How DIY Bond Traders Displaced Wall Street’s Hot ShotsDaniel Kruger and Liz Capo McCormick
Time was, Sherman McCoy could stride into Pierce & Pierce to bray for money on the bond markets with other Masters of the Universe.
That was 1987. McCoy, the hotshot bond dealer at the center of the “Bonfire of the Vanities,” would be 66 by now, and he’d scarcely recognize the Treasury market.
The bond dealers who defined Wall Street success in the ’80s -- and who were immortalized by Tom Wolfe in his best-selling novel -- seem to be losing power by the day.
In their place are money managers like Mark MacQueen, who are assuming a larger role in the market for U.S. government debt as traditional dealers pull back.
The development is not only shifting the balance of power in the world’s largest government bond market, but also making trading Treasuries more difficult for everyone. MacQueen used to be able to trade $40 million of Treasuries by calling one dealer. Now, he must spread out orders in small chunks across an array of electronic platforms and wait for a dealer to bite.
“The liquidity is provided by the clients, not the dealers,” said MacQueen, a 34-year bond-market veteran who oversees $11 billion at Sage Advisory Services Ltd. in Austin, Texas. “Bigger firms are finding it increasingly difficult.”
The problems investors face in Treasuries are small next to those in other smaller markets, such as the one for corporate bonds. Nonetheless, the issue has gained widespread attention on Wall Street and even begun to worry the Federal Reserve.
It has also underscored just how far the old Masters of the Universe have fallen.
“Being a Master of the Universe once meant something,” Mark Rzepczynski, the chief investment officer at AMPHI Capital Management, said from Boston. “Those days are over.”
The shift to a more do-it-yourself approach to trading can be seen in many ways. At U.S. auctions this year, the 22 primary dealers designated to underwrite the debt and trade directly with the Fed bought 36 percent of Treasuries sold, the smallest share on record, Treasury data compiled by Bloomberg show.
Deutsche Bank AG, the biggest bond firm by trading volume, is looking to shrink its interest-rate trading business, a person familiar with the matter said this month.
And in the past year, JPMorgan Chase & Co., Morgan Stanley, Credit Suisse Group AG and Royal Bank of Scotland Group Plc have have either scaled back their fixed-income trading desks or are weighing reductions in those businesses. At the same time, electronic trading of Treasuries has proliferated over the past decade and now accounts for 44 percent of all transactions.
“The dealers are just smaller players,” said William O’Donnell, the head strategist for U.S. government debt at RBS’s unit in Stamford, Connecticut. “The bonds are increasingly being held by end-users as opposed to dealers who formerly acted as a way station for people’s risk.”
Compared with the size of the Treasury market, which has more than doubled to $12.6 trillion since 2008, average daily trading by primary dealers has dwindled to 4.1 percent of the amount outstanding from 13 percent in 2007.
Even if you exclude the Fed’s debt purchases, dealers are still less active in making markets now than they were then.
For their part, the dealers blame regulations such as Dodd-Frank in the U.S. and Basel III, which were put into place to keep financial firms from taking the types of risks that precipitated the 2008 crisis. As a result, the dealers have slashed bond inventories and limited the amount of opportunistic trading that they can do with their own money.
Since 2008, they have collectively cut their holdings of debt securities by about half to $210 billion, according to Jefferies Group LLC, another primary dealer. The estimate takes into account changes in how the Fed collected the data in 2013.
Primary dealers are also relinquishing their traditional role as underwriters of America’s financing needs to mutual funds and foreign central banks. In addition to buying fewer bonds at auction, primary dealers’ share of winning bids has slumped to an unprecedented low of 18 percent.
“To the degree that they’re wanting to step back and not wanting to commit as much capital as before, it’s a form of ceding of control,” said Wan-Chong Kung, a Minneapolis-based manager at Nuveen Asset Management, which oversees $225 billion.
The pullback has been a boon for Prudential Financial Inc., the second-largest U.S. life insurer. At the Treasury’s $16 billion auction of five-year inflation-linked notes on Dec. 18, dealer demand was the weakest in more than eight years, helping to push up yields to the highest since 2010.
The resulting decline in prices enabled the Newark, New Jersey-based firm to buy the notes at a level that was “relatively cheap,” said Erik Schiller, a money manager for Prudential’s fixed-income unit, which oversees $533 billion.
“It’s a good position to be in,” he said.
The trade-off is that when the selling starts, investors may suffer deeper losses without Wall Street dealers that are willing to step up, particularly as the Fed moves to reverse its six-year-long policy of holding rates close to zero.
Those liquidity risks first emerged in May 2013, when then-Fed Chairman Ben S. Bernanke touched off a torrent of selling after he signaled the central bank was considering a reduction in its extraordinary bond buying.
In the two months that followed, yields on benchmark 10-year notes surged 0.81 percentage point, the biggest jump in a decade. The yield was at 1.97 percent as of 12:15 p.m. in New York, falling from 2.72 percent a year ago.
Now, with futures traders pricing in the Fed’s first rate boost in December, concern over a repeat of the “taper tantrum” is growing, according to Donald Ellenberger, who oversees $10 billion as the head of multi-sector strategies at Federated Investors in Pittsburgh. Ellenberger says the episode prompted the firm to trade more electronically.
It “was a wake-up call for a lot of people,” he said.
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