WHEN IT COMES to those conversations that begin with “Cor, do you remember …” or “Whatever has happened to …”, none crop up as often as the ones that bemoan the change in market-making that began in the credit markets but is gradually taking hold of government bond markets too – and not only the troubled ones.
In order to understand why the market-making system isn’t working, one first has to understand what made it work in the first place.
Back when chaps still wore frock coats and top hats, they’d turn up on the exchange floor to trade their securities. However, this meant that they could only trade once a day when their specific stock was called up. The price they traded was the exchange price.
In order to facilitate business, brokers began to offer the possibility to trade “off exchange” and, if they felt that they had the buyer and seller but that they couldn’t get to both of them at the same time and one needed to trade, they’d step up to half the trade in order to bridge the difference in execution time between the two parties.
This was a customer service and a small adjunct to the overall business of broking. It helped to create liquidity and that liquidity had a cost. It was the price of renting some space on the broker’s balance sheet – it was and is the bid/ask spread. The higher the risk of the balance sheet being needed for a longer period of time, the wider the bid/ask spread.
Just 20 years ago, the London market still enjoyed a “knock-for-knock” system in which banks declared the list of securities they made markets in and “reporting dealers” were obliged to make binding two-way prices to clients and to other dealers in predetermined maximum and minimum sizes.
Each morning traders would call their counterparts, ask them a two-way price, lift or hit when appropriate and be prepared to be asked for another security in return. In terms of price finding, this was second to none. However, the obligation to trade limited the size of block that could be traded on a committed basis.
Eventually, we moved to the broker-driven market where dealers made prices if, as and when it pleased them.
IN LIQUID TIMES this worked a treat as it pleased them all and by the late noughties liquid senior bank issues could be traded US$50m and up at any number of addresses in the Street. However, secondary traders were now no longer primarily here for business facilitation as they had no more than a moral obligation to make a market.
They had become portfolio managers in their own right with a salesforce to help them buy on the bid and sell on the offer, which is where such phrases as “we’re not axed buyers/sellers” or “we’re not active in that issue” came into being.
Banks lack the liquidity that would allow them to put on and take off the positions they want
All the while, these same traders were paying lip service to market-making by sending out any number of completely meaningless “runs” of prices on issues in which they had no intention of trading and that created an impression of market liquidity that was not there.
Now, with capital scarce and risk limits falling, the lack of obligation and desire to take risk at the will of institutional clients is giving the Street a bad name. But there is a more serious victim in the frame, namely the hedge funds.
We have seen them filleted during the recent period of volatility. This is not entirely, as many would like to have it, because even hedge fund managers haven’t found a better recipe for boiling water. It is largely because the Street lacks the liquidity that would allow them to put on and take off the positions that they would like to when they would like to.
IN A CHICKEN and egg situation, hedge funds both provided liquidity to and demanded liquidity from the market-makers, often their former juniors who loved to be seen to be gutsy traders while using every trade with a hedgie as a de facto job interview.
The best trade idea in the world is of no use if you can’t execute it and when the market is playing “everybody into the pond, everybody out of the pond” or as it is so stupidly known “risk on/risk off”, the limits of Street liquidity are stretched, often beyond breaking point.
There was a time when a bond was “a quarter, a half” until the bid was hit, when it became “left an eighth, three eights”. If hit again, it was “left figure, the quarter”. Prices were made by trading and not by theoretical relative values based on CDS pricing.
Each bond has a life of its own, determined by how and when it was issued, who led it and how well it had been placed. These are factors of which the current market structure pays no heed but that might once again become relevant. Real market-making is about a few houses controlling the issue, knowing where the bodies are buried and where all the knowledge concerning both buying and selling interest run together.
Maybe the old list of issues in which a house committed itself to make two-way markets in a given size was not such a bad idea. It might mean yet again that former practices, now derided, could see a revival as the era of the supremacy of the big swinging trader appears to be waning.