What is the right business model for FI: agency, principal or a mix of both?

Earlier in November there was an interesting article in IFR by Christopher Whittall, “Fixed income trading enters new era”. It was focused on the principal versus agency models in fixed income. It is an understatement to say the fixed income trading and distribution business has undergone dramatic change, driven by cost and regulatory considerations. But not everyone has reacted the same way.

“…Fixed income has been under the cosh for the past two years in the face of soaring costs and dwindling revenues, forcing many banks to overhaul their cash and derivatives trading operations. Some have opted for nips and tucks, while others have lopped sizeable chunks off their rates and credit businesses and built out agency execution capabilities….”

The competing models seem to be principal versus agency.

“…Fixed income desks earn their keep by offering two-way prices wide enough to compensate for the risk of taking client positions on to their balance sheet – also known as principal trading. The equities concept of brokers charging a flat fee for providing clients with access to an exchange – or agency execution – could hardly be more alien…”

The author looks at agency trading being along the lines of equity brokering, where a fee is charged to put each side together. (We also thought there was as principal risk trading on equities desks too…) The use of CCPs to clear OTC derivatives trades is the primary example of how fixed income markets have responded to regulatory changes designed to make markets look less like “principal” and more like “agency”.

“…Regulators are not trying to shoehorn all fixed income products into this market structure, but have mandated liquid derivatives in non-block size to trade on exchanges. This will equate to around two-thirds of the US$710trn over-the-counter derivatives market. Some believe the regulations will lead to a two-tier market…”

But not everyone is happy.

“…Until recently, dealers were divided into two distinct camps on the agency question…The first consisted of fixed income trading behemoths still reaping the benefits of the principal model, resisting any change for fear of cannibalising their revenue pool. At the other end of the spectrum sat capital-constrained firms, such as the Swiss banks, which embraced agency execution while paring back principal risk-taking business, particularly in the rates space…”

If the definition of an agency model is intermediation with using balance sheet, then calling CCP cleared derivatives a pure agency model has some holes in it. Use of central limit order books (CLOBs) is not grabbing the hearts and minds of investors, at least not yet. Much is still executed by calling directly to dealers for swap quotes.

“…participants have been disappointed with the glacial pace of liquidity development on central limit order books, which experts say holds the key to agency execution taking off. The vast majority of swaps are still being executed on a request-for-quote basis – in effect an electronified version of how the principal market has always worked…”

We wonder if the light use of CLOBs in OTC fixed income derivatives is about old habits dying hard or is there a more fundamental/rational reason? Knowing that you have put several dealers in competition and executed a trade may been seen as a way to get better execution or at least not think you’ve been picked off. For dealers, putting all of your eggs in the agency basket seems, at a minimum, premature. The author of the article thinks the answer lies somewhere in the middle. Some agency and some principal capacity is probably a better strategy.

What about the cash markets? Is there a pure agency model that will be viable? We have written about some of the work to create marketplaces that centralize FI liquidity (see “Corporate bond liquidity and new trading venues: will it matter?”, May 15, 2014). Have any reached a critical mass yet? Do investors believe that there will be liquidity when they need it (read: when markets are stressed)? We are skeptical about that.

And finally, what about repo markets and pure agency trading? Repo CCPs that can deal with all sorts of buy side investors is what we are hoping for, but know the barriers are high. There are some positive signs and know there has been a lot of time focused on the issue.

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