This is not a recommendation of ETF’s, MKTX, TW or ICE. I am not a licensed security representative. This is my opinion.
Whenever I hear the word automation, the above clip from the Simpsons pops into my head. Homer decides to go to the movies while working from home and uses a toy bird to automate his role.
Automation for the fixed income market is happening much faster than I ever thought it would. It reminds me of the Rudiger Dornbush quote that Larry Summers popularized:
Things take longer to happen than you think they will and then they happen faster than you think they will.
The three equities that trade in the public market that will gain the most from the rapid rise in fixed income automation are MarketAxess (MKTX), Tradeweb Markets (TW) and Intercontinental Exchange(ICE).
This won’t be a breakdown of the companies historical financials or guidance estimates. Instead this will be a quick look at how a recent ruling by the SEC will dramatically impact the automation of the fixed income market and subsequently fuel the growth of these three companies.
On September 26, 2019 the SEC unanimously approved the new Rule 6c-11. A rule that will modernize the regulation of exchange-traded funds (ETFs), by establishing a clear and consistent framework for the vast majority of ETFs operating today.
This new rule will have a massive impact for automation in the fixed income market due to the following:
1) More fixed income ETF’s will come to the market
2) More flexibility and transparency for the use of creation / redemption custom baskets
3)Greater Transparency of portfolio holdings for fixed income ETF’s
More Fixed Income ETF’s = higher demand for off the shelf automation
The fixed income ETF market started in 2002. I know because I sat thru the Barclays Global Investor (BGI) roadshow presentation for their first four Bond ETFs at the 345 California office of Bloomberg San Francisco. I will never forget one of my colleagues telling me that these funds would change everything for fixed income investors. Over the next 17 years, I watched those four funds blossom into a market worth over 1 trillion dollars. Blackrock recently made a forecast that the fixed income ETF market will grow to about 2 trillion in the next five years. However, Rule 6c-11 will speed up the timeline because fixed income ETF’s will be able to come to the market without the cost and delay of acquiring an exemptive order that requires the ETF to operate as an investment company. The lower barrier of entry to the market will translate to more asset managers issuing fixed income ETF’s as well as more innovative fixed income ETF’s from the current 30 or so issuers.
As more issues and issuers enter the market, the market will see a spike in demand for solutions that automate the processes that govern the fixed income ETF. MarketAxess, Tradeweb Markets and ICE are all in a position to provide quick off the shelf solutions for existing ETF issuers and new ETF issues.
For example: ICE announced their ETF hub in October of this year. Chris Concannon of MarketAxess mentioned the following on their third quarter earnings call - We are also actively building new portfolio trading capabilities, which is an enhancement to our existing list trading capabilities. Our portfolio trading solution, which we expect to launch next month will support the growth in trading large fixed-income portfolios, including unique customized portfolios as well as the creation or redemption of fixed income ETFs.
Lee Olesky of Tradeweb mentioned their 2 year lead in innovation with RFQ capabilities in a response to a question about the ICE ETF hub on the third quarter earnings call - We’re keeping an eye on it. It’s a new tool that I think will help in the create or redeem space. With respect to confirmation, it’s something we’ll have to look at. We don’t see it as a direct competitive issue today but we obviously have our eye on it. The ETF space is one where we’ve been leading innovation in terms of the RFQ block capacity that we introduced two years ago. First in Europe and now we have in the US. The role of ETFs and how it’s linking into portfolio trading in the credit markets is I think quite an interesting evolution that we have going on and fundamentally, it’s a market that’s growing. So we are laser focused on where we can add value. It’s always where can we step in and provide some technology into our network that solves for some of our clients’ problems that is something that we can get paid for.
Flexibility and Transparency of Custom Baskets will yield a standard protocol for the Creation / Redemption trades
The creation/redemption process for fixed income ETF’s was the equivalent of black magic for me in 2011. I was working at a regional broker dealer and had a mandate to find new business that wasn’t already covered by an existing salesperson. I was in touch a few former colleagues that were working on the street and was informed that the Bloomberg BOLT function was being tested by a handful of Authorized Participants (AP) for the creation / redemption trades for ETF issuers. BOLT was being touted as an alternative to MarketAxess and I had a good pitch for my firms Bloomberg e-trading capabilities. However, I had no clue about the role of the Authorized Participant (AP). I spent several months trying to find the best people that published material on the mechanics of the fixed income ETF and the role of the AP. Blackrock has some tremendous resources and this video gives a good overview of the process. BUT I must note that this video is for stocks and not bonds. Corporate bonds, Municipal bonds and some Government bonds do not have liquid markets like equities.
The research paid off when I signed up a few AP’s that were involved in LQD and HYG. When the first list “basket” came over, the real questions became obvious. How do the AP’s select the securities for the creation or redemption basket? Did we want to be involved in any odd lot positions that had a potential to be a part of the basket? I had no ability to call the AP and ask if they had more to go or if they were looking for more. I was beholden to their systems that identified liquid bonds in the index. I had very few details on what attributes were used in the identification process. I would observe bid ask spreads on constituents of the index and the ETF but had no idea on depth of market. I built clumsy spreadsheets with one pricing source that would attempt to identify if the ETF was trading at a premium or discount to the underlying securities in the portfolio. I was essentially blind on the construction of the basket and backed away from AP’s as clients. I watched in awe at the sizes coming across my screen on each list “basket” and knew it was a matter of time until MarketAxess would lock down the corporate bond AP’s.
Rule 6c-11 will require all ETF issuers that use custom baskets to detail their policies for the construction of the baskets. Detailing the policy for the construction of the basket will help with codifying a standard protocol that will promote automation. The ability to build Application Program Interfaces for the construction and trading of fixed income ETF baskets will be dominated by MKTX, TW and ICE. Why? The market capitalization of each firm will allow the allocation and purchase of resources that are well versed in the nuances of fixed income to build robust FIX API’s for automation with ETF order management systems.
Greater Transparency of Holdings will increase institutional demand for ETF’s
You can go to several fixed income ETF issuer websites and download the daily holdings for a particular ETF. This information allows market participants to calculate arbitrage strategies for a premium or discount between the ETF shares and the ETF portfolio value, deltas in individual bond holdings and deltas in bond issuers. For example, if I wanted to follow the daily holdings of the JNK ETF. I would go to the holdings tab on the site and then select the xlsx download for all of the holdings everyday.
Greater transparency of daily holdings, shares outstanding and daily cash is a GOOD THING for the fixed income ETF market. The more transparency by fixed income ETF’s will lead to less aversion from institutional investors which will lead to an increase in demand for the fixed income ETF.
Rule 6c-11 will require fixed income ETF’s to disclose information about the ETF on it’s website in a standardized format. This will include historical premium/discount information, bid/ask spread information and daily portfolio information. MKTX, TW and ICE will be able to take advantage of the standardization of fixed income ETF disclosed data and create new products from this data. Once again the market capitalization of these firms will allow them to purchase or allocate resources that will create automated extraction methods for the disclosed data. Not only will the data help with the creation of new products but will also help these companies validate prices for the underlying securities in the fixed income ETF. The ability to accurately calculate the prices for the underlying securities in the ETF and ETF NAVs will increase automated arbitrage trades.
Journalists love to write about disruption and Total Addressable Market for companies in Silicon Valley. The acronym TAM is now being thrown around like a football in an Air Raid offense. The disruption and TAM for this market is massive. Growth from 1 trillion to 2 trillion in a matter of 5 years sounds like a forecast from Xi Jinping. Now regulation from the SEC will speed that timeline up. That is worth following the developments of MKTX, TW and ICE.