Coding the markets

I’m still reading chapter 14 of Harris, on bid ask spreads. As always with Harris, it’s highly enlightening and thought provoking. I commented earlier on how the dynamic equilibrium between market and limit orders affects spreads, and how eSpeed charges for market orders in order to minimise spreads. Later in ch 14 he goes on to enumerate the factors that determine the equilibrium spread in order driven markets. In decreasing order of importance they are: information asymmetry between traders, time to cancel limit orders, volatility, limit order management costs, value of trader time, difference between limit and market order fees and trader risk aversion.

All this put me in mind of how bid ask spreads have collapsed in the fixed income rates markets in recent years; by 80% in the last five years, according to some estimates. A lot of that must have been driven by the greater transparency of electronic markets: buy side clients like pension funds can see live ticking prices for euro govies on Bloomberg and TradeWeb, and initiate competitive multi-dealer auctions.

Bloomberg and TradeWeb are quote driven rather than order driven markets, so Harris’ thoughts on equilibrium spreads don’t all apply, especially the ones on limit order cancellation and management costs. For the order driven markets, like Eurex Bonds, eSpeed and MTS, I wonder how much of the collapse in spreads is due to autoquoting engines driving down the cost of limit order management.

For those not familiar, autoquoting engines can translate a stream of bid and ask prices and sizes into buy and sell orders on order driven markets. When the bid and ask change, the engine pulls and places buy and sell orders as necessary. One autoquoting engine vendor used widely by fixed income dealers is ION.

Autoquoting engines are like nuclear weapons, once invented they can’t be uninvented. Dealers may yearn for the days of voice quoting, limited transparency and wide spreads. But there’s no going back. Autoquoting engines almost totally eliminate the time to cancel limit orders, and the costs of managing those orders – apart from any fees. If we accept Harris’ arguments, the use of autoquoting engines must bear down on the equilibrium spread.

Confused is exploring Harris on trustworthiness. Confused reads Harris as explaining the enforcement of standards of behaviour in the market as by contract, rather than covenant. I haven't read all of Harris yet, and I'm expecting him to say something on the 'my word is my bond' market ethos, which is more covenant than contract.

So how does that ethos work in the markets ?  A buy side trader calls a dealer for a quote, and the dealer says '20/25'. The buy side trader says '50 yours' and the dealer says 'done'. At that point they've traded, but the deal has yet to be confirmed by the back offices, so they're not bound by contract yet. If either side subsequently reneges on the trade, they're violating the ethos. Dealers will refuse to quote to a trader who reneges, and a dealer who doesn't honour those trades won't get much business. Both parties have to trust each other until the trade is confirmed. That relationship of trust allows accommodation. Some time back I was on the trading floor helping one of our dealers diagnose an electronic trade on a quote driven market that had RFQed at the wrong price. He called up the counterparty, and they amended the trade price in our favour. Obviously the counterparty valued his relationship with his dealer more than a couple of basis points on the trade.

An instructive recent example of the violation of these implicit trust relationships between market participants was Citigroup's MTS raid. They drove EuroGovies down with a massive wave of selling, then bought them all back, profiting by £14M in the process. They didn't breach any specific rules, but as the story explains " the FSA … is likely to examine the trade with an eye on its very loosely defined rules against behaviour that distorts the market".

Another quote is salient: "It seems clear, now, that Citigroup broke some kind of taboo — but unlike many market conventions, this taboo was not one that anyone could have described or formulated before the event."

To understand what taboo was broken, you have to know that MTS as a market has a special position in the Euro Govt bond markets. It's an inter dealer market where issuers conduct primary market operations. MTS is based in Milan, and is used by the Italian, and other European governments, to issue new debt to the market. Only select dealers get to participate in those auctions of new debt. The right to participate in the primary market auctions is earned by taking quoting obligations. That is by quoting EuroGovies five hours a day. Those quoting obligations ensure that there is always dealer supplied liquidity available so that European governments can conduct treasury operations; for example buying debt back from the market.

Another thing that it's important to understand about MTS is that it's a hybrid market. It's not entirely a quote driven market like Bloomberg, and not entirely a limit order book market like Eurex. Market participants are divided into market makers and market takers. Markets makers send proposals, which are tradeable firm quotes, unlike the indicative quotes of Bloomberg or TradeWeb. Market takers place orders, much as they would on an order driven market. Proposals can cross with orders. However orders cannot cross with orders, so market takers have to trade with market makers, as they do in a quote driven market. Proposals can cross with proposals too.

Since market maker proposals are firm quotes, they are implemented in a transactional fashion, unlike the quotes on true quote driven markets like Bloomberg. Bloomberg's MPF spec specifies that quoting systems should expect an ack once every three quotes, roughly. On Bloomberg, the client doesn't get a tradeable price until an RFQ is initiated, and the quoting system sends a firm price. Since any market taker can trade a market maker's proposal, market makers must know what they're showing on the market at any given instance. Their systems can only know that with certainty because of the transactional model built around getting a quote on the market.

That transactional model has implications. To refresh a proposal a new transaction must be opened for that instrument. That can't be done until the previous transaction has completed. And there's a limit on the number of open transactions a market maker can have. So if a market maker is obliged to quote 300 govt bonds, and they can only have 50 open transactions at any instanct, they have major bottleneck if the market starts to move quickly. Market makers can be left badly exposed, with stale proposals out on the market.

It seems to me that the Citigroup raid was specifically designed to exploit those key features of MTS: market maker's obligation to quote, the hybrid nature of the market, and the transactional nature of proposals. But those market features were all designed to support government treasury operations. The Euroweek article quotes Tom Maheras of Citi as saying the raid was "an innovative transaction that sought to access the liquidity in the European government bond markets". Indeed, and no wonder the government treasury departments were pissed off !