The Bond Bazaar

For years, FICC (Fixed Income, Currencies and Commodities) has been a key profit driver for banks. It’s an $80bn/year industry that has topped out. The financial press has pointed to many different causes for sluggish FICC revenues: low volatility, low rates, low volumes. These causes all factor into the equation, but the way banks make money trading is also changing. Increasingly, market-making relies on pricing models and technology instead of human judgement. This has made trading substantially more competitive.

Bank = Merchant #

Imagine walking into the grand bazaar in Istanbul. Each merchant in the bazaar has his own stall with various goods, but there’s a degree of overlap between the goods offered in each stall, and the merchants all know each other fairly well. When you step into a stall, you are entering into a protracted negotiation with a merchant, whether you realize it or not. The merchant is paying attention to what you look at, how long you look at it, how you dress, and any number of other factors that he thinks would be relevant in determining the price you’d be willing to pay for his goods. There’s competition, because if the merchant tries to charge an outrageous price, you may leave or another merchant may try to lure you into his stall. But the overall level of competition ensures that the merchant can earn a living by selling his goods for more than he paid. Otherwise, the bazaar wouldn’t exist.

The current electronic systems for trading fixed income are not too different from a bazaar. In trading, banks take on the role of securities dealer, indicating to customers at what price they would be willing to buy and sell bonds. Just like the bazaar, dealers wouldn’t show up if they couldn’t earn a living. So the electronic system is explicitly designed to make this possible.

The first key design decision is who gets a stall. The biggest dealers formed a consortium that set up the dominant trading networks. New dealers have to pay a fee to participate in the network and prove that they can handle the ‘responsibility’ of being a dealer. The existing consortium still controls 60% of the distribution channels though, so new dealers don’t get the stalls next to the entrance; they get the stalls at the back of the market with less foot traffic.

The second key design decision is how you, the customer, get to buy and sell bonds. As with most bazaars, the prices aren’t posted; it’s a negotiation. And the format of the negotiation is a key advantage for the dealers. Each time you want to trade, you have to reveal your identity and trade intention, signaling valuable information to the market. This information is catalogued and used in future negotiations.

The end of the bazaar #

The dealer-to-customer marketplace is necessarily separate from where dealers themselves transact. Naturally, you can’t have merchants setting the prices of their goods in plain view of the customer. Dealers also don’t care which other dealers they trade with in the separate dealer-to-dealer market. All transactions are anonymous, so all the dealers get to access the same prices.

The change that is sweeping through banks is that the social contract of the bazaar has broken. Increasingly, the large distributors that dealt in the bazaar have set up their own separate department stores, taking a slice out of traffic headed to the bazaar. The smaller merchants, who always earned less from the bazaar but paid for the privilege of having a stall, can’t get enough traffic to cover their costs. And crucially, a new type of merchant has arrived on the scene. This new type of merchant specializes in trading only the products with the highest turnover and is willing to trade at the same price with customers and dealers wherever, whenever.

The days of the bond bazaar are limited. If customers don’t need to go to the bazaar and haggle over prices, they won’t. In the equities world, securities are traded on exchanges where prices are publicly and anonymously displayed. When you trade, you can do no worse than the price shown at the exchange. And you know exactly what that price is before you decide to trade.

There’s never been an exchange for bonds. It’s a critical asset class in which 82 trillion dollars of the world’s wealth is stored, but trading is still conducted in a similar fashion to your local fish market. When the competitive system of a market that large breaks, huge opportunities become accessible to new companies, which don’t have existing business interests to insulate from competition.