I started reading Liar’s Poker from Michael Lewis. A very colourful description of the US bond trading business in the 1980’s. And my first reaction was – not much has changed in 30 years. At Intercapital Markets we have traditionally been stocks guys. When we started business in 2003, we were obliged by law to trade stocks only on the exchange where they were listed. Then came MiFID in 2007 wand we realised we can also make trades directly between two sides, without necessarily making that trade on any exchange. But still this sort of trades are the exception, even today we send most client orders to the exchange. And many people do that. So if a client wants to know the price of a stock, we just look at the order book (coming from the exchange) and we know, what was the price of the last trade, what is the best bid and offer now etc. And those bids and offers are real. The brokers placing the orders have to honour them if someone wanted to trade.
Then when the stock market in Bulgaria collapsed in 2008 (after a boom in 2007) we started looking for other things to trade and new ways to make money. So we slowly came to trading bonds. And we had to forget most of the things we were used to when trading stocks. Bonds may be accepted for trading on a regulated exchange, but they never trade there. Literally! All the trading happens between counterparties – banks or brokers, who are willing to buy and sell the respective bond. And the transactions are negotiated directly between one firm and the other. First, you have to be set-up to trade with at least some of those firms. This means they have to agree to make deals with you. This is because of the “counterparty risk”. Suppose they agree to sell you a bond at a price of 101 (101 percent of the nominal). You have to pay it the next day or in two days. And if you fail to pay it, they may lose money. The price may have gone lower and they will have to sell it to someone else at that lower price. So, to be accepted to the “club” you have to pass a stringent process of risk and compliance approval.
And then there are the quotes. The bids and offers. Some time ago they were published in news-papers, then when computers came each market participant would show his quotes online. Now, the systems may seem very modern (Bloomberg and Reuters are the most widely used), but the essence is still the same. You are showing to other people at what price you would buy or sell a particular bond. And there are many trickeries here.
First, market participants can print a different “newspaper” to each one of their clients. They may show me one price (say they bid 101.00) but show someone else another price at the same time. Bigger clients get tighter spreads. Instead of say 101/102 bid-offer they may see 101,25/101,75.
Second, all these quotes are “indicative”. Banks “would” trade at these prices. But they may just as well not. Or at least not with you. Bloomberg Bond Trader has a function where a bank can agree to give you so called “Executable” quotes. They are shown in different colour and are supposed to mean that they are really real. But even these are not. The Bloomberg user on the other side may reject a trade, when you click on his “executable” quote. He is not legally obliged to honour it. If someone always rejects trades you stop believing them. But your own clients keep seeing these quotes and they don’t understand why you can’t trade at them.
Banks used to hold a lot of bonds for their own account. Now with the new risk regulations, they have reduced these inventories a lot. For a bit more risky bonds, like for example those of Poland or Bulgaria, they have eliminated the inventory all together. Which means the likelihood of the quote being real and you actually being able to trade on that quote is reduced a lot.
Third, market participants can also contribute their trades to these new systems. But that’s on a voluntary basis. They are not required to show all the trades there.
The result is a lack of transparency. When a client asks: “what is the price of the PZU bond due in 2019?”, we can’t tell them for sure. We, meaning brokers who usually act as agents for the client; we would pass the client order somewhere else for execution for a very small commission. If you are the client of a broker who gives quotes he may tell you what he is willing to pay for your bonds at this time. But it doesn’t mean that another broker is not willing to pay more for your bonds. But you have no way of knowing that for sure.
And there is nothing middlemen (or brokers) like most than the lack of transparency. On the market in general there may be an order from one client to sell at 101 and from another client to buy at 102. Stock brokers traditionally would send such orders to an exchange, where they would probably match at 101,50. The buyer pays a bit less, the seller gets a bit more and the respective brokers get a very small commission. When trading bonds with a market maker, he would buy from one client at 101 and sell to the other at 102 getting all the profit for himself. Arguably giving each client the certainty that they can trade at that price.
The dream situation where you buy at 101 and instantly sell at 102 to someone else is quite rare though. The market maker has to hold these bonds for some time between buying them and selling them. This could be a minute or a day or a month. And when banks and brokers actually do that they take a risk. The market can go against them in this holding period and they may end up losing money. And this risk has to be remunerated, so it makes sense for those taking it to make profits that are bigger than the normal tiny commission on stock trades.
However, in the last couple of years we are seeing a trend where the traditional market-makers don’t want (or are not allowed to) take these risks, but they still want to capture most of the profits they used to get before.
I recently shared these thought with a director at Warsaw Stock Exchange – another stocks guy. And we agreed that bonds are traded today like stocks used to be traded 30 years ago.. or even 300 years ago. We all use powerful computers with millisecond communications, but the principles are the same. The less the clients know, the bigger the profit for the middlemen.