Why we invested in Cicada

The Bond-trading Revolution in the Emerging Markets

The rise of e-trading that took over equities, futures, FX, and commodities markets in the 1990s has just recently started to reach the hard currency bond market vigorously. Fixed-income markets have been the last to digitize due to their oligopolistic nature and lack of incentives on the sell-side, but it’s gaining momentum by the day. The trend seems to be irreversible: 38% of all US bond market transactions in 2020 were done electronically, up from just 19% two years before.

Although hard currency bond trading is changing rapidly in developed markets, local-denominated fixed-income securities in emerging markets still trade over-the-counter mostly. For those not familiar with the fixed-income market slang, this means that transactions are not negotiated on centralized exchanges, but rather on a client-to-dealer basis and a dealer-to-dealer basis. The client represents the buyside (insurance companies, mutual funds, pension funds) and the dealer represents the sell-side (banks’ trading desks).

Under the traditional system, only the dealer or sell-side can provide liquidity to the buyside. In simple words, every trade must go through a sell-side intermediary. In addition, these over-the-counter transactions are executed through non-electronic means, primarily through the phone but also through other non-standardized means of voice or written messaging. Approximately 85% of the US$7bn daily traded volume of local government bonds are executed telephonically or through instant messaging.

Cicada proposes the first true electronic, anonymous, “all-to-all” trading protocol for fixed-income securities in local currency. True electronic means that the trading platform relies only on an algorithm to execute trades end-to-end, while “all-to-all” means that any participant can provide liquidity to the buyside. Besides eliminating the need for a sell-side intermediary, this protocol brings several advantages compared to the traditional system:

1. Anonymity: the traditional system trades are P2P, and the counterparty is known. With Cicada, trades are 100% anonymous.

2. Automation: the traditional system trades are negotiated through telephonic conversations or messaging systems. With Cicada, trading is 100% electronic, from order placement to execution and settlement. Quoting can be easily automated through trading algorithms.

3. Price transparency and access: through the traditional systems, trading is only possible between participants with a prior established legal and commercial relationship. An all-to-all environment means parties can trade with anyone regardless of their previous relationship, bringing price transparency to the market.

4. Spread compression: The spread represents the difference between the highest bid price and the lowest ask or sell price. An “all-to-all” environment where every participant can transact with each other generates increased competition and liquidity, therefore resulting in spread compression.

The fourth point is perhaps the most relevant and what is truly innovative about this opportunity. The benefits are clear: lower costs will bring better returns for the buyside, and in turn to millions of small investors. Just as a reference of the impact “all-to-all” protocols can generate, it is estimated that MarketAxess, Cicada’s US-based peer, has reduced the US corporate bond market spread by 50%.

Cicada estimates that annual system-wide transaction costs in the Mexican government bond market totals US$1.8bn. Using a conservative price point for Cicada’s commissions, the company estimates that savings through this type of protocol could amount to S$1.5bn, from the reduction of bid-ask spread and the elimination of intermediation fees for the Mbono market only. This means that for every US$1 Cicada generates in revenue, the system would benefit with approximately US$5. This is the kind of large-scale impact we are looking for in the solutions that our portfolio companies bring to the market.

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So why now? After all, these inefficiencies in the local-denominated bond market have been present for decades. There’s no particular reason. It’s just the first time that three market insiders from LATAM got together and decided to solve this problem. We strongly believe that given the concentrated, closed-loop, and highly regulated nature of this market, the right executioners should be local insiders. The founding team, Javier, Ignacio and Manuel, clearly match the profile.

As mentioned, it hasn’t been done so far. There’s virtually no competition in the market when it comes to the development of an “all-to-all” local bond trading protocol. We’ve identified two potential threats, and after a thorough assessment, we concluded that the competitive threat is low:

- Local platforms like Remate, Enlace, Icap, GFI, or Tradition that provide a screen with prices, which participants use as a reference, to later execute directly through the phone.

- Platforms like Bloomberg, which provide a chat system and a RFQ service. Again, they are not focused in developing an “all-to-all” trading platform.

The most compelling and innovative part of the proposition for the buyside is not the efficiency generated by the partial or even full digitalization of the trade, but rather the spread compression that can be generated by an “all-to-all” environment.

Among global competitors, MarketAxess has been a pioneer in the development of “all-to-all” protocols in the U.S. However, their focus has been in hard currency bond markets, and they have not been able to develop this type of protocol for local-denominated, emerging markets securities. There are commercial, legal, and operational local complexities that mitigate MarketAxess’ competitive risk significantly.

Along with the advantage of being first movers, both the theory and empirical evidence from international peers seem to indicate that this is an opportunity where the winner takes most of the market. The more sell-side and buy-side participants use Cicada, the more valuable the exchange becomes, and the higher value participants extract in terms of increased liquidity and compressed spreads. Once a certain level of depth is achieved, new and current participants have no incentive to move to another platform.

Assuming an adequate execution in tech and product, as well as an effective initial commercial effort to drive the adoption of large institutional players, the company is well positioned to secure and sustain a large share of this market. This is perhaps the cornerstone of a very compelling case built around Cicada as a global category leader in bond trading in emerging markets.

There’s a very long way to go, but we couldn’t be more excited about this team and this opportunity. Let’s keep rising!