October 29, 2011

Bonds: Part 2a - The Reality

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When I first interviewed for a technology job in fixed income, I knew the “basics” and explained how to to a discounted cash flow analysis to price a bond. The interviewer smiled and said yes, that was the correct way to price a bond, but that wasn’t how it was done in practice.

The reality of EGB trading is strongly influenced by the markets used to trade. If one wants to trade bonds there are two options: Dealer-to-Client (D2C) markets; and, Dealer-to-Dealer (D2D) markets. D2C markets (like Bloomberg or Tradeweb) are where dealers (usually the banks) quote prices on bonds for clients like fund managers or insurance companies to buy or sell. On D2D markets (MTS is the main one in Europe) the big banks can trade with each other and smaller players (even hedge funds) are not allowed to participate. The two types of market work quite differently.

On D2C markets trading is a negotiation. When a potential client wants to buy or sell a bond they send a Request For Quotes (RFQ). This RFQ can go to a specfic bank or multiple banks at once and starts a negotiation process. The banks send back their quotes and the client chooses one quote or makes a counter offer and so on until the price is agreed and the trade done or alternatively no agreement is reached and the RFQ canceled. Banks can send prices to the markets (know as quotes), but these are usually just indicative – that is a price at which they are likely, but not necessarily, willing to trade. It is like advertising. RFQs ensure that trade is done at a price with which the trader (and client) is happy. Thus they should be profitable for the bank unless there is an error somewhere or are intentionally done at a bad price (perhaps as a favour to a client or to offload a large position). Some D2C markets allow “firm pricing”, where the quoted prices should be executable – that is the published price is the final price, no negotiation involved. However, they are not really executable and the trader still gets a last look to ensure the firm price is good (the downside is that if they reject too many firm price trades the market will stop them sending firm prices). To get around the possibility of a bad trade with firm prices the traders send quotes with wider spreads than for indicative prices (ie. the prices are worse than might otherwise be available). Banks almost never send RFQs on D2C markets. The spreads are tighter (and thus the prices better) on the D2D markets.

Government bonds can also be traded on D2D markets (but not corporates). The main D2D market in Europe is MTS. There are a few others, but MTS is by far the biggest. D2D markets use strictly executable quotes. If a price is quoted and someone else trades at that price, then the trade is done – no negotiation or last look. The terminology is that if your quote is traded then you have been lifted, if you trade on someone else’s quote then you have hit them – although at times I have heard the terms used interchangeably.

Executable quotes make the D2D markets a very different place for traders. If a trader is quoting an incorrect price and it is lifted then they lose money with no chance of avoidance (other than not having a bad price). The likelihood of having bad prices hit is very high as all the other market participants are sophisticated traders – other large banks. Generally if some other bank is initiating a trade with you then you are getting the worst of it. There is little motivation for them to lift your quote if it is the correct price (unless they are trying to move inventory or have an error of their own). Most traders hate quoting on the D2D markets.

So why do banks quote on D2D markets? Partly it is because quoting is seen as integral to being a “real bank” and that the D2D markets gives banks access to government bonds cheaper than D2C markets. However, the main reason is they are forced to quote. European governments like to have liquid secondary markets in their bonds. If potential buyers know that their government bonds can be easily resold, then the initial price they are willing to pay at issue increases. Thus governments can pay a lower rate of interest. To get the banks to quote in the D2D markets, European governments have set up the primary dealership program. Banks can apply to become a primary dealer in a country’s debt. The number of primary dealers is generally restricted, so only large international banks and the country’s own banks tend to be approved. The largest recent change in primary dealers was around 2008-09 when some large banks disappeared: Lehmans went bust; Bear Stearns and Merrill Lynch were merged into other firms. This allowed a couple of smaller banks like RBC and Jefferies to take up primary dealerships across Europe.

Primary dealers are required to quote on the D2D markets. This is called their “obligations”. The government bestowing primary dealership will sent a list of bonds every month together with the length of time they should be quoted, the maximum spread they should be quoted and the minimum volume to quote. For example, the French government may say that its primary dealers should quote a set of 50 French government bonds for at least four hours per day at a spread no greater than 50 basis points and at volume of at least 10 million.

The primary dealers are ranked each month on how well they did at meeting their obligation requirements. This ranking then feeds into the bidding process on government bond auctions. When European governments issue new bonds, they do so at auctions where only primary dealers can bid. The government will state the characteristics of the new bond and banks then bid what they are willing to pay for them. Normally when primary dealers buy bonds at issue they can immediately sell them at a profit on the D2C markets. The gains made at auction (together with the prestige of being a primary dealer) make up for the occasions when quotes are lifted. Although a trader might not see it that way when they have been hit a few times in quick succession.

So far all the trading has been done electronically. That is the trade is completed between computers under human instruction. No open outcry like in old films of the stockmarket. A trader in London may trade with someone in a different country who they have never met or even spoken. In fact the nature of the markets make this very likely. At one former employer, a trader calculated that he had made a large amount of money off one particular person at a competing bank and joked he should send them a Christmas card, but he didn’t know their real name (only their market login nickname).

Some trades on the D2C markets still have a human touch. However, this is not from the traders. Alongside the traders (although organised into their own desks) are the salespeople. They work to drum up business. The salespeople themselves aren’t allowed to trade (in London you have to be licensed by the FSA), the actual trade execution has to be done by a proper trader. The salespeople try to think up trade ideas for the bank’s clients. Essentially justifiction for the client to trade with them. Simplistically, this is of the form, “if you do X I think you’ll make money”, although I heard rumours sometimes trades are done more as favours.

I have had very little to do with sales desks. So I can’t give more than a basic description of their function. I have noticed that sales desks tend to have a higher percentage of women than other front office areas. There also tends to be higher proportion of young’ish good looking people in such teams. Perhaps it makes persuasion easier. On government bond trading desks across 3 different banks, I have yet to meet a single trader who was female and only two who were from an ethnic minority (both East Asian) – otherwise they have all been white European men. This is less the case in other teams. I get the impression that the number of minorities on a trading desk is inversely related to the age of the business of the desk. Government bond trading desks tend to have been around for decades and is definitely a boys club. The newer corporate desks are more varied and the recent ABS/MBS traders were about half minorities – at two places I worked they were run by women.

Trading tends to be a young man’s game. Most of the traders I worked with were in their early 30’s, with the occasional guy younger or older. However, most of them were younger than they looked! The stress and early mornings weren’t doing them any favours. A trader’s basic salary tends to be a small part of their overall remuneration. Most of their pay comes in an end of year bonus that is driven largely by PnL. A trader roughly expects some (usually single digit) percentage of their PnL to be paid as their bonus. They monitor their PnL constantly throughout the day. So there is realtime feedback on how well they are doing their job (making money) and know that will directly affect their remuneration. In addition, EGB traders in London start trading at 7am, as that is when the markets in Europe open. Most are sitting at their desks 15-30 minutes before then. Lunch is normally eaten at their desk, only juniors seem to spend significant time away from the desk. EGB traders could always be found during the day staring at their 6 or so computer screens. The trading day ends at 4:30pm London time, but after that is administrative work and meetings – getting out around 5:30pm would be a good day. Very long days – although not as long as I hear investment bankers endure.

Constant financial feedback and long stressful days don’t lead naturally to emotional stability. I found traders often at extremes – either very happy or angry. If they were calm it didn’t take much to tip them over. The stereotype of the shouty trader certainly has a basis in reality around the EGB desk – if they are losing money. Of course when making money they were nice people. Most of the time I have been working with EGB desks they have been profitable, and the traders generally pleasant. Although, before talking to a trader I (and many others) would first check if they were making money that day. If they were up we would pop around and have a chat. If they were down on the day then we would avoid them.

I have many personal or second-hand stories of highly strung traders at work. However, I have no stories of post-work shenanigans. I never socialised with the traders outside of work, both because I was never invited and I was never interested. Traders shouting and swearing at people is such a standard occurrence the experienced support person soon barely notices it, unless it is extreme or continuous. Dismissive and demanding behaviour was also common. Traders run the place and look after themselves. One trader was well known for demanding that support or a developer come see them immediately, but once they had arrived telling them he was busy and making them wait 5 or 10 minutes before making his normally non-urgent request. Trader’s often seem to have a compressed sense of time. When estimating duration they would grossly overestimate. Most support people would smirk at the concept of a “trader minute”, which actually is only a few seconds long (ie “my prices were wrong for minutes!”). Another time I was sitting with a support person while trying to solve a trader’s problem with a market (it was the market’s fault). Nearly every minute the trader would call ask for a progress update and when it would be fixed. The support person always replied with the accurate and decreasing time estimate, after which the trader would tell them to fix it now (and not in a nice manner). I could see no way that the problem could be fixed faster than the support person was managing. At least the trader didn’t storm around and stand over the support person until the issue was resolved (which I have seen happen).

Losing money really aggravates a trader, especially if they don’t see it as their fault (which is nearly always). I’ve heard traders demand we have a trade reversed on the market, even though they know we can’t do that. Once a trader demanded that we have the market open early so he could cover some positions (also not possible, we told him to just wait the 5 minutes until 7am). I’ve also heard of a trader reaching into a support person’s pocket to get their wallet in order recover a loss on a trade – although he was just kidding and returned the wallet back unmolested.

Traders also compete with their colleagues to protect their personal PnL. Underperforming traders are often let go – that is a given. Also, within an EGB desk traders are organised by seniority. The most senior EGB trader is normally responsible for bonds around the 10-year mark as that is the most profitable part of the EGB yield curve. Developers are seen as a cost, but if we do something to generate profit it is hidden in the trader’s PnL. At one bank we wrote a simple automatic trading system that we believed worked quite well – certainly it was doing a large amount of business and the traders praised it. When this system traded it did so as one of the existing traders as this is required by the FSA, so any PnL gain went to that trader. We told the traders we would break out the PnL for the automatic system so they could see how it was performing – and provide the technology team with a little good PR. The traders were insistent that we shouldn’t do that. I believe the main reason (and I wasn’t the only one) was to ensure we didn’t try to claim some of the profit for ourselves (but as a contractor I didn’t get a bonus anyway).

Traders are just the tip of the pyramid – there are a large number of people supporting them. There are the aforementioned salespeople feeding business to traders. Research people produce reports on the current financial environment with forecasts. Quants are the highly mathematical people (usually with a PhD) creating financial models or tools. Sometimes the previous roles merge to some degree – eg a mathematical research person who also does some sales. While EGB traders are often decent mathematicians in their own right (all I know have quantitative science or engineering degrees), quants are usually better. There are various support teams – normally there is a desk of technical support people dedicated to the bond desks. In addition there are phone support, desktop support (for machine problems), marketdata support (for data feeds from the market) and others that handle queries across the whole company. Sometimes support people from external companies (like Bloomberg or Reuters) are also available onsite. Bloomberg was particularly known for typically hiring very attractive young women and sending them to clients as support – the traders were always nice to them! Software developers also do second or third line support if a problem arose with our systems. There always had to be someone around during market hours to field queries. So at each of the three places I worked there was a duty roster for 7am starts and being on-call out of office hours.

Behind the scenes there were also various middle office (risk and control) and back office (compliance, trade settlement & clearance) teams. Although these people often sat in different buildings and I only occasionally conversed with them via email or over the phone. Most IT people were classed as back office, but those of us who interacted directly with traders (and sometimes sat on the trading floor) were placed in Front Office IT, a half-way house. Everyone wants to be attached to a profit centre rather than a cost centre. That made most difference to the permanent employees and their bonus, though still probably at least an order of magnitude or two less than the true front office “money makers”.

Front office people are also required by the FSA to take 2 weeks consecutive leave in order to make fraud harder (which included me at 2 of the 3 places I worked). In public this was taken begrudgingly, but in private people were happy for it. Most front office (or teams that aspired to front office status) espoused a hard-working, hard-charging image. We also had to complete various risk and compliance courses (normally given and tested online). These were universally considered a joke – passing required little more than remembering that stealing is wrong.

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