Welcome to Interest Rates Trading
I made a pithy (140 characters) joke on Twitter about how boring it is to be a trader at a bank these days. Let me elaborate on a few of those points as it’s a good springboard to talk about some of the deep flaws in the current market microstructure:
- Customer requests quote— Only dealers have direct access to the US Treasury market. In order for customers to trade Treasuries they must first request a bid (to sell to the dealer) or offer (to buy from the dealer). This can either be done over the phone (Amazingly, still about 50% of transactions by volume) or through an electronic system such as Tradeweb.
- Copy & paste quote from Tradeweb— US Rates are a highly liquid market. The price of on-the-run bonds (the most recently issued) is readily available in the inter-dealer broker markets. The price of off-the-run bonds is less liquid, but can be determined by using a curve model to fit bonds. Only about 5 of the largest banks actually have a sophisticated enough model (and it’s not that sophisticated) to contribute a unique price. Everyone else just copies & pastes the quote and then applies a rigid tiering modifier (basically, how much do we like you) to the price.
- Slam out of risk on BTEC— BrokerTec is one of the two inter-dealer brokers that have ample on-the-run Treasury liquidity. On-the-runs can be hedged directly, off-the-runs are hedged with on-the-runs and you take the spread risk. Few dealers have invested in the technology to smartly get out of risk. Traders will just slam the markets with more size than it can bear. Inevitable this leads to terrible execution quality and the trader will end up losing money on the trade even though they got paid full bid-offer by the client.
- Yell at IT— It’s never ever ever ever the traders fault for poorly managing risk. It must the IT team for building crappy technology.
If this sounds like a terrible system for all parties involved, it is. Customers pay full bid/offer (especially on phone trades), dealers make no money, and an antagonistic relationship between traders and technology means nothing gets improved.
It doesn’t really have to be this way either. Customers just want to get done on their trade and aren’t really concerned about the source of liquidity. Dealers (and Customers) would be much better served if they facilitated a customer’s trade through a combination of principal market making (when it fit with their book) and agency execution instead of always feeling like they need to take the other side of every trade.
