The fixed income trading business has been notoriously resistant to change. Large banks earn handsome profits from the business—JP Morgan earned $15.5 bn in revenue last year from its fixed income division—and so have been reluctant to change them. That has meant that until now, even in the face of huge technological overhauls elsewhere, most fixed income trades still happened over the phone. However, alongside regulators’ demands for standardized exchange-traded interest rate swaps, banks are beginning to automate some fixed income business. JP Morgan is now using its own fixed income system, Q.M.M., to trade government bonds and interest rate swaps, and other banks are adapting too. Many banks, including Morgan Stanley, have named technological heads for the fixed income divisions, with the broad remit to try to transfer large swaths of the business to online platforms. The banks are meeting internal pressure from traders and salesmen, who do not want to lose their jobs to computer algorithms, but banks say this will not stand in their way.
FINSUM: In the long-term this may have a tangible effect on bank earnings and liquidity, but it is still in the early phases. Corporate and mortgage bonds are likely to stay off such platforms for a long time because of their inherent illiquidity. Banks hope electronic platforms will offer huge volumes despite much tighter margins.
Senior Financial Times Columnist Gillian Tett has written an insightful article on the links between the recent market selloff and the important reality of liquidity. Tett explains that liquidity has been hurt by four factors, and all of them helped exacerbate market volatility over the last few weeks. Firstly, most market investors are holding the exact same views, which has left everyone caught by surprise. Last week, 100% (truly) of surveyed economists said they believed interest rates would rise soon—this helps explain the like-mindedness of investors. Secondly, and leading on from the first point, asset managers have adopted a severe herd mentality, and are all buying and selling the same assets at the same time, which makes rises and falls much steeper. Thirdly, computer programs and algorithms, despite purporting to boost market liquidity, have actually made things worse. Most of them operate in a similar fashion to one another, and because they can function at lightning speed, move markets even faster downward than in the phone-based days. Finally, and perhaps most critically, regulations have forced large banks out of the market-making space in many products. This means that there is simply not enough liquidity in trading to handle the volume of bonds in the market at an adequate level, leading to heavy losses.
FINSUM: A great article showing just how important liquidity is, how a lack of it was hidden by market gains over the last 18 months, and the individual components that have dried it up. A must read for a better understanding of the current liquidity infrastructure of markets.
Global market turmoil, sparked by an uncertain mixture of negative financial news, worries over growth, and the end of Fed stimulus, have very likely spelled an end to dealmaking for the year. 2014 had seen M&A and IPOs at all-time highs, with merger and acquisition deals hitting a historic high of $1.3 tn, while IPOs hit a post-dot com era record of $81 bn. The dealmaking fervor hit its peak on September 19th, when Alibaba held its IPO, only to see its stock jump quickly and the S&P 500 hit a new all-time high minutes after the opening bell. However, many of the deals that were planned for the next few weeks have already been indefinitely delayed, as anxious executives and bankers wait and see how markets react to the selloff of the last few weeks. In contrast to their colleagues in trading, market volatility is very negative for M&A, as shaky markets make companies shy away from listing. However, as ever, M&A bankers remain optimistic, saying there are many more “spin-offs in the pipeline” and that lower stock prices might actually fuel more acquisitions because targets will look cheaper.
FINSUM: While this sell-off has not created a crisis, it has given all participants a serious shock. With markets looking so vulnerable, and rumblings of QE4 already on the horizon, odds are companies will stay in “wait and see” mode for the time being.
A group of market watchers, led by the IMF, has signaled the alarm over high yield bonds. A handful of large asset managers, including Pimco, Fidelity, BlackRock, and Dodge & Cox, hold an eye-popping proportion of high yield bonds, and that poses an unequivocal threat to credit markets. In many bonds, such as auto financier Ally Financial, or student loan company SLM, managers like Pimco control as much as 30-50% market share. This commanding position creates severe issues for both the managers and the markets, as most of their holdings are highly illiquid and only held by one another, meaning in a period of stress, perhaps similar to the one we have just seen, the managers would very likely be unable to offload the bonds without extraordinary losses. This is a major concern because it would incite panic across credit markets, but further, because individual managers would therefore be very unlikely be able to meet redemption demands from their own fund investors. If they cannot liquidate the bonds quickly enough, or at prices high enough, there is no way they could meet immediate withdrawal demands. The same bond investors hold even higher shares of bonds in European markets, including heavily indebted sovereigns like Italy and Spain. Because of regulatory constraints, banks are no longer major market-makers in illiquid credits.
FINSUM: This is a fascinating story which shows just how vulnerable both bond markets and the whole asset management sector are to liquidity runs. Holders of many of these corporate bonds could see heavy losses in the event of a startled market.
Hedge funds are seeing their worst year since the emergence of the Euro crisis in 2011. Many funds have been hurt by positioning and outlooks that have been significantly wrong—such as a rising of rates, the completion of large tax-driven mergers, and bounces at Fannie Mae and Freddie Mac. This has forced many of the largest funds to cut their losses, and that has significantly hurt performance. In total, Hedge Funds are expected to lose 1% as an industry, on top of the 0.75% they lost in September. The so-called “tiger cubs”, including managers like Chase Coleman, are also performing poorly and have gone into the red for the year. Carlyle Group’s fund, Claren Road, has lost 11% since the beginning of October. Funds have also been hit by the drop in Oil prices, as early year bullishness on the sector lead to heavy energy share buying.
FINSUM: Hedge Funds have had a rough year already, with Calpers ditching investment in them, but their poor bets are just adding fuel to the fire. Also, investors beware, many think the late day rebound in equity markets yesterday was from funds buying back stocks as they cashed out on short positions. It may have been a very hollow support level.
Oil’s price is dropping globally. WTI, America’s benchmark, is now just a shade over $80/barrel, while ICE Brent, the world’s benchmark, is at $83. This reality poses a major hurdle to Saudi Arabia, one of the world’s largest oil exporters, and long the leader of the powerful OPEC union. Many have called for Saudi Arabia to crimp its production in order to help support prices, but the country has decided to gamble, and says it will not lower its output. The strategy is a risky one—in the early 1980s it did the same thing, only to see prices collapse. The kingdom seems to believe that prices will stay low no matter what, given the huge surge in production globally, and unilaterally slowing demand. It appears to be using a deliberate strategy of allowing oil prices to drop as part of a plan to severely disrupt US shale production, which it believes is uneconomical at prices below $90/barrel. It hopes that a prolonged bout of low prices will hurt further investment in shale infrastructure and help to restore its own dominance. The move also hurts Russia, which has been funding Assad in Syria, and undermines new Iranian efforts to boost oil production alongside new nuclear agreements with the West.
FINSUM: This is a very important read as it gives insight into Saudi Arabia’s strategy, which will greatly dictate world oil prices. It looks like markets should not be expecting rebounding oil prices in the near term.