Thursday, 20 September 2018

Why don’t I get the context?

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SwissInvest strategist Anthony Peters takes issue with so-called market pricing

WHEN A BUNCH of old market dogs get together for the evening and decide to make an attempt at destroying the world’s remaining stocks of alcohol, much fun is had. I had one of those this very week with both buy-side and sell-side chaps, though I am recovering quite nicely again, thank you.

There will be always a few characters around the table that one has never met, but before long one has worked out who the other guy has worked with, who else he knows, whose wedding both of you went to and within an hour or so it is as if you had always been friends.

Eventually, the subject of the state of the markets will rear its ugly head.

The “state of the market” can mean one of two things. The first is the direction in which it is going. The second, and the one that was taxing minds at the last shindig I took part in, is whether there is any market at all.

I’m sure that I have already written on this subject before but the passage of time has not made it any less acute. In fact, some time ago I sent out a message to a bunch of people asking what, if a market is a place where buyer and sellers meet, you call a place where there are no buyers. At the time, my contact at Goldman Sachs wrote back “A shelf”.

THE BUG-BEAR for the buy-side are the thousands – and I mean thousands – of Bloomberg messages they receive every day with “runs”. The run more than likely shows two-way prices in dozens of securities where neither the bids nor the offers work, where the providers are neither “axed to bid” nor “axed to offer”, and where the providers of the prices have no firm clue as to who is a buyer or seller.

I have spent much of the past week trying to unload a piece of euro-denominated Spanish Lower Tier 2 bank paper. I have dozens of notes from people telling me that the security in question ought to trade in the “73.00/75.00 context”. But my client has no interest in what context they ought to be trading – he would like to know where they really will trade. In other words, where he can sell these bonds he no longer wants to hold.

The price must be where a trade can take place, not where a relative value model tells me that it ought to be

I was brought up to believe that the price of an asset – any asset – will fall until it finds a buyer. Evidently, the securities in question are not trading at 73.00. What about 72.00 or 71.00 or even 70.00? The price must be where a trade can take place, not where a relative value model tells me that it ought to be.

More to the point, the world and his wife are now obliged to mark a position in the security at 73.00 even though it clearly does not represent the real liquidation value, which is what mark to market is supposed to represent. How can you honestly mark your books to market if there is no discernible market – or not at that level at least?

SWITZERLAND, BY THE way, is still in love with its stock exchange and with the prices that it reports in Swiss franc bonds. I was chatting to a Swissli chum this week who tells me that, apparently, all major business is now done over the counter and that if I actually saw the list of firms that make up most of the volume on the exchange, I would be lucky if I recognised three out of the top 10.

But for the Swiss, especially for the auditors, the stock exchange price is biblical. So, my friend concluded, the whole country is marking its books to prices created by a bunch of small fringe dealers and brokers, something he, as an institutional investor, was clearly not happy about.

The days of “I’ll show you a price but you might not like it …” are clearly gone and with them the liquidity that the process of market-making was supposed to bring to the party.

In 2008 and 2009, during the depth of the crisis, bonds traded all day long. The prices might occasionally have been a bit erratic but at least paper was moving around and, I suppose, if buyers and sellers were meeting, the price must have been “right” in one way or the other.

Now, when everyone agrees what the “context” is, nothing is trading – and not only in unusual and tricky names and issues. The introduction of trade reporting systems such as TRACE in the United States or the Zurich Exchange are supposed to create more transparency and thus liquidity but bonds aren’t equities and one does not necessarily accompany the other.

On the contrary – it is often easier to trade a supposedly illiquid piece as buyers and sellers can determine the price among themselves and are not hamstrung by published prices, which aren’t worth the paper they’re printed on.

The most depressing and disheartening of experiences of all is when a market participant – not necessarily us – calls a dealer based either on information received on a run or a screen quote or a piece of research published, only to be told “Sorry, we don’t trade that issue”. I jest not.

There are now so many supposedly sophisticated risk-management systems in place in the banking world that big pricing errors should not happen. However, the recent example at JP Morgan proves that not all of these work quite as well as they were intended to, not least if there is a positive feedback loop being created in terms of trade reporting and book valuation.

Alas, that is one hot potato that I will hand to the SEC, sit back and merely watch with bated breath.

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