If you want to buy a bond, one thing you can do is, you call up your bond dealer and say, "I want to buy Bond X, how much is it?" and the dealer says, "let me see ... that'll be 98.75," and if you still want the bond you pay him 98.75. This is how essentially all commerce in the non-financial world works, so it is a straightforward model. But it works poorly if your dealer isn't trustworthy, and the whole history of the universe is mostly one long demonstration that your dealer isn't trustworthy.1 So if you do this, there is a nontrivial chance that your dealer will sell you a bond "worth" 90 for 98.75.
So if you're smart, you take some simple steps to protect yourself from your dealer's villainy. You ask for two-sided markets,2 and you get quotes from multiple dealers, and you see where Bond X has traded recently and what benchmarks have done in the interim and where comparable bonds are trading now, and you develop an independent view of what the credit is worth, and all that good stuff. And so you're less likely to be blatantly ripped off, at least not without some serious creativity on your dealer's part.3
There are two problems with this, which are:
- All this checking around, etc., is sort of a pain for institutional investors: It's a lot of work, might tip your hand, etc.
- On the other hand, all the checking is virtually impossible for retail investors, who have other things to do than trade bonds, my lord, but who for some reason want to do it anyway.4
Calling up three dealers for tight two-sided quotes is not really how the retail market operates.
Now problem 1 sounds sort of vague but is a big problem. I mean, not always. If lots of bonds trade a lot, it's easy to get a good sense of where Bond X should trade. And if lots of dealers are carrying lots of bond inventory and taking risk on their balance sheets, then you can easily call up a bunch of dealers and get tight quotes on where they'll trade with you.
But that's not the world of the last couple of years. Instead, driven by the Volcker Rule5 and capital regulation, dealer inventories have fallen, so it's become harder to get two-sided quotes from dealers. Dealers are more likely to act as brokers: If Investment Manager A calls looking to sell some bonds, the dealer now might call up Investment Manager B to see if she's interested in buying, before committing to trade with Investment Manager A. And for complex reasons -- declining dealer inventories, a low-interest-rate environment, the rise of exchange-traded funds -- bonds are increasingly socked away in asset managers or ETFs rather than trading actively. It's hard to triangulate to where Bond X should be trading, based on where it's traded recently and where other bonds are trading, because bonds just don't trade that much.6
This problem is not really about institutional investors getting ripped off, that is, being tricked into buying bonds at off-market prices. There are more fundamental structural worries about declining liquidity in the bond markets: What will happen if investors want to sell and there are no dealers to buy?7 How risky is it to have so many bonds held by ETFs? Should big bond managers such as BlackRock and Pimco be regulated as too-big-to-fail risks to financial stability?
These are tough questions, but one plausible way of addressing them might be to open up trading of bonds somewhat. The current model of investors calling dealers for quotes makes sense if dealers provide a lot of liquidity; but if the dealers are just working as well-paid, information-hoarding middlemen between investors, then maybe there are more efficient ways for investors to interact. And in fact there have been efforts to develop electronic, inter-institution trading platforms that would make the bond markets a bit more like the stock markets, by allowing investors and dealers to post quotes in the same place, and trade directly with each other.8
Problem 2, on the other hand, is just, like, it's hard to be a retail investor, you're always gonna get ripped off, maybe just index. But, sure, there's no reason that you should be egregiously ripped off if you're a retail investor who finds pleasure in municipal bonds, which are lightly traded and opaque, rather than in equities, where modern markets have been amazingly gloriously good for retail investors.9
Anyway, the point of all this is that Mary Jo White, the chairman of the Securities and Exchange Commission, gave a speech to the Economic Club of New York today about market structure. Here is a good paragraph:
It is important to recognize that this “structure” does not just mean regulation, but also the much more complex interaction among regulation and other factors like competition and technology. Every incremental change in these interactions can produce significant, sometimes unintended economic consequences that may not become evident for a period of years or even decades.
She talked about equity market structure, in line with her previous comments, though with some new-to-me and interesting stuff.10 But what's gotten attention was White's call for more transparency in bond markets. In particular, White wants more technology-supported pre-trade transparency: That is, she wants more publicly available, electronically distributed, quotes for bonds, so you can know before you trade what prices are being offered in the market for the bond you want to buy.11 This would be a move toward making the bond market more like the equity market, with publicly posted quotes and potentially electronic (and high-frequency! maybe) trading.
Bloomberg News describes the SEC's concern:
“This potentially transformative change would broaden access to pricing information that today is available only to select parties,” White said in prepared remarks to be delivered today at a speech for the New York Economic Club in Manhattan. New rules may help by “promoting price competition, improving market efficiency and facilitating best execution.”
The practice of dealers showing clients different prices for the same securities on electronic bond-trading platforms has drawn the scrutiny of the SEC. The agency is concerned that smaller investors are being penalized, a person with direct knowledge of the inquiry said in March.
This is the sort of thing that drives me nuts.12 Of course "smaller investors are being penalized." They're being penalized all the time, in everything that they do. They get worse research, worse service, worse allocations, worse customer perks, worse everything. There are volume discounts on bonds, as there are on most things in life. Is this unfair? I really don't care.
On the other hand, these things are true of the world:
- A complex interaction of regulation, economics and technology has produced "significant, sometimes unintended economic consequences" in the structure of bond markets.
- Those consequences worry a lot of people, not as a matter of unfairness to the little guy, but as a matter of market and economic stability. A deep, liquid, transparent bond market, where big investors can transact easily and where prices move smoothly, is good for the world.
- The SEC seems to have some desire to make changes in bond market structure, to make it more transparent and (a bit) more of an order-driven, equities-like market and less of a secretive dealer-driven market.13
- Those are changes that could -- maybe! -- interact in useful and productive ways with the current state of the bond markets to produce greater liquidity and efficiency and stability.
- But the SEC's actual focus is on smaller investors getting a worse deal than bigger investors.
I talk about this a lot but it matters. The SEC's job is to regulate the financial markets. One way to approach that job would be to put a priority on optimizing market efficiency and stability. Another way to approach it would be to put a priority on protecting retail investors and preventing two-bit frauds. Obviously both are good but one is more important. If you think about bond market structure in terms of protecting the little guy, you will make one set of choices; if you think about it in terms of providing a stable liquid platform for massive flows of capital, you will make a second, probably somewhat different, set of choices.14 The second set of choices is probably right.
1 Oh man. Just the tiniest sample is yesterday's story about the currency markets, where basically if you were smart and checked execution you paid 1 pip for execution, and if you didn't monitor your dealer constantly you paid 30 pips, because the dealers would take whatever they could get away with. Or there are these guys who charged 8 percent markups on retail trades, just because. Or ConvergEx, which charged clients undisclosed fees if the clients were asleep.
2 That is, you call up your dealer and say "what's your market on Bond X," and he says "98.25 bid, 98.75 offered," and then you say "I'll buy at 98.75" or "I'll sell for 98.25." If the dealer doesn't know if you're a buyer or a seller, he has no systematic reason to set his market too high or too low, so you should mostly get honest quotes with the dealer earning a disclosed, acceptable spread. Or such is the idea.
3 For instance, Jesse Litvak invented intricate dramas of how he was sourcing bonds to make his customers feel like they were getting a good deal.
4 These retail investors tend to concentrate in municipal bonds for tax and marketing and historical reasons, though some of them trade corporates too.
Users of the Volcker Assistant answer a series of yes-no questions to determine if the Volcker Rule permits the activity they want to carry out. Colorful thermometers tell the users the degree to which their assessments are complete.
6 Not entirely on-topic, but this Citi research note, "Who stole the markets' mojo?", is very interesting throughout. On our topic, note the chart on slide 14, "Entrance with no exit," which shows mutual fund and ETF credit holdings shooting up as dealer inventories decline. (Also chart 12, which shows that corporate bond trading volume varies with new issuance.)
7 Again in that Citi note, check out slide 17: "Lower liquidity means lower day-to-day vol, but higher tail risk."
8 Disclosure: I work at Bloomberg LP, which is very much in the business of electronic communication and trading of bonds, so, y'know.
9 Very much related: Cliff Asness on high frequency trading here at Bloomberg View:
[F]or small, self-directed investors, only the bid-ask spread is relevant because their orders can be filled without affecting the price. For the little guys, it’s a lock that their trading costs are cheaper than before HFT.
10 For instance, there's a partial defense of Regulation NMS that is worth reading if, like, a lot of people, you're suspicious of Reg NMS.
11 The problem:
Trading in these massive fixed income markets, however, remains highly decentralized, occurring primarily through dealers, where costs of intermediation are much more difficult to measure than in other, more transparent venues. And while transaction prices for both corporate and municipal bonds are now available to investors shortly after the trade occurs, the amount of pricing information available before a trade – bids and offers – is very limited, and is certainly not widely available to the investing public.
Here, in contrast to the equity markets where the concern perhaps is whether technology and competition have taken us too far, one might instead ask for the fixed income markets whether the transformative power of these forces has been allowed to operate to the extent it should to benefit investors.
And the proposal:
More broadly, we must take steps to ensure that the benefits of technological advances are realized by all investors in the fixed income markets. Accordingly, I have asked the staff to focus on a regulatory initiative to enhance the public availability of pre-trade pricing information in the fixed income markets, particularly with respect to smaller retail-size orders. This initiative -- referenced in the Commission’s 2012 Report on the Municipal Securities Market -- would require the public dissemination of the best prices generated by alternative trading systems and other electronic dealer networks in the corporate and municipal bond markets. This potentially transformative change would broaden access to pricing information that today is available only to select parties.
12 But also seems totally correct. If you read the speech, there's a lot about municipal bonds and markup disclosure and best execution obligations, all of which matter more for retail investors than for savvy institutions.
13 I'm exaggerating; White is talking, I think, about public dissemination of dealer quotes, not public dissemination of investor orders. But it's a step.
14 Arguably Regulation NMS itself -- the stock-market rule that many people blame for the fragmentation of the equity markets and the proliferation of order types, but that ensures that retail investors get the best available price -- is an example of this bias at work in the equity markets.
To contact the writer of this article: Matt Levine at firstname.lastname@example.org.
To contact the editor responsible for this article: Tobin Harshaw at email@example.com.