Recent Trends in the Use of the Internet in Fixed Income Markets -- A Threat or an Opportunity
-- Speech delivered by Afsaneh M. Beschloss, World Bank Vice President and Treasurer, at the Euromoney Conference in London, June 22, 2000
Last year during the Euromoney meetings, technology was not a major topic. Few thought that the time was ripe. E-bonds had a mixed reception. In this year's meeting, on the other hand, there have been many discussions on different aspects of technology, e-commerce and the use of the Internet in our business. The thesis of this talk is whether the use of the Internet in the fixed income area is a threat or an opportunity. As we will see in the course of the discussion, the Internet is an opportunity: one can envisage a day – in the not-too-distant future – when bonds and equities can be bought and sold via ATMs and through wireless devices. In this world, who will be taking the lead: the traditional financial institutions or the new technology players?
The World Bank: Market-Based Financial Intermediary
Technology is a topic that is very close to our hearts at the World Bank. In the World Bank's main business - as the largest multilateral development bank in the world - we aim, as you know, to reduce poverty in the developing world, and promote sustainable development.
In doing our work, we face the issue of the digital divide everyday. One of the World
Bank's first projects was to finance the bullet train in Japan- certainly a new technology at that time. Today, one of the main areas of our work is to bring technology to our clients. This includes helping to develop a new breed of entrepreneurs, and giving them the tools they need; for example, distance learning and promotion of appropriate technology use across all World Bank projects.
In the Treasury of the World Bank, we have historically had a keen interest in technology. For example, the Bank was one of the first major users of the Bloomberg systems. We have invested in and bought many proprietary systems and technology. This has ranged from investing with a number of top venture capital partners for the pension fund of World Bank staff, to the use of technology in our asset management business that is more than USD60 billion in a wide variety of asset classes; our more than USD35 billion in annual derivative trading; and, our about USD25 billion of fixed income borrowings, as well as in middle office functions, such as performance and risk measurement, monitoring, control and settlement and all aspects of our back office.
In the World Bank's Treasury, one of our main efforts has been – as part of our technical assistance work in emerging markets - to introduce the relevant technology in the trading rooms of many central banks and other official financial institutions. On the other hand, we ourselves now outsource a lot of systems related work to, e.g., Infosys in India where we are working with their people.
Our emphasis on innovation and the understanding and use of new technology has helped us hugely in our performance. The World Bank did the first currency swap in 1981. To finance its lending operation, the World Bank raises money by tapping the world's capital markets. The Bank, as you know, is a AAA-rated borrower. In many countries in Western Europe, we were the first international issuer. We are also a leader in emerging market currency bonds, issuing most recently the first international bonds in Mexican Peso and Chilean Peso.
The World Bank designed the first global bond in 1989 - and now these benchmark issues are quite common. The e-bond is the latest innovation. Technology has been key in all these innovations.
The Power of Online Finance
The power of the Internet is the sublime ease with which it brings buyers and sellers together, transfers information – everyone's favorite commodity – and allows buyers and sellers to transact at anytime and from any place. This synergy is most apparent in securities trading, and we expect to see large improvements in the efficiency of secondary market trading. The Internet allows more people into the market, settlement can be made just by switching a few digits around in cyberspace, and you can trade when you want, where you want. The Internet provides two key services: ease of transaction and price transparency. Consumers/investors can compare similar products – mutual funds, securities – in the best possible statistical light using common standards.
We are at the threshold of a major revolution in the capital markets, impacting on all the major players in the world of finance. Let's not forget that while e-commerce took over the sale of books on Amazon.com and memorabilia on e-Bay, and started to make a dent in the hard sectors, some would say its progress in changing the way we do business in finance has been much slower.
In some areas, the power of online finance has been most visible and more progress has been made, for example, in the equity market. Discount stockbroking now accounts for a remarkable 30% of market turnover in South Korea, where retail investors dominate and the technological infrastructure is strong. In the major equity markets, including the United States, Germany and the United Kingdom, online stock trading has risen to a market share of between 10 and 20%.
Online brokerage has also been growing at a rapid pace in Japan where several thousand Internet brokerage accounts are being opened each day. This is also changing the fabric of society as women seem to be one of the fastest growing users of these services in Japan.
Jupiter Communications, an IT consultancy, estimates that by 2003 online brokerages will be managing assets worth USD3 trillion, roughly equivalent to what the top three investment banks held in 1998. Forrester, another IT consultancy, predicts that the number of households with online accounts will more than quadruple over the next three years from five million in 1999.
Technology and Fixed Income
Let me now turn to the topic of technology in fixed income markets. In the fixed income area, progress to embrace the Internet has been slower than in equities.
There are a number of new electronic trading systems that already cover a wide spectrum of market needs, as well as different types of securities – including government bonds, corporate and high-yield bonds, municipal bonds, commercial paper and Eurobonds. We hear about new systems such as the Bond Book every week that goes by. The various systems out there include:
- Action/bidding systems where dealers and investors bid directly on new issues (such as Bloomberg Municipal, Intervest, MuniAuction, etc.);
- Multi-dealer systems where institutional investors trade with dealers but not with each other (such as TradeWeb, Bloomberg BondTrader, QV Trading Systems, Bond Book etc.);
- Cross-matching systems where buyers and sellers trade or periodically match orders anonymously (such as BondConnect, Bondlink, BondNet, etc.);
- Interdealer brokers – for dealers to trade anonymously with one another – Brokertec Global, Cantor E-Speed, Instinet and Libertydirect come to mind. In Europe, there is Euro-MTS, Euro-CP Trade and SWX – to name a few.
However, most dealers still emphasize single dealer systems. On our side, as an important issuer as well as a large investor, I hope there will be new systems that will enable us, for example, to efficiently execute more complex, arbitrage-driven trades involving multiple securities; obtain real-time, accurate information on trading volumes; and get a better sense of market breadth and depth in terms of number of dealers and size of transaction. All of these would ultimately help to further reduce the gap between quoted markets and actual execution of transactions.
Our traders and portfolio managers at the World Bank were not the first to embrace these systems. They were large players who preferred talking to the sales force and benefiting from the personal touch. It has taken some time for us to start using these systems, and there is no question from an investor's point of view that unless we move much faster to the multi-dealer and next stage exchange systems, life will not really change. Talking to financial institutions today, the progress in these areas is slower, compared to single dealer systems. Until traditional financial institutions begin to see the benefits collectively, it is not impossible that more innovative groups could become active in this business - at least in the more commodity-type products and liquid areas of the business providing a transparent exchange.
Are these recent trends in technology a threat or an opportunity for market participants? Quite clearly, they represent a radical change for the better – not only for issuers and investors, but also for intermediaries, who can only benefit from focussing their highly skilled resources in the areas where they can add the most value. We are already witnessing a wholesale embrace of technology on the part of most major financial institutions in many parts of their traditional businesses. Some are rethinking their business strategy in light of the new powers endowed by the Internet.
Building on this projected robust growth in online usage, we at the World Bank believe that change is inevitable and, therefore, we will continue to innovate in capital markets and design products and investment strategies together with our financial partners to meet the challenge of the time.
When we were here last summer for the Euromoney meeting, we began discussing with a number of underwriters the possibility of an e-bond. Intermediaries showed great disparity in terms of their interest. It was interesting as their cultural readiness for using e-commerce in the fixed income world was also disparate. And, of course, in view of the coming Y2K event – which, as we know, really turned out to be a non-event – many banks had employed all available resources to fix the potential millennium bug, with little extra time left for any other technology tasks.
The World Bank's first e-bond landmark transaction of January 2000 set a new standard in international capital markets. The main objectives behind it were:
Number 1 – Democratization of bond purchases: This has to do with the virtually unlimited reach of the Internet, and the fact that anyone with Internet access would be able to purchase our electronic bond at the time of the primary offering. In contrast, under the traditional way of issuing bonds, the salesmen of an investment bank would only be able to cover, by telephone, a limited number of the most important investors. We had all experienced this as we visited the smaller investors.
Number 2 – Transparency in book building: Through the Internet, the World Bank as an issuer would be able to see exactly the order book as it develops for a new bond issue. We would know the strength of the demand for our issue, and we would be able to price the new issue precisely in line with that demand.
Number 3 – Efficiency in trading: After the initial launch, the electronic bond would start immediately to trade on an electronic platform, allowing investors to buy and sell the security online.
And Number 4 – Effectiveness of web-based dissemination of information: The Internet allows the borrower to reach investors instantly with all relevant information about the new bond issue. Investors could watch our road-show on their screens, or they could pull up the World Bank's Annual Report along with its most recent financial statements, all without the need to send any paper through the mail.
By combining these four product design elements, we defined our end-product: the fully integrated electronic bond, "integrated" – meaning from the front end of offering the bond online, to the back end of electronic trading in the secondary markets. Such a bond had never been issued before, and we had the objective of being the first issuer to bring such a transaction to the market.
Final Product: The Fully Integrated Internet Bond
So what was the outcome? We now have developed our final product. The first e-bond was a USD3 billion 5-year global note of January 2000. By offering the bonds online, we added a new distribution channel for the placement of our debt securities. One third of the bond issue was bought over the Internet. In the case of our second e-bond, this number went up to 50%.
We reached new investors: we placed more than 20% of the first electronic bond with smaller institutional accounts and private individuals through some 550 tickets. Most of these investors have never purchased a World Bank bond before. Private individuals buying the bond, for example, through Charles Schwab - an underwriter of the bond - were paying the same identical low fees of 10 cents per USD100 as paid by larger institutions. So, this again broadened the market. We had private investors who bought as little as USD1,000 or as much as USD250 million. Some said why worry about broader markets when our bonds do so well? Because having a broader investor base is the magic behind our bonds doing well even in difficult market conditions.
Finally, by monitoring the order book online, we were able to price the new issue exactly at the market clearing price. Hence, there is no surprise that the bond did so well not only in the primary market but also subsequently in the secondary market.
The electronic secondary trading for our e-bond was immediately opened after pricing and 22 trades were executed in the first 24 hours. Since then, these bonds have performed very well in the secondary markets, rewarding investors.
So what did the World Bank get? A broader investor base, better pricing information, easier market access to new investors, and better secondary market performance.
And what did the underwriters get? Being first mover in this new business, broader access to new investor classes that were previously too far removed, increased volume of secondary trading income, use of the sales force and others for higher value work in this labor short economy and a much more efficient syndicate and front-to-back operation for underwriters.
Finally, what did the investors get? More transparency in the primary and secondary markets, and lower costs for the retail sector in the primary and secondary market. On the latter point of secondary market trading, I would like to emphasize that our first e-bond has outperformed other AAA-rated bonds in the USD bond market. Our security has tightened its relative spread compared to bonds of the same maturity and credit rating. This directly benefits the investors in our security.
E-bonds are changing the nature of the fixed income market by making bonds more attractive to those investors who previously did not buy bonds for fear that they could not sell them easily at a reasonable price.
In summary, we used e-commerce in all the ways we could in order to advance the bond issuance business and broke new ground that has benefited investors, underwriters and issuers alike. While we were a catalyst for change in the use of new technology in fixed income markets, since our e-bond transaction, many other issuers have adopted this new standard of securities' offering. They include sovereigns such as Argentina, Portugal, Philippines, Finland and other supranationals (EIB) and agencies (KfW and U.S. agencies) and some U.S. corporates.
Looking into the horizon, we expect almost all of our bonds to be offered through the Internet. The Internet will play a valuable role not only in primary and secondary market trading but also in improving efficiency and productivity in middle and back office operations. Straight-through processing of transactions will happen soon. Some derivatives and structured products will also be traded over electronic platforms. In due course, one can envisage that bonds can be bought and sold via ATMs, and through remote access devices such as Palm Pilots.
The manner in which the financial sector will deliver its services will change dramatically for the better. Of course, there will be hurdles and challenges ahead that need to be resolved. For example, more work is needed on the regulatory aspects of selling securities via the Web. In many jurisdictions, securities laws have not been able to keep in line with the rapid deployment of Internet technology, thus prohibiting sales of bonds via the Internet. There is also concern about security and the fraudulent use of the Net. Finally, the infrastructure for delivering data and information over the Net may be constrained by the limitation of bandwidth or lack of access. For investors, issuers, and underwriters, there is still a lot of work remaining in changing our middle and back office processes, simplifying them with the new technology and using web-based technology to truly make all our businesses more efficient so that we could all spend time on what is more productive and fun for all of us.
I will conclude by saying that the Internet is now a virtual reality – an opportunity and not a threat - one in which, through democratization of bond and equity sales, all of us can benefit.
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