fixed income assets was a major contributor to the resulting chaos, which also led to the shattering of fragile sovereign debt issues and downgrades of the credit ratings of countries previously thought untouchable.
Part of the solution was to press for improved transparency in the fixed income and derivatives markets, by proposing to move swathes of previously over-the-counter instruments onto exchanges-or at least, centrally-cleared, exchange-like venues-to generate more accurate and transparent pricing and eliminate counterparty risk. Not only does this help investors better price assess the risk of potentially riskier instruments, but it also helps them determine which are actually risky-there's always talk of a flight to quality when markets look fragile, but first you have to figure out which assets are quality and which aren't.
Another component of the solution-in part a result of the above move to exchange-like venues-is the availability of more data. As the "electronification" of fixed income markets continues, it naturally begets a more structured and safer trading environment, encouraging more liquidity, more trading, and more data as a result. The upshot is that if you have more data that is more timely and delivered at a higher frequency, the more accurate your pricing will be as a result.
However, this increased liquidity and availability of data has an unintended consequence, making the fixed income markets more attractive to algorithmic and high-frequency traders seeking alternative sources of alpha from their algorithms outside the equities markets. But are the still-convalescing credit markets ready for the inevitable disruption of HFTs, or is fixed income still too fragile for high-frequency? And should algos with the power to create Flash Crashes even be allowed to trade the debt issued by the government that regulates them. Either way, any HFT involvement would also open the fixed income markets to the same regulatory scrutiny that HFT has attracted in other asset classes. But considering credit's role in precipitating the financial crisis, perhaps even more regulatory scrutiny of the fixed income markets isn't a bad thing after all.