The differences between exchange-traded and over-the-counter (OTC) markets
Before XTBs, dealing in corporate bonds was mostly the domain of institutional and sophisticated (or wealthy) investors. These investors traded bonds ‘over-the-counter’ (OTC) in the wholesale market.
OTC trading is a colloquial term used to describe trading that takes place away from stock and derivatives exchanges. Bond and currency trading mostly takes place OTC. Globally these markets dwarf equity markets in turnover. In fact, more financial market trading takes place OTC than it does on-exchange.
No central marketplace
There is no central marketplace like ASX or Chi-X for OTC trading in corporate bonds and government bonds in Australia. Trading occurs over the phone or via Bloomberg between the various participants in the wholesale market. These participants are generally banks, asset managers, bond brokers, and proprietary trading firms.
OTC trading usually involves buying in large parcels. Sometimes corporate bonds can be broken down to $50,000, but more commonly trading is in $500,000 parcels, too large for most investors. Even $50,000 can make it difficult to split your investment across a range of bonds.
XTBs come in $100 lot sizes specifically to address this problem. Investors can now access the returns from individual corporate bonds and can build a diversified portfolio of XTBs from only a few thousand dollars. This makes the capital stable returns from corporate bonds accessible to a much wider audience.
No transparency in OTC trading
If OTC trading isn’t well known to you, that’s probably because there is little or no transparency in OTC trading. There’s no central market for the media to report on daily, like they do with shares. Trades that occur OTC and their prices and volumes are not centrally reported.
The downside for smaller investors is that there’s no clear price to compare to see if they’re getting a fair price. Each broker or bank quotes their own bond prices on a transaction-by-transaction basis. Fees or commissions are generally included in the price you pay, rather than being disclosed.
What about fees?
You should not believe it if you’re told you don’t pay brokerage or fees for trading bonds OTC. There is always a fee. If it’s not disclosed as brokerage, it will be a margin added to the price you pay, compared to the price they bought the bonds in the wholesale market.
The lack of transparency in OTC markets is the opposite model to the exchange world where all trades must be reported to the market, along with all trade prices and volumes. Before you trade on exchanges, all orders are ranked – first by price priority (best price trades first) and then by time priority (first in at a price trades first). This ensures the system is fair and all investors get the best price possible when they buy or sell.
In the OTC world, you’ll trade at a price agreed between you and the bank or broker. Unless you’re a fund manager or another bank or broker, this generally means you’ll trade at the price you’re given. You will not have any visibility of other recent trades to compare your price, because the market is opaque.
Nobody knows how much volume goes through, or even in what securities. The media needs news and data to report on markets, so they focus on the transparent equity market and far less is said about the opaque OTC markets, except at a headline level.
OTC price lists
Some brokers publish corporate bond price lists, which are usually quotes from the day before, generated by the banks that are the main participants in the OTC bond market.
- They’re a day old.
- For retail investors these were not prices you could actually have traded at yesterday anyway. They are the starting point for a bilateral trade discussion between the bank and brokers.
- The broker will either add a mark-up to that price, or on-sell the bonds to you with brokerage attached. If there is no transparency on brokerage from the broker, then it’s likely they’re selling the bonds at a higher price than they bought them for. When you ask them what this margin is, they will generally not tell you.
The lack of transparency in wholesale OTC markets is there by design. It works for the banks and fund managers who prefer this structure, and OTC markets have always worked this way. It works and from their perspective it’s efficient.
What’s best for small investors?
You can easily argue it’s not the best model for regular or small investors compared with the transparent market you get when you buy shares, REITS, ETFs, or XTBs on ASX or Chi-X.
XTB prices at which you can buy or sell at immediately are published throughout the trading day on the ASX by the XTB Market Makers, who are subject to market surveillance by both the ASX and ASIC.
Let’s compare buying bonds in the wholesale market with buying XTBs over the same bonds on ASX via an online broker or digital wealth management platform:
OTC: Trading is generally over the phone and you’ll be told the buy or sell price. They won’t tell you both at the same time, as they will not want you working out how much margin they are charging you.
ASX: You can see the prices of XTBs on ASX before you trade. You’ll see the buy (bid) and sell (offer) prices, and what volume is on offer. You immediately see all the trades that go through, so you can compare the price you might trade at.
XTBs were developed to provide access to corporate bond returns, in reasonable $100 lots, and on an exchange where the transparency works in favour of smaller investors.
OTC bonds have a big technology problem when it comes to delivery to individual investors. Most of the technology used to bring investments to everyday investors relies on transparency of prices and firm orders to execute against.
Think of the times you may have bought BHP shares via an online broking account or digital wealth management service. These services simply wouldn’t work if you were told you can’t see today’s prices or you need to call a hotline in order to trade.
The managed funds, shares, ETFs, XTBs, REITS and other securities that people invest in are on ASX. Or they’re on Wrap Platforms, and sometimes both. In all cases, you can see prices that you can trade at. Platforms and ASX and CHESS are fully integrated with each other. This makes the entire system, or distribution grid work.
But corporate bonds aren’t in CHESS, or on platforms. They’re held in Austraclear, another institutional investor system similar to CHESS. This may seem rather academic. However, if securities aren’t compatible with the distribution technology, then you won’t be able to access them.
A combination of the opaque OTC market structure and the fact bond issuers do not want to list their bonds on ASX and CHESS is the reason corporate bonds are generally incompatible with Australia’s investment products technology grid. Little wonder the retail corporate bond market has struggled to develop, despite many a government review saying it should.
This is exactly why XTBs were developed, and AGBs for government bonds. From a technology perspective, XTBs and AGBs took corporate bonds and government bonds from the opaque OTC world, and put them into the transparent world of ASX and CHESS
There is a much wider range of bonds in the wholesale market than on ASX in government bonds via CDIs and corporate bonds via XTBs. But the range of on ASX is growing as new XTBs are issued and ASX brings out more CDIs over new government bond series.
Overview of XTBs on ASX vs OTC
Certain investors may be able to access minimums of $10,000 or $50,000
|FEATURE||XTBs||WHOLESALE BOND MARKET|
|Product Range||ASX 100||
|Separate account opening required||No||Yes|
|Retail / Wholesale||All investors||Mostly sophisticated or wholesale investors|
|Liquidity||Yes, via Market Maker||Yes on a request basis, but OTC|
|Investment amount||No minimum||Minimum generally $500,000. Certain investors may be able to access minimums of $10,000 or $50,000|
Applicable brokerage charged by your broker.
|The Fee is part of the spread payable to the bank or broker, which can vary.|