LAST WEEK I wrote about the way in which market-makers are all too often whipsawed by investors with more power than themselves, and how as a result their very existence is being threatened. In response, I received a call from one investor who had little to no sympathy for the Street which, in his view, had spent enough time nickel-and-diming clients out of every penny and who are experiencing nothing more than their own medicine.
Not only that, but he expressed a strong element of resentment for the way in which “the market” is subjected to the idiosyncratic needs of individual dealers.
Let me explain. In the “good old days”, the International Capital Markets Association, the trade body of the European market-making community, and its forerunner, the Association of International Bond Dealers, served as the arbiter of bond pricing – via the Council of Reporting Dealers. Market-makers submitted their closing prices to the council and these were compiled to give an “official” close to all bonds. This worked well when the universe of bonds and of issuers was limited but the rapid expansion of markets, especially in the credit space, has significantly changed the environment.
Markit, originally dreamt up and still in effect controlled by two of my former colleagues from Wood Gundy days, Lance Uggla and Kevin Gould, recognised the lack of efficient and consensus mark-to-market values. Markit was largely able to resolve the issue for the CDS market and it was long assumed that if one had accurate pricing for the derivative, the price of all related cash products could be accurately … well, derived.
IN MARKETS, THE derivative tail can happily wag the cash dog until a crisis occurs and investors want to see real, working prices and not just receive hypothetical values based on where a security would be priced if nobody cared to either buy it or sell it.
Things have, however, moved on yet again. The hunt for yield in the low interest rate environment has brought issuers to the market who a few years ago could not have borrowed a cup of sugar – I won’t go into what I think about, for instance, Angola as a borrower in public markets – and central authorities love the idea of risk being on investors’ books and not on those of the banks.
The effect is a bevy of issues with only one or two price-makers. We know that many of these will offer neither a working bid nor a working offer and thus they can price securities as and where they like with utter impunity. That might work for them but it plays merry mayhem with investors who have to provide daily liquidity and for whom an accurate price against which to mark a position is of paramount importance.
There seems to be a generation of traders that has forgotten that this is not a computer game
I REPORTED LAST month on the dealer who found he’d made a mistake in buying a different bond than the one he thought he had and, wholly forgetting that he had entered into a binding contract, simply unilaterally cancelled the transaction. I remarked at the time that there seems to be a generation of traders that has forgotten that this is not a computer game that can be rebooted but a business relating to other people’s hard-earned money.
Well, the same issue comes into play when books need to be marked. There is a habit developing, especially in some of the less common credits and especially in the high-yield market, to randomly mark bonds in which the trader has not got a position and no desire to acquire one. Often the dealer’s mark is the only one available to the investment manager and although it is of no particular consequence to the trader in question whether the mark is an adequate reflection of a tradable price it is of vital significance to the valuation of the portfolio.
It’s barely news that portfolios should not be valued to the mid-price but to the bid as that is the price at which the book should be able to be liquidated. When marks are played with fast and loose, there is a follow-through effect, firstly on the money manager’s performance and then, far more importantly, on the value to the actual end-investor. The further investors step away from the mainstream credits in order to find a bit of extra yield, the more exposed they are to rogue valuations.
THERE HAVE BEEN cases – and I’m sure most credit investors have experienced this – where the market appears to be presenting a nice little backwardation that quickly transpires not to be one because neither the low offer nor the high bid actually “work”. It’s relatively easy to place the debut bond of a medium-sized German metal-basher or a French software group if it pays mildly over the odds for money, but the extra yield, when adjusted for the wider bid/ask spread if the paper needs to be sold after a reasonable holding period, must in the end still leave a pick-up and hence make economic sense.
The feeling is, however, that this is not the case and that investors are being given the impression that there is a price for a security when there isn’t and, even worse, if the asset needs to be sold the real bid proves to be a country mile away from the mark.
Investors are none too happy about the randomness with which some risks seem to be marked and I do hear repeated complaints from the buyside that the trading community neither knows nor cares what effect sloppy valuations can have on its customers.
As aggressive price expectations by the buyside have taken hold and as best-ex sinks mutual trust and loyalty between dealers and investors, so the former’s desire to help anyone other than themselves fades into history. There used to be a wine bar in the City called The Altruist. I can’t really imagine another one opening under the same name.
