Future of Investing

How to solve the chicken-and-egg problem of new bond marketplaces

  • Corp bond liquidity is down 80%
  • Getting the big institutions to trade electronically

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How to solve the chicken-and-egg problem of new bond marketplaces
Nobody said building a financial services business from scratch would be easy. While some of the consumer-facing upstarts at least have a certain sexiness factor going for them, the same can't be said for those startups toiling away at technology solutions for bond trading. At their heart, these are institutional platforms with marketplace dynamics, dealing with long sales cycles to the largest institutions in the world. These firms are running a sprint and a marathon at the same time. Between the Fed, Dodd Frank, Basel III capital requirements and Volcker, liquidity has dried up. Dealer inventory is down 80% from pre-crisis highs. Solve the liquidity problem and you're in business. But injecting liquidity into bond trading means reenacting and recreating market structures. The top bond trading startups are addressing the changing role of dealers, price discovery, and commitment to making markets through technology. These new bond platforms need to enable information sharing between both sides of the marketplace sufficient enough to find prices and cross trades that doesn't tip buyers' and sellers' hands too much — just like real life bond traders. Getting enough supply and demand on these new bond trading platforms is the billion dollar issue. Tradestreaming spoke to Amar Kuchinad, CEO of bond trading marketplace Electronifie, to understand more how the upstarts are getting participants to “hold hands and play nicely”, as he puts it. He should know — the upstart's CEO co-ran Goldman Sachs' US credit trading business until 2011, when he joined the SEC as a senior policy advisor to help draft Dodd Frank. Here's how bond trading platforms solve the chicken and egg problem of marketplaces — how do you get participants to join and use a platform in the early days?

Make your product dead simple for traders

Traders are a fickle bunch and it's not easy to get them to change their ways. These are the same types of people who are still addicted to Yahoo Messenger. Electronifie studied traders' processes and designed a self-initiated auction process: If a trader is interested in a specific bond, he can initiate an auction and within 15 minutes, start receiving bids or asks. Successful bond trading platforms need to accommodate how different traders' workflow changes throughout the day without being too disruptive. “We're disruptive enough as a company,” said Electronifie's Kuchinad. “We're not a big BD calling on hundreds of buyers when we need to move product.” So, it was important to design a product that didn't require traders to do things too differently. Electronifie currently has 115 institutions signed up for its platform, including 3 of the top 5 institutions in the market, according to Institutional Investor rankings. Of course, getting an institution to sign up is just the first hurdle on their way to transacting on the platform. Kuchinad admits to being surprised how long it takes for a large financial institution to fully onboard. Where hedge funds can become fully compliant and cleared to trade on a platform like Electronifie in just a matter of weeks, it's not uncommon for this same process to take 4 to 16 months for legal and compliance to do its thing once an institutional trader has signaled his interest to participate.

Get feedback, fail silently

To really be trader friendly, Electronifie established a feedback loop with its users. The firm solicits periodic reviews from its clients and determines what new functionality to roll out for future releases. It's an ongoing process and one Kuchinad feels is essential to getting users onboard the system and using it. “Rule number one for us is to waste as little of traders' time as possible,” he remarked. “On failed trades, it's imperative to make sure there's no leakage of information that could ruin a trader's next trade. One of our clients calls it 'failing silently'.” The payoff for solving the chicken and egg problem of filling out a bond marketplace is the resultant network effect of having critical mass. More participants bring more participants. Linkedin, with just a few thousands members, isn't as interesting as LinkedIn with a billion signups. So too, in bond trading. Once critical mass is reached, it becomes imperative for traders to join the marketplace if they want access to liquidity.

Be the honest broker

As transaction volumes and size increase on these new bond trading platforms like Electronifie, it's not uncommon for a user to put $20-$50 million of inventory into the system. Clients determine how much to show. Show too little and it's possible that a potential buyer and seller, who each want to transact, miss each other. It's here that technology can actually improve the marketplace. Software can't exercise discretion and in an online exchange like this, participants know that whatever they 'tell the system' doesn't spread to humans. The system matches up supply and demand if both sides agree on a price. “Software can't exercise discretion,” Kuchinad explained. “We operate as an exchange and participants know exactly how we operate. It's not salespeople working individual orders. They realize how much they can -- and can't -- glean from seeing other orders in the system.”

Understand who's your client

The challenges of building out a double-sided marketplace are well-known as supply and demand typically seesaw back and forth as liquidity is being built. A marketplace may be the transactional structure but for Kuchinad's firm, it's very clear who his client is: it's the people who need the most help. "For us to be successful, we need to be in partnership with the people suffering from the core problem of decreased liquidity," he said. "For Electronifie, that means institutional investors. These guys are managing hundreds of billions of dollars of corporate bonds and they need a way to to trade everyday." Photo credit: Kevin Cortopassi via Visualhunt / CC BY-ND

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