Fixed income
March 18, 2022
The volatility seen at the onset of the COVID-19 pandemic and the ensuing shift to working from home accelerated the “electronification” of fixed income markets. We asked Tracy Rucker-Wilson, global portfolio risk manager at Vanguard, to tell us more about what’s behind the trend and how it has been playing out for derivatives trading in our Fixed Income Group.
“When a trader wants to buy a bond after its issuance, they typically have to go out and find it,” Rucker-Wilson said. “Stocks typically trade on ‘lit’ exchanges where bid/ask prices and volumes are publicly posted. Bond trades differ in that they are traditionally negotiated through over-the-counter, or OTC, transactions between investors and bond dealers.”
Electronic trading offers some undeniable advantages over that process, including greater liquidity—which essentially means you can more easily buy or sell a security without affecting its price—along with greater speed and price transparency.
At Vanguard, the majority of derivatives trades are executed on an electronic platform. The pandemic further accelerated electronification with the use of rules-based automated execution for low-risk orders. This change “helped us manage our trading volumes, given that more of our team and the brokers with whom we trade were working outside of the traditional office in new remote work environments,” Rucker-Wilson said.
“Electronic trading of derivatives allows us to manage orders of nearly any size,” she said. “We can effectively trade potentially market-disruptive orders by trading them over longer periods or slicing them into smaller sizes to execute at the best price. It also gives us access to a wider pool of counterparties, which translates into better pricing and lower transaction costs.”
Rucker-Wilson said there is, though, “still a place for OTC trading, when factors such as trade size, market volatility, or timing could make OTC trading the better option.”
For example, market headlines or comments by a policymaker can immediately affect prices in the derivatives market as the broader market digests the news. In that environment, we may choose to negotiate a level with a broker to transact a larger order. The broker may have an additional charge for taking that risk on their books, but it could be worth it for the certainty of getting the trade done instantly. Trading that same order electronically over the span of an hour, for instance, could result in our paying more because of price fluctuation over that time frame.
Both trading methods have advantages that vary depending on market liquidity, timing, and the size of the trade. The decision on which one to use is left to the skill and expertise of our traders.
A lot of thought and planning goes into how Vanguard trades electronically. We consider maximum trade thresholds and adjust the size of trades based on what we believe the liquidity in the market can bear. We continually fine-tune our smart order routing processes to effectively handle our buy and sell orders. We have developed an “algorithm wheel” that filters each order based on various parameters before distributing it to the best algorithm to execute that trade on a third-party electronic execution management system. And we partner with our in-house transaction cost analysis team to regularly review algorithm performance and adjust the volumes that are routed to specific algorithms based on how they’re performing.
“Electronic trading is a great tool,” Rucker-Wilson said, “but it’s only one tool in our toolkit for improving efficiency, minimizing costs, and ultimately delivering value for our investors.”
Notes:
All investing is subject to risk, including the possible loss of the money you invest.
Diversification does not ensure a profit or protect against a loss.
Investments in bonds are subject to interest rate, credit, and inflation risk.