Bull Market
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Bull Market

Putting one’s money where one’s mouth is

Dear Buy-side. You seem very concerned about liquidity. Can I suggest paying for it?

Attention conservation notice: More techie and market-oriented than my normal posts

At the moment, a lot of the great and the good are writing letters to the newspapers about liquidity, sponsoring blue-ribbon panels on liquidity and carrying out central bank research projects on liquidity. They will tell the Wall Street Journal that they’re worried about the biggest liquidity crisis in recent history, and warn the Bank for International Settlements that new capital regulations risk a massive liquidity shock if and when the interest rate cycle changes.

In short, as far as I can see, people in the market are prepared to do anything to improve bond market liquidity except pay for it.

This is not rocket science. The matter at issue is that the regulatory changes made in the wake of the financial crisis have the effect of greatly increasing the capital requirement for bond trading. As a result of this, banks are devoting less capital to holding inventories, and so it is more difficult to get a big trade away without moving the price against you. Lots of people think that this might be somewhat dangerous, particularly once interest rates start to go up, and investors start to rearrange their portfolios accordingly.

But hold on. There’s no law of the universe which says that a higher capital requirement for inventories should mean that banks stop wanting to be in the business of bond trading. What ought to happen is that, if the capital requirement is higher, pricing should go up, in order to cover the cost of the larger capital requirement.

Right, yeah, can anyone tell me why market makers are not dedicating more and more capital to this fantastic industry?

And that hasn’t happened. For one reason or another, investors still want to execute bond trades for single digit basis point spreads. They also, as the forex and LIBOR litigation shows, want to get the highest standards of best-execution for that price. And nobody wants the banks to be able to use their order flow to make money on proprietary trading, god forbid.

If you consistently demand to be provided with a Cadillac service, but to pay Fiat Yugo money, then you shouldn’t be surprised that a) it’s going to get harder to find a car service at the times when you want one, and b) that the Cadillacs which eventually roll up seem to be getting older and older and in a worse and worse state of maintenance.

If you ask for a Cadillac service but only pay Yugo money, this is what you get

The buy side seems pretty determined to ignore this fundamental economic fact, though. At the moment, their answer appears to be to try and set up multilateral trading facilities to try and deal big blocks between themselves. I am, shall we say, sceptical. Even if we ignore the fact that giving away your trading information to your competition is likely to be significantly more damaging to your eventual execution quality than giving it away to middlemen, the simple fact is that the buy side, as a whole, can’t provide liquidity to itself.

The current hope of the central banks of the world is that non-bank intermediaries, possibly from the hedge fund sector, will step in to provide the market making services which the banks no longer find it profitable to offer. But why would they? If it’s not profitable for the biggest incumbents in an industry, why would that attract market entry?

The reason is that the central banks have, for the last couple of years, been explicitly assuming that bid-ask spreads will widen, making trading more profitable and attracting new capital into the market. But this hasn’t happened. A combination of regulatory uncertainty, institutional inertia and, most importantly of all, the unwillingness of clients to countenance even the smallest widening of spreads, has kept nearly all possible entrants out.

What needs to happen? Basically, the buy side needs to face up to reality. It needs to start looking at its cost of execution in the long run, rather than on a transaction-by-transaction basis, and understanding that if it prices the brokers out of business, it will have nobody left to make its trades. At present, the regulators aren’t helping with this at all — in a misguided attempt at consumer protection, they make it more or less impossible for a fund manager to make an investment in helping its counterparties. But really, the issue is with the clients themselves. If they want to keep on offering immediate liquidity to their investors (and they do), they need to stop creating the conditions under which that sort of immediacy is impossible for the market to provide.

Dan Davies is Senior Research Advisor at Frontline Analysts

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A collection of finance and business writing by @alexisgoldstein, @delong, @dsquareddigest, @DuncanWeldon, @felixsalmon, @jamesykwak, @Mark__Buchanan, @WhelanKarl

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Dan Davies

Dan Davies

Senior Research Advisor, Frontline Analysts