Electronic Trading and Market-Making in Danish Government Bonds 

In almost every EU member state, and other countries with mature financial markets, trading and market‑making in the wholesale market for government bonds take place electronically. Electronic trading and market‑making can contribute to creating efficient markets for government bonds. In Denmark, trading and market‑making in the wholesale market predominantly take place by telephone. Implementing electronic market‑making is therefore a key aspect of developing the Danish market for government bonds, and bringing its facilities in line with standards in other countries with mature financial markets. Electronic trading is furthermore a precondition for new securities dealers finding it attractive to become market‑makers in Danish government bonds. 

Work is ongoing to establish electronic trading in the wholesale market for Danish government bonds using the electronic trading system MTS as the platform. Today, MTS is the dominating system for wholesale trading of European benchmark bonds. 

Closely related to the establishment of a Danish MTS solution, the design of a primary dealer system is also under preparation. Electronic trading and primary dealer systems can supplement each other in creating more efficient wholesale markets for government bonds. 

Section 9.2 describes the advantages of electronic trading in government bonds. Hereafter Section 9.3 presents how electronic trading and primary dealer systems can supplement each other in creating a well-functioning wholesale market for government bonds. Section 9.4 describes the background to the ongoing work of establishing electronic market-making in the wholesale market for Danish government bonds. Finally, Section 9.5 presents the background to choosing MTS as the platform for a Danish electronic trading solution.

9.2 Advantages of electronic trading on government bond markets

Despite the advantages of electronic bond trading, electronic trading systems have been introduced more slowly in the bond markets than in the currency and stock markets. In recent years, however, there has been a rapid development in electronic trading, also in bond markets. This applies especially to trading in government bonds. The development of IT technology has made it easier and less expensive to trade various types of securities electronically, and the trend internationally, including within Europe, has been for greater standardisation of government issues. Electronic trading systems are best suited for standardised products where both buyer and seller are familiar with the product, and therefore do not need to be in contact with each other. 

In almost all countries with mature financial markets, trading in the wholesale market for government bonds today takes place electronically. 

The various advantages of electronic trading are inter‑related and mutually reinforcing. The key advantages are: 

• Lower trading costs 
• Economies of scale and scope 
• Greater transparency in the market 
• Better risk management 
• More potential market participants. 

Lower trading costs . When securities are traded electronically, part of the dealers' work can be taken over by so-called price machines, i.e. software that on a current basis matches offered bid and ask prices on the basis of the market information (pre‑trade information), automatically received by the system. This means that one dealer can monitor several markets simultaneously, thereby saving resources. Once a deal has been closed, the relevant information is transmitted automatically to both buyer and seller, who can then each use the data as input to internal systems, i.e. risk‑management systems, bookkeeping systems, etc. This reduces the resources devoted to registration in the dealers' own systems. Finally, today's sophisticated electronic trading systems have facilities to package details of all trades in the system, and send on this data for use in clearing and settlement. This saves the resources that each dealer would otherwise devote to receiving trading data and on that basis providing instructions on clearing and settlement.

Market information can be collected quickly and cheaply in electronic trading systems. As described, the pre‑trade information held in the system is available to dealers automatically, e.g. as input to price machines. Since all trading information is registered, trading statistics, i.e. post‑trade information, are also available at no additional cost. 

All other things being equal, lower trading and trading‑related costs will contribute to increasing trading volume and thereby greater liquidity. 

Economies of scale and scope.  Electronic trading systems offer economies of scale. Once an electronic trading system has been introduced, the marginal costs of each individual transaction are minor. The marginal costs of involving additional market participants are also small. There are also economies of scope, since dealers that are active in different markets will prefer the same system to be used in all markets. In this way, the success of some electronic trading systems will be self-rein­forcing. 

Greater transparency.  Electronic trading systems make it possible to achieve greater transparency in the market. One factor is that gathering market information becomes less expensive, but the main reason is that it is now possible to base investment decisions on pre‑trade information concerning the prices and amounts that can be bought and sold in the market. How far and in what way the greater transparency potential is utilised, will be determined within each market. 

Better risk management.  Electronic trading provides for better risk management, first and foremost because straight ‑through processing ensures fast and secure registration of relevant trading data in the right systems. The operational risks in both front‑ and back‑office functions are reduced. 

More potential market participants . Electronic trading systems are global in the sense that market participants' opportunities to trade are not governed by their geographical location. This is also true for telephone‑based trading, but not for floor trading. Moreover, electronic trading systems can accommodate a very large number of participants who can be in the "marketplace" simultaneously to offer bid and ask prices. Electronic trading therefore gathers a far greater number of dealers as potential market participants. 

These advantages entail that electronic trading can create a more effective and liquid market for government bonds. An efficient, competitive market is to the benefit of both borrowers and investors. For sovereign issuers, a well‑functioning market with tight bid-ask spreads makes it more certain that the government borrowing requirement can continue to be financed on attractive terms. 

How the potential advantages of electronic trading are utilised also depends on the interaction between electronic trading and the other elements of the market structure, including e.g. primary dealer systems.

9.3 Interaction between electronic market-making and a primary dealer system for government bonds

In most OECD countries, primary dealer systems support the objective to ensure well‑functioning wholesale markets for government bonds. Primary dealers are financial institutions that on the basis of an agreement with the issuer are committed to participate in the marketing and sale of government bonds^[1]. 

There is no international standard for the design of primary dealer systems. To varying degrees, the existing systems take specific national con­ditions into account. In step with the internationalisation of bond trading, especially after the introduction of the euro and the joint financial market in the euro area, there has been a tendency for greater uniformity between primary dealer systems. This tendency is e.g. related to the fact that especially within the euro area, a number of large banks are primary dealers in most national government‑bond markets. 

At the heart of primary dealer systems is the combination of the rights and obligations allocated to primary dealers. Both the rights and the obligations are determined so as to give primary dealers an incentive to trade in the market in a way that utilises the potential advantages of electronic trading. Primary dealer and electronic trading systems in this way supplement each other in the wholesale markets for government bonds. 

Sovereign issuers are parties to primary dealer systems and have a decisive influence on the concrete design of the systems. They hereby have favourable opportunities to create more efficient wholesale markets for government bonds, to the benefit of government borrowing in the future. 

The key obligation to which primary dealers are subject is to offer current bid and ask prices within fixed spreads and for fixed amounts. Thus, it is a market‑maker obligation towards the secondary wholesale market^[2]. Market‑making ensures continuous liquidity in the market. The transparency provided by an electronic system gives the participants in the system – and others with access to the market information – detailed pre‑trade information on the prices and amounts that can be traded in a given paper. Market‑making and electronic trading systems in this way supplement each other in creating a more efficient market. 

In addition to the market‑making obligations, the primary dealer systems usually entail a number of less specifically formulated obligations such as the requirement of active participation in issues and buy‑backs of government bonds, and the requirement to keep the issuer updated on market developments, etc.  

In return for these obligations, primary dealers are granted certain privileges, first and foremost related to a preferential right to purchase government bonds on issue. Primary dealers' rights also serve as incentives to promote liquidity and activity in the market. In this way too, primary dealer and electronic trading systems supplement each other in achieving a more efficient market.

9.4 Background to establishing electronic market-making in danish government bonds

In the mid‑1980s, Denmark was the first country to introduce electronic trading and registration of securities. However, disregarding the transactions to which Danmarks Nationalbank is a party on behalf of the central government, trading of government bonds in the trading systems of the Copenhagen Stock Exchange is limited. Trading and market‑making in the wholesale market for Danish government bonds take place predominantly via the telephone market. 

In almost all EU member states and countries with mature financial markets, trading and market-making in the wholesale market for government bonds take place electronically. Implementing a competitive solution for electronic trading and market‑making is an important part of developing the Danish market for government bonds and bringing the facilities in the Danish market in line with current standards in other government securities markets. 

The objective of a Danish solution for electronic trading and market‑making in government bonds is to achieve the advantages described in Sections 9.2 and 9.3. The focus of the ongoing work has been especially on the lower trading costs, greater market transparency, and easy access to the Danish market for government bonds for foreign market participants. 

Transparency in the Danish government bond market is today primarily based on the post‑trade information provided via dealers' reporting of transacted deals. Electronic trading and market‑making will ensure that pre‑trade information concerning the wholesale market is easily accessible. 

There is an objective to attract new participants to the wholesale market for Danish government bonds. Government bonds are traded in a global market where government issuers more than ever before are confronted with international competition for investors. 

There are now only few active participants in the Danish wholesale market for government bonds and their numbers are declining in step with the consolidation in the sector. New (foreign) market‑makers will only be interested in joining the Danish market if the fixed costs of establishment and less variable costs are at the level of those in other wholesale government securities markets. New market‑makers will only see a business advantage from participating in the Danish market for government securities if trading takes place electronically, and on a platform which the new participants already use in other bond markets. In other words, electronic trading and market‑making are a necessary, but not sufficient, precondition for attracting new foreign market‑makers to the Danish bond market.

9.5 An MTS solution for electronic trading and market-making on the wholesale market for danish government bonds

The Danish market‑makers and Government Debt Management together hold ongoing discussions on the design of the wholesale market for Danish government bonds. During these deliberations, there has been agreement on the need to introduce electronic market‑making. International banks have likewise expressed their support for this. 

Market participants agree that a Danish electronic market‑making solution could profitably be based on the MTS trading system^[3]. The reasons are as follows: 

• MTS is now the dominant system for wholesale trading in European benchmark bonds, cf. Table 9.5.1 
• International banks operating in EU government securities markets already use MTS. Therefore, without additional costs to their systems, they will be able to become market‑makers in a Danish MTS system 
• MTS is a system developed for bond trading 
• Experience in other countries indicates that only an MTS solution will make it possible to attract new foreign market‑makers to the Danish market for government bonds. The feedback received by Denmark's government debt management clearly points in the same direction.
  
  

An MTS solution can be established either as a separate MTS company or as a market segment under an existing MTS company. The choice between these two solutions is a question of the market participants' opportunities to influence the strategic decisions made in the respective MTS companies in the longer run. On the other hand, there is no difference between the two solutions in terms of freedom to determine the design of the market, including rules for market‑making. 

Originally, the MTS system was disseminated by the establishment of additional independent national MTS companies. However, recent developments have been towards establishing separate segments under existing MTS companies. In Finland, a market segment has been established under MTS Associated Markets (MTSAM). This is a Belgian MTS company under which there is now both a Belgian and a Finnish market segment. In Ireland, a market segment in EuroMTS has been established. EuroMTS is the international MTS platform for trading large benchmark bonds. 

Several market segments within the same MTS company presents certain advantages. Firstly, the segments can share the administrative costs of operating a separate company. Secondly, the segments can agree on "discount schemes" that make it more attractive for participants in one market segment to participate in other segments within the same company. As stated above, the internationalisation of the group of primary dealers has led to a number of international banks participating as primary dealers in several of the government securities markets within the EU.