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Thursday, 19 October 2017

Pay to play

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FOR OVER A decade from the early 1970s to the mid-1980s, British television was graced (if you’ll pardon the pun) with a rather simple sitcom about the staff of a department store, called Grace Brothers. The programme, titled “Are You Being Served?”, is best remembered (if it is remembered at all) by the catchphrase often uttered by the camp Mr. Humphries. “I’m free”, he would regularly cry. It was about being free to serve, not about serving for free.

Like Mr. Humphries, we work in what is described as the service sector. We sell service and we expect to be paid for it. The harder we work for our customers and the better we serve them, the more we deserve to be paid. Simple.

But one day someone dreamt up the idea of “best execution”, which means that rewards are to be enjoyed not by those who provide the best and most consistent service, but by those who simply offer the best price.

As a result, our industry is in a fix. Best execution has sidelined the hard-working salesman or broker as institutions are required (in the name of their clients, but in truth in order to assuage their control and compliance departments) to take the most competitive price.

By which they mean, the best of three or four or five instantly tradeable prices. Who cares whether it is the best achievable price, so long as it is the best instantly visible price? We all know that it’s the wrong way to go about things, but regulation is not about best practice and investors’ money, it’s about making sure that the right boxes have been ticked.

Tightening capital and risk requirements have basically put an end to market-making as we knew it

THE REAL FIX, though, is a bit different. Tightening capital and risk requirements have basically put an end to market-making as we knew it. Dealer inventories are sharply lower – in some cases by as much as 75% since 2008 – and hence a significant proportion of investment banks’ fixed income departments’ core revenue has also evaporated. Banks have therefore had to move into what is effectively broking, but broking doesn’t pay the way that positioning did (much of the cost of the trading floor used to be covered by the carry on the trading books).

The banks have thus taken away what is in effect broking business from the brokers. The latter now struggle to live on what’s left and the former stand no chance of covering their enormous costs from low-margin, risk-free business alone and without the big carry book. In other words, both banks and brokers are up the Swannee without a paddle.

THERE THEN FOLLOW, just to make life even harder, the expectations of the buyside, whose own oversight authorities have drawn up the best-ex rules based on some unquestioning assumption of deep and persistent liquidity in the industry. By now they should all know that it doesn’t really work, but in the binary world of box-ticking, a holistic interpretation of best execution is often a step too far.

I lunched last week with a trader turned broker who came back to the City from early retirement. He had traded bonds for 14 years at the same Tier One shop and is, in City parlance, financially “done”, so his return was more about boredom than any particular material necessity.

He told me over “a sneaky couple of glasses of white” of a chum of his who works for one of the very top investment firms – think top 10 if you care, or maybe even higher – who wished to sell €3.8m of a go-go corporate bond. He noticed one of the dealers – it might have been a highly rated American shop – to be an axed short and buyer of €2.25m of the same issue. He duly made the call, only to find that the bid worked in €2.2m and not in a penny more. Not even for his name. That’s an example of the limited market liquidity available to a top client in a good market.

THERE IS A cost to doing business and this is, for the banks, rising at a time when revenues are falling. The low-cost producer, the back-to-back broker, is being squeezed out by many clients’ inability simply to leave firm orders. There have, of course, always been times when orders have been executed because a rising or a falling market has helped to bring the price on-side. But what’s so bad about that? Stock markets live and die by price movements. Bond people, obsessed by spreads, often seem to be incapable of getting their heads around that.

In order to satisfy the onlookers, relationship business has largely been sacrificed in favour of transactional business. That is fine in the happy times, but with such limited liquidity around now and the expectation of a lot less when markets begin to fall, what little there is will be saved by dealers for investors who didn’t squeeze the living daylights out of them when they could.

This is, therefore, a time when those most likely to find themselves on the wrong end of the trade, the most exposed class of investor – namely mutual funds who can be forced to sell at any price in order to meet redemptions – should be making friends. Following a strict best execution policy is not the way.

What part of that is so difficult to understand? Sink the ship for a ha’penn’orth of tar or – pay to play? For that, I’m free.

(A version of this commentary will appear in the July 13 issue of the International Financing Review, a Thomson Reuters publication)

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