“Price Discovery” is the Thing

Shakespeare’s Hamlet said, “The play's the thing wherein I'll catch the conscience of the King.” One of the major reasons that some credit markets are nearly frozen is the “thing” missing is price discovery.

Hamlet used a play to see whether his uncle King Claudius would flinch at the topic of regicide, so that he would know for certain whether Claudius had murdered Hamlet’s father, the former king. Buy-side institutions use bulge-bracket investment banks’ dealing desks to help discover the price of complex credit instruments and complete trades. However, as the restructuring of the bulge-bracket model is underway on Wall Street, the investment management business has been left holding the bag.

I would argue that although these firms were not “too big to fail,” the cumulative domino effect of Bear Stearns', Lehman Brothers', Merrill Lynch's, Goldman Sachs', and Morgan Stanley’s dramatic fall from grace has forced the buy-side to question their reliance on Wall Street brokerage firms for market insight and trade execution. Although these investment banks are finding new homes within large commercial banks—an evolution that was already underway—we cannot expect the new model to perform the same vital role in credit markets as market makers who assume significant risk. The demise of price discovery is the immediate result, as investment managers have lost confidence in Wall Street’s role of providing liquidity and clarity.

The current narrative in Washington about a government bailout, changes in regulation, a reduction in taxes, or modifying mark-to-market rules do nothing to address the need for price discovery in what have been referred to as less liquid fixed income markets (i.e., where there is no standing market for a specific security). The “play” has been suspended, and Hamlet needs a new “thing” to provide price discovery and promote liquidity for buy-side institutions to reenter the credit markets. TowerGroup has provided us with the answer, although they hid it in plain site within the list of predictions below. Can you guess where buy-side institutions will find the new play?

TowerGroup has predicted that the buy-side will be impacted in the following ways:

1. Less capital commitment from Wall Street
2. Disruption in the provision of execution services
3. Changes in securities lending services
4. Greater focus on risk management
5. Decreased buy-side appetite for structured products
6. Shift in order flow from dark pools to crossing networks
7. Buy-side opportunity to hire top Wall Street talent
8. Elevated positions of second-tier brokers, independent EMS providers, and OMS vendors

I truly appreciate your time spent reading my blog, so I tried to make it easy for you. It should come as no surprise that technology must provide the solution. Has anyone noticed that no one is worried that the equity markets will seize up? Investment banks and insurance giants are going bankrupt, regulators are seizing failed commercial banks, and the impact on industrials and retail remains uncertain. Yesterday we saw the largest point drop in stock market history, yet the equity markets remain robust and liquid. Why?

Price discovery is alive and well in the equity markets, because this function has already shifted away from the voice trading paradigm and bulge-bracket dealing desks to electronic trading platforms and crossing networks. The fixed income markets have lagged the equity markets in adopting new technology, and they are now suffering as a result. If Washington were willing to listen, they may be interested to learn that removing the most toxic loans and securitized loan portfolios on bank balance sheets will not solve the Credit Crunch. To be sure, hoarding of cash, the widening spread in inter-bank lending, lack of commercial paper, and the outcome of credit default swaps are also fueling this crisis; therefore, a multifaceted government response is required. However, promoting and providing liquidity to electronic trading platforms targeting the fixed income markets—so that credit markets can operate under uncertainty like the equity markets—should be a top priority.

ECNs like MarketAxess and TradeWeb have successfully introduced electronic innovation to fixed income, but these networks are still dealer-centric, not anonymous, and only address the most liquid fixed income markets. In the equity markets, companies like LiquidNet and Pipeline have enabled both large buy-side institutions and dealers to find liquidity for dark pools; however, you could characterize most of the less liquid fixed income market as dark and no electronic platform has achieved scale. In fact, there is only one company that I know of that has built and is operating an electronic trading network, which can electronically match orders and execute transactions within the less liquid fixed income market. Take a look at Beacon Capital Strategies, if I have peaked your interest.

TowerGroup’s predictions #1 and #8 are also relevant, because as Wall Street commits less capital to support trading in these markets, the central role of these bulge-bracket dealing desks to providing price discovery and liquidity will decrease. Beacon’s platform facilitates these dealers’ need to reduce capital commitments as well as empowers second-tier brokers to service their regional clients better. These second-tier brokers are trying to step up to fill the gap, and they need a new mechanism for price discovery as well.

The Credit Crunch is accelerating the evolutionary transition to electronic trading in the financial markets. Nevertheless, it is imperative that Washington understands that for the healthy flow of credit to resume, liquidity is predicated on not only removing fear that trading partners may fail (i.e., counter-party risk), but also promoting solutions to reestablish price discovery to essential credit markets.