LIQUIDITY, TRANSPARENCY AND the warped relationship the regulatory authorities have with understanding both has been occupying me since the beginning of the global financial crisis.
It has long been clear that regulators, who have never traded a bond in their life, believe that transparency fosters liquidity – which most of us who have traded bonds know isn’t true – and that in pursuit of this Holy Grail they have sown the seeds of a future bond market crisis.
I heard last week that even the US Treasury is becoming rather concerned that the market in its bonds, supposedly the most liquid in the world and the financial markets’ safe-haven of choice, is beginning to struggle. I raised this point in one of my daily columns and the machines started pinging with inward messages and the phone went on perma-ring.
Perhaps one of the most significant calls came from the global head of rates sales at a proper global house. He revealed that, just a few years back, it was accepted that a trade in under US$250m in a US Treasury security would not move the market but that, under current conditions, the relevant size had shrunk to US$85m. No wonder the Treasury is worried. Banks’ ability to trade has been filleted by regulators and the push towards best execution and platform trading has made things significantly worse.
My global head chappy took the opportunity to let loose about the nonsense that now affects everyday business. Liquidity is not some abstract, computer-driven model but the function of the aggregation of players in the market being willing to provide it. When things get tough, the little bit that is left will be reserved for those who acquired the right to it.
Banks’ ability to trade has been filleted by regulators
FRENCH INVESTMENT FIRMS probably have the worst reputation for being shameless price-takers. They and their “tables de nego”, their execution desks, ruthlessly pick off prices. They are happy to decline phone calls and want no more than access to trading platforms but are then surprised that when price action is choppy other traders happen to be “off the desk” when their enquiries pop up on screen or that an enquiry was missed “because our systems were temporarily down”.
Price discovery should not be a yes/no process. The quid pro quo for liquidity is information exchange. If a dealer understands a client’s what and why, he’s more likely to work around that investor’s requirement. Having learnt my trade in American markets where offering a firm bid or offer is courteously met with a firm offer or bid in return, living with “Non!” without further feedback or the attempt to find a mutually acceptable price leaves me deeply uncomfortable. A motivated seller and a motivated buyer should, in most cases, find a price that works. If customer and dealer only ever meet via a hit, lift or pass button – as if trading was some sort of X-Box game – this won’t happen.
Pressure on balance sheets has pushed banks into allocating capital away from trading and with every downgrade that hits the sector, capital requirements increase. Best execution rules, which remove a lot of the P&L once generated by customer service being properly rewarded has rendered it even harder to make a decent return. Thus, one must wonder, when will the first major players decide that it just isn’t worth it any more and shutter their dealerships?
ALL THE ABOVE applies in our current bull market. The Treasury’s concerns are about what happens when the Fed finally begins to tighten. Whether that will be the second half of this year or the first half of next year is a matter of opinion but one does not need a PhD in order to extrapolate the effects of investors trying to sell bonds to dealerships that are already snowed under with unsold stock. Friends and family first, those who took liquidity and gave nothing back in return can kindly form an orderly queue.
I have in the past even heard of central bankers issuing warnings to the regulatory authorities about some of the negative effects on market efficiency that ever tighter regulation and compliance rules bring with them. I was told that these were either not heard, or not listened to. Whether the Treasury will have any more success I venture to doubt.
As I wrote in the aforementioned column “regulators and compliance departments are just like those legendary generals who are busily preparing to fight the last war while they are doing nothing to prepare for the next one … Restrictive regulation has developed a life of its own, which gets a huge high from demonstrating the power it exercises over those horrid little traders who get paid fortunes for having fun.”
In short, our markets are in a lamentable state. Risk-taking is a holistic activity and all the computers and risk-management systems in the world can’t take that away. Gung-ho trading has been squeezed out and the new breed of traders isn’t brought up on how to take risk – but on how to avoid it.
When the brown stuff hits the propeller, and hit it it will, the lawyers, accountants and politicians – ably assisted by sycophantic bankers scared of losing their seniority – who created the one-eyed, one-legged, one-armed cripple from what was once a well-functioning, liquid bond market will surely be found crawling around under their desks looking for that elusive pen they lost some years ago. “Not my fault, guv, I was just doing my job.”
