Being from Chicago, and having visited the NYSE and NASDAQ, I knew that commodities markets, currency markets, and equities markets had made a fairly rapid transition to electronic trading over the past 15 plus years. On the other hand, I had never really thought about the $7.7 trillion US fixed income market. It turns out the process for buying bonds remains largely antiquated, but at least one company, MarketAxess Holdings (MKTX) is doing something about that –and making a ton of money doing so.
Fortune just ran a great article on MKTX and its CEO Rick McVey. (Fortune is always about the CEO.) But what struck me in the story, was that anyone with any knowledge of e-sourcing since 1996, will instantly recognize the simplicity of the idea! Here’s how MarketAxess Holdings’ 10-K describes the traditional bond buying process:
Traditionally, bond trading has been a manual process, with product and price discovery conducted over the telephone between two or more parties. This traditional process has a number of shortcomings resulting primarily from the lack of a central trading facility for these securities, which creates difficulty matching buyers and sellers for particular issues. Many corporate bond trading participants use e-mail and other electronic means of communication for trading corporate bonds. While this has addressed some of the shortcomings associated with traditional corporate bond trading, we believe that the process is still hindered by limited liquidity, limited price transparency, significant transaction costs, compliance and regulatory challenges, and difficulty in executing numerous trades at one time.
Seriously. That’s for a $7.7 trillion market. And here’s how Fortune describes the innovation that MarketAxess Holdings brought to bond buying:
Here’s how MarketAxess’s basic platform, which still accounts for most of its business, brings competition to the market and lowers markups. An asset manager such as BlackRock BLK 1.09% will issue a “request for quote,” or RFQ, for either one security or a list of bonds. Let’s say the asset manager wants to buy $1 million in 10-year, 3.8%-yielding Walgreen bonds maturing in 2024. Only dealers—banks and market makers—can respond to the RFQ. BlackRock sets a window of 10 minutes for dealers to respond with quotes. At the close of that deadline, all the quotes pop onto BlackRock’s screen at once. Its trader has five minutes to choose a quote, which is expressed in a “spread” over the rate on Treasuries of the same maturities. Imagine that the dealers post 10 offers. BlackRock will then typically grab the highest spread, representing the lowest price. MarketAxess gets its revenue by adding an average of 0.2 basis point to the price of each trade, or a tiny portion of the total markup.
I don’t know about you, but where I come from, that is about as close a description of a basic e-sourcing tool as I can write. It’s even a reverse auction, though by using yield or spread instead of price, it looks like a forward auction. And it’s for bonds–which are highly definable, rated, etc. It is a poster-child application of the “matchmaker” value proposition of B2B platforms.
MarketAxess started in 2000 (when else?) and went public 10 years ago last month. It has been a steady, not flashy, grower, ever since–though the stock did not take off until 2010. As a result, I am really only four years late in letting you in on this secret–and just behind Fortune magazine. (And where were my genius friends in financial services?)
MKTX still has only about 14% market share, but it has 85% market share of all electronically traded bonds. Here are some other gaudy MKT numbers from the last five years:
- Increased combined high yield and emerging markets trading volume to $151 billion in 2013 from $22 billion in 2004;
- Expanded its active institutional investor base to over 1,000 firms in 2014 from 539 in 2004 and has grown the number of broker-dealer market-maker firms to approximately 90 in 2014 from 22 in 2004;
- Increased annual revenue to $239 million in 2013 from $76 million in 2004, achieving a compound annual growth rate of 14%;
- Generated a compound annual growth rate in diluted earnings per share of 29% from 2005 to 2013; and
- Generated a compound annual return for shareholders of 20% in the 10 years ended Oct. 24, 2014 (including reinvestment of dividends). One thousand dollars invested in MarketAxess common stock at the IPO price would be worth about $5,800 today.
Here’s a graphical view of the missed opportunity!
MKTX’s innovation seems like such an obvious idea–and it is–but also note how long it took MarketAxess to really make it big: 10-15 years. These are hard slogs, not the kind of slogs most folks want to stick around through these days. Markets do not like to be made efficient. But when the market is $7 trillion plus, it is sometimes worth the slog. I wonder if MKTX makes it if it does not go public during the euphoric period of early 2000?
It will be interesting now to see if MKTX can hold on as Bloomberg and others try to take some of that gigantic market share. One big negative of making a market more transparent, standards-based, and efficient is that others can copy, or “free-ride”, and squeeze out the margins. Such was the case in e-sourcing software. Freemarkets was the pioneer, but it was relatively easy software to write and once it became an accepted tool, others were able to copy quickly. The market value created was gigantic, but that value was eventually captured by the buyers, not the intermediaries.
Never assume a market is already efficient, someone has to make it that way.
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