Liquidity in The Fixed Income Markets: A Panel Discussion at Stanford University

What follows is an approximate rendition of part of a panel discussion that took place at the Third Stanford Conference on Quantitative Finance in March 2012. The topic was the future of the fixed income markets. The participants in the discussion include organizer George Papanicolaou, Professor of Mathematics at Stanford University; Tom Eady, Senior Policy Advisor at the SEC; Ravi K. Mattu, Managing Director and Global Head of Analytics at PIMCO; Tanya Beder, Chairman of SBCC Group; Darrell Duffie, Dean Witter Distinguished Professor of Finance at the Stanford GSB; and Jim Toffey, Founder and CEO of Benchmark Solutions. The conference web site contains full biographies and the conference program. The panel discussion was moderated by Kevin McPartland of TABB Group.

[Apologies to panelists for any lack of fidelity to their precise words]

Kevin McPartland: We here a lot about liquidity and the impact of the Volker rule. What will Volker do to liquidity and will it get through in its current form?

Darrell Duffie: We don't really know what the Volker rule will do, what it will be in its implementation. The SEC has put forward a proposed implementation of the Volker rule which has generated a huge amount of discussion and concern. In my view what it would do at least for the next few years is dramatically reduce liquidity (for example in corporate bonds). This liquidity might be replaced over time by other sources, as the Chairman has suggested. However a follow on concern is that much of that liquidity would no longer be provided by the banking system because the rule would dramatically reduce the ability of the banking system to do that. So it will come somewhere else, outside the banking system. We don't know yet whether the new providers of liquidity will be sufficiently capitalized, supervised, or have access to emergency sources of funding and that raises concern that somewhere down the road we might end up with a financial system that is closer to the one we had before the crisis, where some of the largest sources of market making liquidity were also outside the banking system and were retaining risks that we now believe were excessive. That's the follow on concern. I think the agencies will rethink the Volker rule and we may see a lessening of that concern. The implementation will be delayed past July and the distinction between market making and other forms of trading will be rethought. That separation is the most difficult part of this implementation. I suggest that the risk should instead be treated by capital requirements rather than an explicit attempt to distinguish between market making and proprietary trading.

Kevin McPartland: Is there a quantitative way to define market making or proprietary trading?

Darrell Duffie: There is a way to define it but in reality the only way to know is to have complete knowledge of the intent in the mind of a trader when he makes a trade.

George Papanicolaou: In connection with this is it really a question of information? You are suggesting it is not an issue of information

Darrell Duffie: Certainly not. Again there are so many trades where you cannot know if market making or proprietary trading is the intent. There are so many trades that could be alleged to be not market making trades even though the trader may have intended that. To separate the two you are basically going to have to administer a lie detector test or a truth serum to the trader and say "what did you have in mind? Are you really trying to make markets here?".

Tanya Beder: Further, depending on what time horizon you evaluate a trade over the question is murkier. You might compare the situation to spec limits in futures markets. There are a lot of the same issues. If there is one true statement that can be made it is "it doesn't work". There are a lot of people who are claiming to be hedgers who are actually speculators and it is a pretty extensive problem. I tend to think that if Dodd-Frank were thought through on a common sense level then one of the things we should put on the table is that there is a big difference between credit risk and interest rate risk. Interest rate risk is much more fungible. Two steel companies are not. When you think about banks one of the things that went wrong is that we got into the beauty of the theoretical math and tried to put credit together and trade them through the same instruments. I think we need to take a big step both in academics and practice and decide whether you have to go back to idiosyncratic credit analysis and shrink banks back to where they used to be. Or do you move CDS trading onto an exchange. The tough questions lie there. Do you want to limit exposure? Or do you want to trade them like commodities where there are many more trades than barrels of oil in the ground? In credit everybody got it wrong. All along the chain from borrowers up.

George Papanicolaou: The implication is that people knew the AAA ratings were false. I don't think that is true.

Tanya Beder: On one side of the debate is the notion that AAA should provide some type of assurance and obviate a look under the hood. Those on the other side of the debate would argue that due diligence is a fiduciary responsibility. Myron Scholes and Robert Merton could not agree on this point.

Ravi Mattu: As a practical matter, at some point an additional 20bps is not worth the research and due diligence. The reality is that many people who were buying AAA securities were by definition not the most sophisticated.

Darrell Duffie: A disclosure. I am on the board of directors of Moodys but I have to agree that the ratings were relied on without checking under the hood and in many cases if an investor is buying AAA securities then they probably are not equipped or likely to hire a consultant to do the work. So the rating agencies got it wrong ...

George Papanicolaou: The academics got it wrong too. I recall vividly in the spring of 2007 there were seminars held near here - not in this building but near here - where people would get up - perfectly respectable theoreticians - and they would give any number of arguments based on data why not only were they AAA rated but default could not occur in the next five hundred years. And then six months later we witnessed collapse ..

Darrell Duffie: It is not as easy as it is suggested to be. I can tell you that.

George Papanicolaou: The academics were not out of this.

Ravi Mattu: (directing the discussion back to Volker rule) In terms of trying to separate out what is proprietary from what is being done to facilitate customer flow there is some proposal to have capital charges based on rating (Darrell Duffie may know) with a high penalty after ninety days. I don't know if that is the reason but if you look at dealer inventories even in the last five or six months corporate bond inventory has come off by about $70-80 billion dollars, treasury inventory on the other hand has gone up by [inaudible] billion dollars. There might be lots of other reasons why... in any case in the past liquidity was artificially cheap. This goes back to the not so old days of banking when people were looking at fixed income revenues and equity revenues and realized there was far more money to be made in fixed income. Of course they were under-capitalizing fixed income to achieve those returns on equity. Fixed Income was four or five times the scale. And even within Equities it was derivatives not cash. Cash equities require zero capital but everyone thought it was an unprofitable business. I don't know how so many MBAs and smart people came together in that consensus but everybody wanted to grow fixed income and nobody wanted to grow equities. If we go back to the more balanced situation you'll see a significant reduction in employment in the sell side. So in summary I think liquidity was just too cheap. It was underpriced by the street.

Jim Toffey: On the point of liquidity and the Volker rule the bond market is a tough market to price and think through market structure. For an IBM there is not one security but a whole issuer curve. One of the things we've found as we've been out showing our pricing is that the banks also need a measure of liquidity to satisfy Basel and other requirements. One of the things banks are trying to figure out is can you quantify liquidity. Can you build a statistical measure of liquidity? Of course bid-offer spreads is one measure of liquidity but there are many dimensions. Issuer size, age to maturity, trading frequency enters the picture. We've created liquidity scores to help the banks in this respect. It is notable that there are several players already who have developed their own liquidity grades for bonds and if they are asked to bid on a bond may decline the opportunity if the liquidity is not deemed sufficient. So that is just an example of how the knock on effects are happening.

Kevin McPartland: So Jim to your point liquidity in the bond market has always been relatively sparse so given now we have a few more roadblocks to liquidity in the corporate bond market is there any way to make a transparent bond market or are we just going to see people moving to CDS and replication strategies or other ways to get that exposure?

Jim Toffey: One of the things I've thought about are the parallels between what the OTC markets are going through now and what the Equity markets went through 15-20 years ago when the crash of 1987 led to Reg NMS which led to new transparency and liquidity pools. I think there are some analogies there. If you think about the OTC markets over the last twenty years in some regards you could say they weren't really markets. In my definition of a market there are natural feedback loops and liquidity pools and just only in the last 15 years was there even a post-trade tape in corporate bonds and municipals and then only in the last two years has it become clear that there will be a tape in agencies and mortgage backed securities. So if there is really a marketplace there needs to be the ability for all market participants to be informed on a real time basis because a transfer of this asset over here will imply a new value for an asset over there. That's one mechanism that is just going to have to evolve over time. The second one is that these debt markets have become so huge in the last twenty years and yet the number of market markers has shrunk so dramatically. If you look at J.P. Morgan Chase for example, just think of the number of banks I saw get swallowed up along the way - or Bank of America. There used to be Manny Hanny, Chemical Bank, Bankers Trust ... I mean the nature of the market structure has consolidated and yet the markets that these banks have had to support has just exploded. So I fundamentally think that one way of another it has to be flattened. You can't have that kind of concentration. Transparency helps do that. New types of market structure helps do that. You've gotta create more balance in the market place and you also have to think about new venues and how to exchange risk. The OTC markets are ironic in a sense that if there is a natural buyer and a natural seller they can't find each other in any kind of market place that exists today. They always have to call a trading partner, lay off the risk there and then that trading partner goes to find the other side. It is hard to fathom that in the age of the internet and Google there aren't more direct alternatives to do that.

Kevin McPartland: So if we talk about something like CDS is there actually pent up demand to trade CDS that will ultimately drive volume? Or is it the case that new regulation will drive trading sizes down but not really result in additional liquidity?

Darrell Duffie: I do think you'll see some new retail or high net worth investment products coming out of the improvements to liquidity in CDS markets. Somebody will write a new ETF, for example, that is somehow linked to credit behavior once you can actually get transparency out of the market. Goldman has announced that it is going to have an electronic bond trading platform. That is one good effect of the Volker Rule insofar as it is pushing liquidity away from an oligopolistic, dark, dealer oriented market into the open...

George Papanicolaou: Darrell, what do you think electronic bond trading means?

Darrell Duffie: Most likely forum would be a request for quotes system or a small limit order system where you can ask say five dealers. Or you can have a continuous order book system where someone can lob in bids and offers. It won't be the same as the Chicago Mercantile Exchange or the New York Stock Exchange but it will bring investors closer together. They won't, as Jim said, be an insulated by the dealer community which is not anxious to give up that oligopoly. Jim mentioned the TRACE system which introduced price transparency into the corporate bond market. The dealers dug in their heals and screamed about providing transparency to the market. They said it would harm liquidity, which almost any academic that looked at the issue thought was a joke. It actually hasn't improved liquidity as much as we'd hoped but it has improved it somewhat.

George Papanicolaou: When did this kick in?

Darrell Duffie: 2003.

Tanya Beder: There are some other big examples of liquidity changes. If you look at the CDS market while it appeared that CDS volumes fell of the face of the planet after the Lehman collapse what in fact happened was the opposite. That was against a backdrop of a huge compression cycle around the street and that was a place where the street was really digging in its heals. Yet the process of netting has helped tremendously in reducing operational risk. But if you think about how you get on a bond platform or how you can have so few dealers supporting this huge market you come back to the idiosyncratic problem. How are you going to assess the bonds of all those municipalities that issue bonds? How are you going to evaluate all the individual credits of the homeowners. That's a big challenge. We lost huge faith in the rating agencies and the monolines. You have to make a judgement as an investor as to what the credit of that company is and I don't think there is a good answer to that.

Kevin McPartland: I find it constantly ironic that the regulators that tend to look at CDS as the most evil of instrument are writing rules to make it easier to make ETFs that anyone can participate in, even retail investors.

Darrell Duffie: Maybe I am being optimistic but I don't think the regulators think that CDS instruments are evil. Some people speaking in public, even from the public sector, might have created that impression. The regulators want to curb the abuses and control the externalizes...

Kevin McPartland: The legislators ...

Darrell Duffie: ... well that's a different story! What they say may not be what they believe.

George Papanicolaou: I think what they sense is that CDS can play a destabilizing role. That is the intuition behind this. It is not that it is an evil instrument. It has its uses. But it is an instrument that can be stabilizing and that is the intuition of, certainly, the Europeans. The question is how do you come up with regulations or mechanisms that take away that edge.

Jim Toffey: Was it the instrument or the way it was traded? There was essentially infinite liquidity. You can buy and sell and put up no capital. You were creating huge bilateral risks.

George Papanicolaou: The latter, I agree.

Kevin McPartland: So once we trade them electronically will the liquidity increase?

Darrell Duffie: We don't know yet. We don't know what form the swap execution facilities will take. There is a point where transparency can curb the ability of the market to transfer large blocks. There are all sorts of things we don't know yet. Ideally it should work.

Kevin McPartland: So throughout the day we've talked a lot about measuring liquidity as well. What are the different ways to do that and how should we think about that. Can regulators put the rules in place and measure the impact over the first twelve months so we know if the rules are working or not?

Ravi Mattu: I think if there were a marketplace where prices and quantities were known we could come up with good measures of the market impact of trades and this would be a good measure of liquidity. Now I think an open system would be much better than a close system not because natural buyers and sellers would meet (in the best of internalization schemes only one percent cross) but more because it allows other pools of liquidity to come in. People who are willing to do the research and put a price on anything. That, and central clearing, might solve the problem. Professor Duffie talked about multiple venues for clearing and that is a tough one but couldn't the government at least demand a single clearing venue in each jurisdiction? What we've seen is that banks are global in life and national in death. We could think of J.P. Morgan as three different banks. J.P. Morgan U.S. and so forth.

Darrell Duffie: Except that if you want to do a trade in another jurisdiction ... you might have a good reason to do that.

Ravi Mattu: So long as you do the trade with the correct legal entity in that jurisdiction ...

Darrell Duffie: You might have a race to the bottom.

Ravi Mattu: Not after this crisis ...

Darrell Duffie: It might take a while ...

Kevin McPartland: We've heard a lot about the clearing house race to the bottom but do you think the bottom is limited to some reasonable level. At some point aren't the participants going to say "yeah this is cheap but it is crazy".

Darrell Duffie: They internalize the risks to themselves. They don't include the externalities and the risk to the financial system itself. Those externalities can only be controlled (in this setting) effectively by the government imposing additional capital requirements, liquidity requirements, transparency requirements, collateral requirements ... those requirements are not going to be adopted to the same high levels if everyone is only worried about their own risk.

Kevin McPartland: Is there a concern that managing an exposure to CME Clearing, say, is more complicated than managing an exposure to a direct bilateral counterparty?

Darrell Duffie: Right now I would take J.P. Morgan over CME Clearing but that isn't the way it should be. The regulators should make sure CME Clearing is very bulletproof and not make that choice so difficult.

Kevin McPartland: How do they do that?

Darrell Duffie: Capital requirements, transparency requirements, collateral requirements, default management plans, the whole nine yards.

Jim Toffey: This is critical to the overall systemic risk. You are talking about one guy and how he wants to think about risk. When you think about the overall market it has to go to central clearing.

Kevin McPartland: Right. (Joking) We can't just create CDS on the clearing house I suppose and manage the risk that way (laughter). So total cost analysis has been common for years in other markets (e.g. equity) but still relatively new in credit markets. Now people are starting to come out with products just in the last couple of months. Why has it taken so long?

Jim Toffey: The problem of measuring transaction costs and understanding where I traded relative to someone else goes to the sparseness of the bond markets (as you saw from the graphs this morning). You can have trades here and there and there is no continuous market to measure it against. That is one of the gotchas that has always existed in the bond markets. By us providing an example in the form of a benchmark price others can at least say "this is how I traded relative to one benchmark". You can also consider measures of dispersion and do it that way as well.

Ravi Mattu: How can you do pre-trade analysis?

Darrell Duffie: You can do post-trade analysis

Ravi Mattu: Do they disclose the size?

Darrell Duffie: Up to a certain level

Jim Toffey: You see that is one of the things I would point out about the OTC markets. There needs to be more feedback loops provided that the right time elapses to facilitate hedging. Why is it that at the end of the day we don't know what traded in the U.S. Corporate bond markets? It seems kind of crazy to me that in the age of market places at the end of the day we don't really know what happened.

Kevin McPartland: Why is that? A dealer conspiracy?

Jim Toffey: I don't call it a conspiracy. I just call it the natural incentives of the market participants. I think it is up to regulators to push the market structure forward and share that information.

Corporate bonds are marked up excessively more than 10,000 times per month. Fines would run into the billions if FINRA enforced them automatically.

My country of birth and country of residence differ in their approach to speeding fines. In the U.S. an officer must pick the worst offender, literally chase them down and finally present a ticket. In Australia things are a little more streamlined. A camera registers the license plate of every speeding car, whether or not it is merely going with the flow.

In the corporate bond market the equivalent of speeding is selling a bond to a customer with a markup that is judged excessive. The line appears to be drawn somewhere around 3%. To be clear, that means charging the customer more than $3000 when they go in for $100,000, say, or a whopping $30,000 when they buy a million. You might think these violations are rare, given the wide spread and reluctance (you would think) of investors to pay real estate level commissions. But they are not and FINRA regularly fines market participants quite heavily.

For example FINRA fined Morgan Stanley last year and although 5% used to be the guideline, the language around a more recent Citibank case is not so clear.  Citibank was found guilty of marking up bonds by "2.73 percent to over 10 percent" and this was "excessive given market conditions, the cost of executing the transactions and the value of the services rendered to the customers, among other factors". FINRA's press release quotes Thomas Gira appearing to discard the 5% precedent.

"FINRA is committed to ensuring that customers who purchase and sell securities, including corporate and agency bonds, receive fair prices. The markups and markdowns charged by Citi International were outside of appropriate standards for fair pricing in debt transactions, and FINRA will continue to identify and address transactions that violate fair pricing standards, regardless of whether a markup or markdown is above or below 5 percent."

Back in 2001 FINRA wrote in this letter that they would not provide interpretive guidance on the appropriateness of a commission or mark-up schedule under Rule 2400 (NASD). But as noted by Eckert and Newman that didn't stop the heat being turned up somewhere around 2007. Firms were reminded of their obligations, including the need to consider the following:

1. Prices of contemporaneous inter-dealer transactions in the security
2. Prices of contemporaneous dealer transactions in the same security with institutional accounts with which any dealer regularly effects transactions in the security
3. For actively traded securities, contemporaneous bid or offer quotations in the security through any inter-dealer mechanism through which transactions generally occur at displayed quotations

Furthermore, as also noted by Eckert and Newman, firms are obligated to consider similar securities and specifically:

1. Prices of contemporaneous inter-dealer transactions in a similar security, or prices of contemporaneous dealer transactions in a similar security with institutional accounts with which any dealer regularly effects transactions in the similar security
2. Yields calculated from prices of contemporaneous inter-dealer transactions in similar securities
3. Yields calculated from prices of contemporaneous dealer transactions in a similar security with institutional accounts with which any dealer regularly effects transactions in the similar security
4. Yields calculated from validated contemporaneous inter-dealer quotations in similar securities

It is unlikely that FINRA envisaged the automation of all these criteria in real time. And wherever the line is to be drawn, it is clear that FINRA has adopted the U.S. version of enforcement - the officer chasing down the speeding driver and issuing one fine at a time by hand.

Have you ever wondered, however, what might happen if they had a speeding camera? Until recently that was not possible because there was no independent, real-time indicative mid price to compare the reported trades to - one that is not easily fooled by pairs of dealer-dealer and dealer-customer trades well off market (to pick one technique for "moving" the mid). How many non-compliant trades would the Magenta Line catch?

The answer is astonishing. A colleague ran the numbers last night on 9000 corporate bonds tracked for approximately the last four months. Of the 1,090,898 reported investment grade trades there were 29,825 examples where the customer was at least 3% off market. That number rises to around 50,000 when you include high yield bonds and, while it would never happen, if FINRA was to levy a $30,000 fine for each and every violation it would bring in $4.5 billion annually! 

We are not likely to see punitive numbers on that order but more realistically, FINRA could demand restitution for many, many trades. Customers paid an excess of $866,801,894 to dealers over the last four months alone, by buying investment grade bonds far above the mid.