Fixing What Market Providers Won't: Bonds

by: Kurt Dew

This article proposes a new kind of exchange, trading a new kind of financial instrument.

The existing stock exchange management firms (EMFs) are losing market share to dark pools.

This new exchange will offer markets designed to improve upon both EMFs and dark pools.

EMFs and dark pools are in the crosshairs of the SEC and European regulators. (See my most recent article.).

This proposal addresses these regulators’ concerns.

Whatever the reasons, since the transition of market trading from voice to electronic trading, the existing stock EMFs, Intercontinental Exchange (ICE), Nasdaq (NDAQ), and CBOE global markets (CBOE), and dark pools (financial institution-owned trading platforms) have seemingly reached a state of arrested development. This arrested development shows in the absence of new products. Platforms for trading existing financial instruments are proliferating, but since the advent of ETFs, there has been little innovation in the instruments themselves. The marketplaces for securities trading are basically numerous clones of Joshua Levine’s Island trading platform. As a result of dark pool competition, the market share of the major EMFs is in decline.

Here, I suggest a joint innovation: an exchange that both lists and originates instruments designed by the exchange itself; a way the exchange can originate instruments of its own choosing. This form of exchange permits a market sector to decide for itself the structure of the instruments the sector needs for risk management purposes.

Marketplaces have gotten stuck.

We have reached a kind of plateau in improving the structure of financial markets. Most new marketplaces are dark pools, designed originally to seduce the buy-side with the promise of protection from high frequency traders (HFTs), a promise honored largely in the breach as frequent litigation demonstrates. Later, the dark pools became one of the ways broker-dealers process orders received from internet retail brokers like TD Ameritrade (AMTD), promising improvements on the prices of the Securities Information Processor (SIP), the SEC’s poor reflection of current market prices. SIP prices are so poor that these broker-dealers can pay fees for the business sent to them by retail brokers, improve on the SIP prices, and still make a profit. Firms like Virtu (VIRT) are rapidly expanding their fee-for-execution services into markets other than common shares.

But there is room for improvement in the things we trade.

The trading of common shares has been revolutionized by market index mutual funds, market index exchange-traded funds (ETFs) and stock market index futures. While these developments are not the final answer to the implementation of the revolution in stock market risk management based on the work of Markowitz, Sharpe, and others, there is nothing new on the horizon of efficient trading of stock market portfolios.

But debt trading languishes in the past. While there are debt ETFs and debt mutual funds, they have not enjoyed the success of stock index-based instruments. There are multiple reasons. For example, large debtors are not always blue-chip borrowers. Nonetheless, there are several successful passively managed bond funds, mostly Vanguard products. These funds meet customer needs for diversified-risk, low-cost, bond investments; where the change in market value is most important.

What is wrong with the debt market?

One key problem in the debt market is that the purposes of debt acquisition are not, as with stock, always the balancing of risk and return. Insurance companies, for example, buy bonds because they seek a predictable series of receipts to match their predictable series of policy payments.

Thus, bond issuers, through their investment banking advisors, market to two primary constituencies: investment companies like Vanguard that seek to design bond index funds used to manage risk and return; and insurance companies, pension funds, and other wholesale institutional money managers that seek predictable income payments. This second class of bond buyers is limited to buying individual issues – thus saddled with all the vagaries of the decision-making process of a single issuer. See this article on General Electric (GE) debt for a cautionary example of a stumbling issuer.

To list the basic needs of bond traders:

  • A single instrument that simultaneously serves as an index of bond risks and returns for some investors; and as a fixed series of low-risk predictable payments for others.
  • An instrument with yields exceeding Treasury debt but with lower risk than any single corporate long-term debt issue.
  • An instrument whose payments may not be held hostage by a single issuer.

How to fix the debt market.

This article provides a summary description of a new kind of financial instrument with a new kind of exchange upon which to trade it. A more lengthy explanation is available here. (Look on the Financial Market Microstructure page, "A PowerPoint presentation of Exchange Originated Instruments.")

Liquidity is achieved in the stock market, and to a lesser degree with debt index funds, by dramatically reducing the risks specific to a single issue. That method works almost flawlessly in the stock market since the lion’s share of publicly held corporations issue a dominant single common stock with a price that reflects corporate success. Thus, combining individual shares, weighted by their share of total market value, produces a portfolio that reliably reflects the value of the entire stock market, with very little need to conduct expensive transactions to keep the portfolio on track.

The bond market is more complicated than the stock market since a large corporation usually issues multiple bonds. These bonds are also managed in the interest of the stockholders of the issuing corporation. Bonds are often retired, for example, when their coupon yields exceed market yields. Individual bond values are affected by such specifics as seniority. There is a bias in the bond market against the bondholder – in favor of the bond issuer. If a change in bond policy benefits the issuer, it will invariably work against the bondholder. As a result, issuer decisions often work against the interests of bondholders.

In other words, the unpredictability of the payments to be received from a bond is an enemy of the bond’s value to the bondholder. To improve the predictability of a bond, these improvements would be useful:

  • Let bondholders determine the terms of the bond. Have an intermediary that represents bondholders create modified issues that meet bondholder needs. That change would assure that the resulting modified bonds wouldn’t be altered to suit individual issuers. For example, bondholders could delegate the daily composition of the assets supporting a bond to an investment manager, an agent of the exchange, without affecting the bond’s payments. The debt issuers that support a given bond could be selected daily by this agent. The issuers would logically be the highest quality names, widely diversified, to be altered daily at the agent’s discretion.
  • Let traders that choose to take bond ownership (buy and hold) receive a known set of payments that would be unaffected (except for seismic events in the market for debt as a whole) by decisions of the manager of the debt instruments supporting the bond.
  • Let traders that choose to go long the bond, seeking to obtain the bond’s portfolio risk and return properties, gain access to a derivative instrument that is immune to liquidity problems of the underlying debt. This could be accomplished through the use of futures exchange-like margining methods. Margin payments and receipts would produce the risk/return profile of any desirable bond index with lower expense ratios than the bond index mutual funds.

The performance of these bond-like instruments would be designed to meet bondholder needs, not original issuer needs.

Bondholder representation.

The biggest barrier to developing a space in the bond market designed for bondholders instead of corporate issuers is a deadly combination of buy-side lethargy and sell-side aggressive protection of its historical turf, the financial marketplace. Johnny-come-lately firms such as the HFT/fund management firms, like Citadel and Virtu, pose a threat to sell-side turf in their early years; but are soon co-opted by the established broker-dealers.

One alternative that would not be so easily co-opted by sell-side money would be a new, different, exchange. Such an exchange could return to the ethos of the Twentieth Century exchange – a membership organization that could choose its own membership and reassumes the self-regulatory habits of the exchanges of this earlier time. The exchange could be formed from a kernel of buy-side industry leaders, some like-minded investment management firms (such as Vanguard), and perhaps selected investment banks.

The new exchange would seek to innovate through the introduction of exchange-created financial instruments. Originating bonds supported by a new kind of hybrid fund, with some characteristics of the collateralized debt obligation, some characteristics of the ETF, and some characteristics unique to itself; this new exchange could create financial instruments suiting the needs of risk managers, not simply the needs of risk takers.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.