FIIG - The Fixed Income Experts

News and Education

No “Flash Boys” in bonds

by Sam Morris | Apr 15, 2014

Key points:

1.     Most corporate bonds are traded in the over-the-counter (OTC) market which is still dominated by brokers as opposed to electronic exchanges.

2.     The volume of debt traded in the Australian OTC market is nearly 12 times larger than what is traded on listed equity markets.

3.     Bond markets are characterised by standardised valuation practices and sophisticated participants, resulting in lower volatility than listed equity markets.

Australian investors can rest easy knowing the controversial high-frequency trading strategies exposed in Michael Lewis’ book “Flash Boys” cannot be used in our corporate bond market.

According to Lewis, some US fund managers are manipulating automatic equity exchanges by using powerful computers and rapid communications to figure out which stocks investors plan to buy, and then purchasing them first and then selling them back at a higher price. 

Our corporate bond markets are not susceptible to this because bonds are almost exclusively traded Over-The-Counter (OTC) rather than through automated exchanges.

Trading in bonds is done by dealers such as FIIG that invest their own capital in inventories of bonds and sell them to customers. Larger investors also trade directly between themselves or using brokers such as FIIG.

The trading process can only be confirmed when the two parties individually agree on a price and a volume, not via automated matching rules like those on listed equity exchanges.

This OTC market structure is the dominant form of trading debt securities all around the world. In Australia around 95% of bonds are traded over the counter, which is worth an estimated $1 trillion (including hybrids) with over 230 issuers and investors.

In fact, the volume of debt traded OTC here is nearly 12 times larger than what is traded on listed equity markets.

In Australia, the minimum OTC trade was $500,000 for decades before FIIG brought it down recently for retail investors to $10,000. This meant that participation was limited to large, sophisticated investors who still dominate the market.

Combined with the fact that trading is still largely negotiated directly between these knowledgeable institutional buyers and sellers, this has meant that calculating the price of bonds is relatively standardised once parties agree on a few areas of subjectivity such as the appropriate yield for the credit risk of a bond.

As all bonds have a maturity date or call date as well as a formula for determining their interest payments, there is less judgement required to determine their fair price than with equities where future earnings are unknown. This results in lower price volatility than with listed equities.

While there is no one place to view the best bid and offer for bonds, the fact that there fewer judgement areas means that more often than not, the bids and offers quoted by bond dealers will be very close by virtue of competition for business.

In conclusion, Australia is fortunate to have large, diverse and largely scandal-free capital markets that help companies raise capital for growth and investors to purchase appropriate securities suitable for their needs and risk tolerances.

FIIG does not have a view as to whether high frequency trading in equity markets is a good or bad thing, but we can say that debt markets largely rely on sophisticated participants competitively seeking the best bid or offer and individually agreeing prices for each trade. As a result, high frequency trading strategies cannot be used in debt markets as they currently operate.