Friday, June 15, 2012

On crossing at the Magenta Line versus paying the bid-offer

More bond market participants are considering guided crossing networks as an alternative to paying the bulge bracket bid-offer spread. The idea is very simple, at least in theory. An independent third party real-time price is computed in real-time, and anonymous parties can cross there. Of course they could also modify their desired price or allow it to float with the reference price (or reference spread). In 99.9% of cases this sort of crossing appears to be a no-brainer, since the typical bid offer in U.S. corporates is quite wide. It is visually obvious that buy side participants will save a lot - arguably on the order of several billions per year.

Because the development costs are very high, the only real-time reference price for U.S. corporates is currently provided by Benchmark Solutions. It is known as the Magenta Line. Crossing at the Magenta Line is a real, dare I say imminent possibility. For years the available reference prices have been inaccurate and produced no more than a few times a day. Needless to say new technology brings new commercial opportunities.  

This short note preempts a possible objection: the quality of the reference price in fast markets. Market participants can see the sort of display shown below and can easily make their own judgement, at least for liquid bonds (and they may exercise prudence by waiting for the market to settle down, of course). But what about illiquid bonds, that must be priced off "the" curve (or really two curves - credit and basis, plus idiosyncratic estimates)? Fortunately the Magenta Line is really a Magenta Curve, so the performance can be assessed by looking at relatively liquid bonds.

The other day we saw a big move in NAV that occurred in the space of twenty minutes, thus providing an opportunity to test whether the Magenta Line is suitable for crossing in fast markets. In fact the Magenta Line performs extremely well - a couple of years of research helps. Below you see the result of a recent code cut and the curve response. The even mildly technical reader will correctly infer that non-gaussian price dynamics are being modeled (together with numerous micro-structure devices that are less obvious in this particular example).

There are two things worthy of note here. First, this is actually an intermediate result in the sense that there is additional post-filtering applied after the fact - which in practice would improve the performance further (particularly in the period 3pm-4pm where I think there is a little room for improvement).

But at the risk of repetition, I am showing the response for one particular bond on the curve which is liquid. The point is that the entire term structure of credit and basis (as well as interest rates, of course) will also be moving. That how customers crossing at the Magenta Line on a far less liquid bond can still receive a fair price, no matter when they choose to trade.

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