The prevalence of alternative trading systems will result in a transfer of trading power from financial institutions to the institutional investors they now serve.
But plenty of work needs to be done first, according to those active in the bond industry.
"I think the market is just now getting comfortable" with online trading, said Curt Mitchell, portfolio manager at the Chicago office of Loomis, Sayles & Co. LP.
Officials at Meridien Research Inc., Newton, Mass., expect that all types of fixed-income investments will be traded online within the decade.
"From this point forward, institutional investors will be the dominant force in determining how these platforms develop," according to a study by the firm titled "Shifting Power to the Buy Side: Automating Fixed Income Markets."
The main obstacles to online trading systems' gaining a foothold are: lack of liquidity, because many of the systems only came on the market in 1999; and the lack of a decisive trading model.
Plan sponsors have shown interest, which has yet to result in large blocks of trades.
The Alaska Permanent Fund Corp., Juneau, where Randy Sears is manager of fixed-income investments, likely will be one of the dominant institutional players for which system providers are waiting.
He and his staff use TradeWeb, a multidealer trading system chosen for its ease of use and number of subscribers, as well as the competitive spreads it offers.
While the $26 billion fund was short staffed last year, Mr. Sears conducted about 80% of the $8.5 billion U.S. bond portfolio's trades on TradeWeb.
Now, with more investment staff on hand, he expects 50% of the system's bond trades to be electronic, depending on the liquidity of the marketplace.
While he is not a proponent of online execution replacing verbal execution, Mr. Sears expects trading of the more commoditized forms of fixed income, such as government bonds, increasingly will take place online. Corporate bonds, however, still lend themselves to old-fashioned negotiation via the telephone, he said.
Right now, his staff uses TradeWeb for individual trades of $25 million to $50 million.
Phil Schutt, a fixed-income portfolio manager at the Illinois State Board of Investment, expects to use TradeWeb soon.
The market's evolution to price transparency, which is something the Securities and Exchange Commission is pushing bond brokerages toward, is likely to continue, Mr. Schutt said, predicting that by the middle of the year, there will be a demand for posting every trade price on the Internet.
"Transparency drove me from the market and it will drive others away," said Mr. Schutt, who worked as a broker, but left as the margins on trades and commissions continued to shrink.
Although Mr. Schutt predicts trading will become more automated, only $300 million of the Chicago-based fund's $8 billion bond portfolio will be traded online, he said. TradeWeb will be used only for Treasuries, he said.
"When you take out the human element, you have a big risk of error that you can't just go back and change," he said.
Plan sponsors aren't the only ones interested in the future of alternative trading systems.
Teri Geske, senior vice president of product development at Capital Management Sciences Inc., a Los Angeles-based bond analytics software provider, said she has noticed a lot of people are trading Treasuries electronically. Because Treasury data are easy for traders to collect and manage, CMS hopes to profit from providing descriptive data and risk measurement tools to alternative trading systems, which can then provide that information to their users via the trading screen, she said.
Institutional money managers also are paying attention.
At Strong Capital Management Inc., portfolio manager John Bender already has chosen winners from among the online trading companies that have visited his office in Menomonee Falls, Wis.
His first choice is TradeWeb, which he already uses for trading 60% to 70% of his $3 billion to $4 billion Treasury portfolio.
Bloomberg Bond Trading will be a close second in gaining market share, Mr. Bender predicted, although trades are not yet executed on the system. Strong is using it on a trial basis and Mr. Bender predicts BBT ultimately will conduct trades in addition to listing prices and information.
BondHub is his third pick. Like Bloomberg, he believes it will branch out from providing research and strategy information to trading.
But other managers are concerned with liquidity and are avoiding large block trades on web-based trading systems. "We don't have enough history with it (Tradeweb) to feel comfortable with it yet. . . . It will pick up as we get more comfortable," said Mark Newlin, director of fixed income, Harris Investment Management, Chicago.
The firm typically executes trades on TradeWeb only after getting three or four competing bids. Traders at the $9 billion fixed-income shop still are not certain they are getting the best execution on larger blocks of trades, Mr. Newlin said.
As they gain popularity, alternative systems will continue to clamor for liquidity from institutional traders.
The strategy for online system QV Trading Systems Inc. is to pursue institutional trades by offering access not only to the Treasury market, but also soon to European debt, Brady, investment-grade corporate and government bond markets.
"We're trying to compete on innovation and brains, because we can't compete in volume yet," said Al Moras, chief executive of the New York-based company.
So far only brokers and dealers are using the system, which has been running since November.
Since April 15, QV competitor BondLink has completed more than 13,000 orders, which translates into $14 billion worth of high-yield, convertibles and emerging market bond trades. With about 200 buy-side accounts and 20 broker/dealer accounts, the system has yet to sign up its first plan sponsor client directly.
Murray Finebaum, chairman and chief executive officer of Trading Edge Inc., which created BondLink, expects pension funds will benefit in greater market efficiency by using alternative trading systems.
"The competitive environment proves to me that there is a prize out there," he said.
Debbie Williams, director of research at Newton, Mass.-based Meridien, believes liquidity within each trading system will improve, but the result may be consolidation and segmentation.
The study by Meridien points to the 1998 bond market scare and the subsequent dry-up of market liquidity as some of the impetus for the creation of the 14 systems now on the market.
The first stage of consolidation will occur as order matching methods beat out negotiation-based methods, she said.
Although some more thinly traded issues may stick with the negotiation method, most market trades likely will be matched.
Currently, only six systems provide order matching: QV Trading; eSpeed; GFINet; BondLink/Trading Edge; Integrated Bond Exchange/Intervest Financial Systems; and Instinet Corp. The others allow users to negotiate the price of a bond via the Internet. While the research firm declined to pick out-and-out winners, the report predicts full price discovery, order matching capabilities and the ability to work with institutional investors will be the keys to success.
QV Trading, BondLink and IBX are the only systems that have all three capabilities, with eSpeed and GFInet pulling up the rear in planning the inclusion of institutional investors.
