By Matt Levine
The job of a dealer in financial markets is to buy low and sell high. Of course that’s the job of an investor too. That’s the obvious, only job. What distinguishes dealers from investors is, loosely speaking, that dealers are not making their buying-and-selling decisions based on some analysis of the value of what they’re buying and selling, but rather based on information about who else wants to buy and sell, and at what price. Their job is to know their customers, not their securities. And the information they have about potential customers is pretty much the value that dealers add. It’s what they get paid for: Sellers come to dealers to find buyers, and buyers come to find sellers. So the dealers try to make sure that they have information that other people — like the customers — don’t have.
This explains like half of the scandals in modern finance. We talked earlier this week about the former Nomura mortgage bond traders who were accused of going to baroque and possibly illegal extremes to hide information from customers. In the mortgage-backed securities market, trades were not publicly reported, and the only way for customers to find out the price of a bond was to ask a dealer. The Nomura traders were accused of lying to the customers about the trades they were doing, to obscure the market price from the customers. In other markets, trades are publicly reported, but dealers can still make nefarious use of customer order information. That’s sort of what the foreign exchange fixing scandal looks like: Customers gave orders to dealers, and dealers used those orders to manipulate prices in ways that the customers did not expect. In the equity market, both trade and order information are public: Anyone can see how many buyers and sellers there are for a stock, and at what price. But electronic market makers race to see it faster, so they can make a fraction of a penny on each trade, and the exact mechanics of how they do that are subject to endless controversy. Meanwhile, spoofers are trying to deceive market makers about the supply and demand for stocks, so they can profit from the market makers’ incorrect information.
The accusation in the CDS case is that dealers didn’t like this erosion of their informational advantage, so they put a stop to it. They took care to keep information to themselves:
To protect their positions of prominence, Dealer-Defendants restricted pre- and post-transaction price transparency. Before a transaction, Dealer-Defendants strove to keep investors in the dark about both the volume of supply and demand and the real price at which CDS were trading. For instance, investors could not see Dealer-Defendants’ solicitations of bids and asks.
And after a CDS contract traded, the trade information went to Markit, another defendant in the case.
In exchange for receiving this data, Markit agreed to DealerDefendants’ condition that Markit not provide pricing information to its subscribers in real-time. Instead, Markit would delay before circulating information, allowing Dealer- Defendants to quote different prices in the interim and to disavow as stale the information that Markit eventually released.
With increased standardization, the market was ripe for alternative means of CDS trading, such as an electronic exchange. Such alternative means would have diminished the buyside’s dependence on the over-the-counter trading services offered by Dealer-Defendants.
And so Citadel and CME Group got together to set up the Credit Market Derivatives Exchange to provide electronic trading of CDS through a central limit order book where anyone could post orders to buy and sell CDS and trade with each other directly, and where trades would be reported in real time. “CMDX would thus have excluded Dealer-Defendants as intermediaries in many CDS transactions and made real-time pricing information available to investors.” But, according to the plaintiffs, the dealers got together to shut this down. They refused to invest in CMDX when asked, refused to participate in the exchange, cleared transactions through a different clearinghouse from CMDX, and convinced Markit and ISDA not to license price data or CDS agreements to CMDX, making it impossible for CMDX to actually trade CDS. And they did this all in classically conspiratorial fashion:
TOne thing to say about this is that it is not hard to understand where the dealers were coming from. CMDX wasn’t just trying to compete with them. It was trying to use their own information to compete with them: It wanted to license their documents and use their trade data to build a product to replace them. The dealers had built up all that informational advantage, which was their livelihood, and CMDX wanted to put them out of business. So they said no.
The banks need to get together and figure out how trades will be processed and how information will be shared; they need to coordinate with each other to make the market function properly.
Another thing to say about it is that the plaintiffs have pretty high counterfactual expectations for how much better the market could have functioned. Mmmmmaybe CMDX would have led to cheap electronic trading of CDS where dealers couldn’t overcharge clients. But there are reasons to doubt that. People keep trying to launch cheap electronic trading of corporate bonds, but the corporate bonds keep stubbornly resisting. So one lesson is the usual one: Don’t put it in e-mail. But another lesson might be that customers and regulators and courts are just less tolerant than they used to be of dealers’ desires to keep information to themselves.
It used to be that everyone grudgingly conceded that dealers should be able to profit from their information. But in a new age of transparency that’s a less popular view, as banks keep unhappily learning.
Bloomberg
By Matt Levine
The job of a dealer in financial markets is to buy low and sell high. Of course that’s the job of an investor too. That’s the obvious, only job. What distinguishes dealers from investors is, loosely speaking, that dealers are not making their buying-and-selling decisions based on some analysis of the value of what they’re buying and selling, but rather based on information about who else wants to buy and sell, and at what price. Their job is to know their customers, not their securities. And the information they have about potential customers is pretty much the value that dealers add. It’s what they get paid for: Sellers come to dealers to find buyers, and buyers come to find sellers. So the dealers try to make sure that they have information that other people — like the customers — don’t have.
This explains like half of the scandals in modern finance. We talked earlier this week about the former Nomura mortgage bond traders who were accused of going to baroque and possibly illegal extremes to hide information from customers. In the mortgage-backed securities market, trades were not publicly reported, and the only way for customers to find out the price of a bond was to ask a dealer. The Nomura traders were accused of lying to the customers about the trades they were doing, to obscure the market price from the customers. In other markets, trades are publicly reported, but dealers can still make nefarious use of customer order information. That’s sort of what the foreign exchange fixing scandal looks like: Customers gave orders to dealers, and dealers used those orders to manipulate prices in ways that the customers did not expect. In the equity market, both trade and order information are public: Anyone can see how many buyers and sellers there are for a stock, and at what price. But electronic market makers race to see it faster, so they can make a fraction of a penny on each trade, and the exact mechanics of how they do that are subject to endless controversy. Meanwhile, spoofers are trying to deceive market makers about the supply and demand for stocks, so they can profit from the market makers’ incorrect information.
The accusation in the CDS case is that dealers didn’t like this erosion of their informational advantage, so they put a stop to it. They took care to keep information to themselves:
To protect their positions of prominence, Dealer-Defendants restricted pre- and post-transaction price transparency. Before a transaction, Dealer-Defendants strove to keep investors in the dark about both the volume of supply and demand and the real price at which CDS were trading. For instance, investors could not see Dealer-Defendants’ solicitations of bids and asks.
And after a CDS contract traded, the trade information went to Markit, another defendant in the case.
In exchange for receiving this data, Markit agreed to DealerDefendants’ condition that Markit not provide pricing information to its subscribers in real-time. Instead, Markit would delay before circulating information, allowing Dealer- Defendants to quote different prices in the interim and to disavow as stale the information that Markit eventually released.
With increased standardization, the market was ripe for alternative means of CDS trading, such as an electronic exchange. Such alternative means would have diminished the buyside’s dependence on the over-the-counter trading services offered by Dealer-Defendants.
And so Citadel and CME Group got together to set up the Credit Market Derivatives Exchange to provide electronic trading of CDS through a central limit order book where anyone could post orders to buy and sell CDS and trade with each other directly, and where trades would be reported in real time. “CMDX would thus have excluded Dealer-Defendants as intermediaries in many CDS transactions and made real-time pricing information available to investors.” But, according to the plaintiffs, the dealers got together to shut this down. They refused to invest in CMDX when asked, refused to participate in the exchange, cleared transactions through a different clearinghouse from CMDX, and convinced Markit and ISDA not to license price data or CDS agreements to CMDX, making it impossible for CMDX to actually trade CDS. And they did this all in classically conspiratorial fashion:
TOne thing to say about this is that it is not hard to understand where the dealers were coming from. CMDX wasn’t just trying to compete with them. It was trying to use their own information to compete with them: It wanted to license their documents and use their trade data to build a product to replace them. The dealers had built up all that informational advantage, which was their livelihood, and CMDX wanted to put them out of business. So they said no.
The banks need to get together and figure out how trades will be processed and how information will be shared; they need to coordinate with each other to make the market function properly.
Another thing to say about it is that the plaintiffs have pretty high counterfactual expectations for how much better the market could have functioned. Mmmmmaybe CMDX would have led to cheap electronic trading of CDS where dealers couldn’t overcharge clients. But there are reasons to doubt that. People keep trying to launch cheap electronic trading of corporate bonds, but the corporate bonds keep stubbornly resisting. So one lesson is the usual one: Don’t put it in e-mail. But another lesson might be that customers and regulators and courts are just less tolerant than they used to be of dealers’ desires to keep information to themselves.
It used to be that everyone grudgingly conceded that dealers should be able to profit from their information. But in a new age of transparency that’s a less popular view, as banks keep unhappily learning.
Bloomberg
