Electronic Dreams

Automation is everywhere.

The displacement of humans by technology is affecting the world around us in a myriad of ways, especially labour markets. Healthcare, law, crime, transport and, our world, finance and trading, are heavily impacted.

There is a school of thought that believes an efficient machine will soon replace the traditional method of trading, with dealers being superseded by platforms that provide perfect deal flow and liquidity.

But is this electronic revolution really going to sweep all before it? Or, in the same way I still want to drive my car, is there still a place for humans in the markets of tomorrow?

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Electronic trading isn’t new, but it has come a long way in a short space of time.

Traditionally, open outcry or voice trading involved a dealer intermediating two counterparties, making a market and bearing risk until deals cleared. The dealer’s conventional role – in all trading, from equities to bonds to diamonds to paintings – was to intermediate by betting on a counterparty being found. Hence, dealers were individuals of courage and repute, whose job relied on strong relationships with both sides of the trade.

Electronic trading has been around for decades, with companies like EUREX and Tradeweb operating since the late 1990s. What is new is the volume of trading that is now being completed electronically, especially in the bond markets, with around half of Treasuries, and 60% of European government bonds being traded on over 100 electronic platforms. Corporate bonds, whilst slower to catch on given their varied terms, are catching up.

The benefits for the bond markets are huge, hence the popularity.

From an operational perspective, with trading revenues being squeezed by competition and regulatory overheads, any form of technology that reduces labour costs and deal friction is being invested in by banks. As per last week’s post, banks are desperate to innovate. Electronic trading is one way they can with near-term benefits to the bottom line.

From a transactional point of view, in theory, the success of electronic trading should open up new pockets of liquidity and it is creating increased price transparency in a densely populated, fast-moving market. With regulation becoming more onerous, the audit trail created by an electronic trade is useful to buyers, sellers and regulators, too.

So, like the driverless car that is meant to drive me to work in a few years’ time, the principles and intended efficiencies make sense to both the industry as a whole and the individuals involved. But, in the same way that I like to be in charge of my own destiny when approaching a busy junction, intermediating machines remain far from perfect.

A major problem that has arisen as a result of the rise of electronic trading is that liquidity has actually dried up. A platform is perfectly efficient at matching a buyer to a seller when both are present and markets are calm, however, unlike a human dealer with a balance sheet, a machine won’t take risk and make a market when markets are volatile. If there are only buyers (or sellers) present, we have no market and we have zero liquidity.

What the machine has not replaced – risk, courage, relationships – is precisely what is needed to complete a trade. Without these human qualities, a perfectly efficient market exists, but it is a lot smaller and far less liquid.

This problem reflects a wider concern with automation that is yet to be wholly overcome, despite the positive projections that advocates place on the success of the machine: humans remain uncomfortable yielding total control to machines.

A possible medium-term solution could be the employment of a machine to provide an efficient market, with human dealers providing oversight and optionality, stepping in to provide liquidity when needed. Like flying an aeroplane, a machine does the hard work, whilst a human provides expert, emotional, judgment-based input. They put clients at ease.

We also need to consider trading on an institutional level, within the wider framework of the business. Ultimately banks earn their fees by underwriting commitments and making markets. Banks have deep-rooted institutional relationships with clients that are reciprocal in nature, and provision of liquidity to issuers and investors by leveraging balance sheet and managing risk is an important piece of this puzzle.

In time, with the implementation of effective AI, maybe we will have a machine that can replace human dealers. But that won’t tackle the deeper challenges of liquidity. For the foreseeable future, banks are still ranked by their institutional commitment to clients on both sides of the trade, and dealers will continue to be prized for their very human qualities of trust, loyalty and creative thinking.

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This article was created in association with Origin Markets, directly connecting dealers and issuers in the primary marketplace for the first time. 

Edward Playfair