Topic 4 Dealers and Inter-dealer Brokers (IDB)

1. Topic 4 Dealers and Inter-dealer Brokers (IDB)

2. Primary Dealers • In Treasury markets, primary markets are characterized by an important set of players known as primary dealers. They are banks and securities brokerages that trade in U.S. Government securities with the Federal Reserve System. • They have a direct phone line with the Fed and participate in the open market operations. • Primary dealers daily average trading volume in fixed income markets during the first week of June 2008 exceeded $1 trillion, of which trading in U.S. Government securities was in excess of $500 billion.

3. Inter-dealer Brokers (IDB) • The inner market in the government securities market comprises the interdealer brokers (IDBs). Interdealer brokers aggregate information about the bids and offers posted by various dealers and disseminate that information on computer screens. • They do so without revealing the identities of the dealers. This enables the dealers to undertake their proprietary trading activities anonymously. Dealers pay the interdealer brokers commissions for this service. • Major interdealer brokers include Cantor Fitzgerald (eSpeed is their electronic trading platform), ICAP (Garban), Liberty, and so on. IDBs provide access typically only to primary dealers.

4. Inter-dealer Brokers (IDB) • In 1991, a real-time price and quote distribution system known as GOVPX that disseminates information about the Treasury market around the clock was established. It showed all the executed trades, best bids, and offers. Since then, electronic trading platforms have become rather common for trading newly issued Treasury debt securities. • Broker Tec and eSpeed are two firms with major electronic trading capabilities in the Treasury debt markets. • IDBs account for nearly 50% of trading in Treasury debt securities, whereas they contribute to less than 1% of trading in corporate bond markets and less than 2% of trading in agency markets. In MBS markets they account for about 25% of all trades.

5. Inter-dealer Brokers (IDB)

6. Inter-dealer Brokers (IDB)

7. Market Transparency in Debt Markets • Unlike stock markets or futures markets where trading tends to occur in organized exchanges, debt securities, by and large trade in dealer markets. • Transparency of a market can be defined as “ the widespread availability of information relative to current opportunities to trade and recently completed trades.” • Transparency is classified into pre-trade transparency and post-trade transparency.

8. Pre-Trade Transparency in Debt Markets Pre-trade information includes: • Firm (live) bid prices and (live) offer prices and the quantities that the market maker is willing to transact, which enable the investors to know the prices at which specified quantities of bonds can be bought or sold. 2. In multiple dealer markets (as in corporate bonds), pre-trade transparency information will require the consolidation of bid prices and offer prices as well as the quantities associated with those prices across all market makers (or as many market makers or dealers as possible)

9. Post-Trade Transparency in Debt Markets Post-trade information includes: • Relevant post-trade information includes the prices and the volume of all individual transactions that have actually taken place in the market at the time a potential investor is contemplating a trade. • Post-trade transparency of a market determines the information that investors will have about most recent trades and will help them evaluate the quality of execution of trades relative to recently concluded trades. • Once again, existence of effective consolidation mechanisms serves to reduce the search costs to potential investors by providing them with a complete picture of recently completed buy and sell orders with various dealers and the quality of trade execution.

10. Evolution of Transparency

11. High Frequency Trading • HFT • Firms leveraging high speed market data and analytics to look for temporal supply and demand trading opportunities. These firms typically are self capitalized and hold positions for very short periods of time (typically less than minutes) • Includes • Equity market making • Index arb • Options market making • ETF arb • Stat arb/pairs trading • Narrow and more typically used definition • Equity market making

12. Who trades? US Equity Share Volume by Market Participant High Frequency Trading accounts for 61% of Share Volume Source: TABB Group Estimate

13. Goal of HFT - first to spot an opportunity & first to take advantage of it • Co-location • Depending upon the firm, the HFT may need multiple locations • May also want access to dark pools • Sponsored access • Flash trading • Market data • Direct feed • Messaging • Low latency time series • Back testing tools • High speed analytics • CEP (mostly home grown) to locate trends • Execution technology to trade

14. HFT – Fast and Furious

15. HFT – Compound Complexity • Algos Proprietary – uncertain to the market • Generate repeated Crashes: • 1987 – Black Monday, Dow down 23% • May 2010 – Flash Crash – Dow down 1000pts, nearly 10%, recovered in minutes. CFTC Study: markets can become fragile when imbalances arise as a result of large traders (hedge) seeking to buy or sell quantities larger than intermediaries (market makers) are willing to temporarily hold, and simultaneously long-term suppliers of liquidity are not forthcoming even if significant price concessions are offered. (HFT is inconsistent with traditional Market Making – holding inventory – can’t/won’t absorb so price crashes) • Knight Trading – August 2012; avg 39 trades in 1 second, buying at offer selling at ask – loss with each trade. 15 cents on each trade, 2400x a minute in 134 stocks for 45 minutes. An efficient way to lose money.

16. Electronic Trading Has Caused Steep Decline in Average Trade Size US Equity Share volume and trades Source: TABB Group and Exchange Data

17. Algos have broken up flow into much smaller executions Shares by Execution Venue (volume weighted) 2 Year CAGR ’07-’09 Source: TABB Group – Institutional Equity Trading in America ’09/’10 – Preliminary

18. Is it worth it? • Benefits • Greater automation • Low fees – exchange competition • Tighter spreads • High certainty of execution • Challenges • Finding the needle in the haystack • Massive quantities of • Data, IT,& Bandwidth • Greater obfuscation – now up to 71% of the market with only 2% of trading firms participating. • All of this tilts market toward larger brokers • Will benefits remain when only mega-brokers can play? • Application in Fixed Income Markets?

19. Topic 4 - Conclusions/Main insights • Unlike equity or futures markets, debt markets are organized as dealer markets. • Primary dealers and inter-dealer brokers (IDB) provide important intermediation functions in debt markets. • Secondary market trading differs significantly across debt markets, and even within the same debt market as the security gets seasoned. • Market transparency is important to investors in debt markets. Not all debt markets are equally transparent. • Concepts of pre-trade and post-trade transparency are useful in assessing the execution costs in debt markets.