Odd Lots - 48: The Lost History of Financial Market Modernization

Episode Date: October 3, 2016

How is it that stocks are traded on electronic exchanges in the blink of an eye but bonds still trade over-the-counter by phone and sometimes even by fax? Today we discuss one of the most pervasive mysteries of market structure with Chris White, the former Goldman Sachs executive who's now CEO of ViableMkts, and his old boss, Les Seff, COO at AIMPaaS LLC, to discover why bond trading remains so darn old-fashioned despite numerous attempts to pull it into the 21st century. Looking back at history, we can see a pattern to market modernization that was initiated by the OTC equity market almost 50 years ago. Can this history provide us with insights that can put fixed income markets on a path to modernizing?See omnystudio.com/listener for privacy information.

Thanks for listening to OddLots. Follow the show on Amazon Music for more future episodes or just ask Alexa play the podcast, OddLots on Amazon Music. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a very big line. It's a lot. It's a firm. a commitment to your clients. We're talking top grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com

slash audio. That's vanguard.com slash audio. All investing is subject to risk vanguard marketing corporation distributor. Put knowledge to work and grow your business. with CIT. From transportation to health care to manufacturing, CIT offers commercial lending, leasing, and treasury management services for small and middle market businesses. Learn more at cIT.com. Put knowledge to work. Welcome to another edition of Oddlots. I'm Tracy Allaway, executive editor of Bloomberg Markets. And I'm Joe Wisenthal, managing editor of Bloomberg Markets. So, Joe, when you think about a modern marketplace, what makes it modern? I think about, a lot of people around computers and data flashing in their eyes. And maybe there's not even a person

from the computer, maybe just some software making decisions, but lots of screens and blinking data, basically. So you're actually thinking about some very specific markets, probably the stock market, maybe the currency market, because there is actually one very large market that has stubbornly resisted all attempts to electronify itself and to modernize. Yeah, I guess I am. I. I guess I'm probably, yeah, stocks and currencies probably. Maybe commodities. Right. All right.

The one that's been left out is basically the bond market. This is the place where people trade corporate debt, securities issued by companies, and a lot of that is still taking place over the phone, sometimes even by facts, which is kind of insane when you think about where we are today in terms of technology. That is sort of pretty hard to believe. I mean, we've talked about this before. And, of course, you can look up prices of a corporate bond on a terminal, and you'd think that

why not just be able to enter in that you want to buy or sell? But it still kind of blows in my mind that it's not, that it's the case that it's not that easy. All right. So today we are going to delve into the mystery of bond market modernization or lack thereof, why it hasn't happened before. And I'm pleased to say that we have a recurring guest with us today. It's Chris White from, well, he's now at viable markets, used to be at Goldman and was very involved in the bond trading platform they built there called G Sessions. And to make things extra special, Chris has brought along his former boss. It's Les Seff.

He has a very long history not only in bond market structure, but also in stocks. And he's currently at a software firm called AIMPASS. I'm really excited about this because the last time we talked about market structure with Chris, I think was one of my favorite episodes. So I'm glad we're returning to the well and going deeper on this subject, which is fascinating. So let's get gone. Let's dig deep. Chris and Les, thank you so much for joining us today. My pleasure to be back, Tracy. Just having listened to a lot of the other Odd Lots podcasts, I'm just happy to be a part of some of the original.

The early days. Yeah, exactly. That's the exact thing to say to get you on yet again. Well, no, I really do enjoy it. That's an honest statement. And I think that you're in for a really special treat today because Lessef can talk about an area of equity market structure history that I think is really pertinent today. It was the formation of a piece of architecture that if you look through history, the NASDAQ system is something that's been mimicked throughout other market systems in terms of being a critical piece of architecture on their way to modernization. So I think it's going to be very

interesting to hear what Les has to say about the before and after picture in the equity markets in 1971. That's when NASDAQ was introduced and that's when Les arrived on the scene. Well, Les, why don't we start with you then? You've said you've been in trading in some way or another since the 1970s. Tell us what the stock market was like back then. Sure. Well, let's start with 1971, which is when I started. At that time, not only was the market not connected by computer, or the equity market, not connected by computer, but the people that comprised the trading departments were very different as well. Today, you've got MBAs from MIT sitting on the desk. Then, basically, we were a bunch of street fighters. And the connection between one firm and another, or the connection was something called the pink sheets.

If you wanted to know the price of a stock in those years, pre-Nazdak, that is, if you wanted to know the price of an over-the-counter stock, was called over-the-counter at that time, you would get a copy of the pink sheets, open it up to the alphabetical. listing of the stock. And there'd be a list of five or any number of market makers that traded the stock with their name and their phone number. And you would simply call them up and ask them for the market in XYZ. And you were obligated to make three phone calls. There may have been 10 market makers. You were obligated, if you were executing a client order, you were obligated to get three quotes, which left seven out, potentially. So even with pink sheets, you had best execution requirements. Best execution was really, if it's a fuzzy concept now, it was even fuzzier then

because the markets were very, very thin. So an execution of a thousand shares could have been at multiple markets. And the guy on the desk who was executing on behalf of the client would basically stay with one firm. So obviously these days with electronic trading, there's so much talk about collapsing margins of trading and, you know, people making fractions of a penny here and there. But this sounds like, you know, the extreme opposite end of that where lots of, lots of opportunity to make money in the human interaction and the fact that you only had to call three out of ten people and so forth. Spreads that you could drive a bus there. Yes, exactly. Yeah, well, that was that was very true. I mean, Mark, markets have collapsed in recent years primarily as a result of increased volume and as a result of decimalization back, you know, almost 15, 16 years ago. But in those years, there was no

such thing as decimalization. Stocks are traded with very often a point spread. A half a point spread was not unusual, and stocks under a dollar was sometimes traded with three. three-eighths to a half a point spread as well. So the difference between the bid and offer was, you know, as you said, you could drive a truck through it. So market makers could essentially pocket the difference between the spreads on the buy and sell orders. What made that change? Like, what was the impetus for the stock market to start modernizing and to head towards things like decimalization? Well, there were a number of reasons.

Firstly, while the spreads were substantial and the likelihood of making money on a trade was pretty substantial, the volume just wasn't there. I remember a big trader in 1968, which is before, I'm thankful to say, before I started, was making somewhere around $100,000. And his profitability was there for. like maybe 250. And that was, that was huge at that time. But as I said, the volume was just wasn't there. Subsequent to that, that period in 1970, late 70, early 71, I believe it was NASDAQ started. And NASDAQ was a more transparent view of the markets. Now, during the Pingsheet environment, As I said, prior to NASDAQ, the client or the trader at another firm would call up the market maker and ask for a quote. And as a result, market makers would give different quotes to different folks.

If they sensed that you were a buyer, you might have gotten one quote. If they sensed you were a seller, you might have gotten another quote. And if they sensed that you were calling on behalf of a competitor, then you got a really strange quote. So actually, Les, this is one of the things that I think is most fascinating is that you're talking about a period in time that was almost 50 years ago. But in terms of the cultural practices and the infrastructure, it's not that far away from where we are in terms of the modern day corporate bond market. Today, there really isn't a facility that organizes all of the quotes, the way that NASDAQ organized the quotes. and also what you describe in terms of different prices for different people is absolutely a function of the market. What sort of drove the idea that you need to get out of the pink sheets and into something that was a bit more centralized and focused around pricing?

Well, it was driven partially by the retail firms. I don't remember now the name of the guy who started NASDAQ, but I believe that it was sponsored by the NASD. And I believe that Reynolds, which was one of the larger retail firms, one of the executives at Reynolds was the guy who was tasked with starting the NASDAQ system. And basically, it was kind of, rolled out over time and the functionality changed over time. Initially, it was simply a presentation of the median market, which is the most repeated market. So, make an easy example, if there were

four traders trading a stock, one was 10, 11, another one, 10 and a quarter, 11 and a quarter, third one was 10 and a quarter, 11 a quarter, and the fourth one was 9 and 3 quarters, 10 and 3 quarters. The inside market was 10 and a quarter, 3 quarters. The market that was visible on level 1 was 10 and a quarter, 11 and a quarter. It was the most repeated market. So they didn't see the inside market. The salesman, for example, at Merrill Lynch, didn't see, you know, just to, not to single them out, but the salesman at the brokerage firms didn't see the inside market at the time.

And they weren't aware of what the volume was day one. So how did the market makers actually feel about those changes at the time? That's exactly what I was going to ask. Who fought it or these changes happened? And so how did they feel? And were there any people right from the beginning resisting the changes? Try everyone was resisting the changes. The market makers were shaking in their boots.

because they were in their minds making a living, and this was going to destroy their living because you didn't want your competition to know your market, and this was going to make your market very transparent. Plus, you had to honor your market, which prior to actually divulging what your market was, you know, in a NASDAQ environment, you had to honor what the market said you were on NASDAQ,

and that was kind of a new concept. Did they try to stop it? Yeah, all the soldiers tried to stop it. The generals thought it was a good idea. And basically it was an amazing idea. It was right for the client. Being right for the client meant that a volume exploded over time, but really just exploded.

and from 1971 to today, I mean, volume is just so different than it was then. And in addition to the volume exploding, the profitability of the market maker exploded with it may not have made as much money per trade, but the spreads ultimately tightened a little bit. They didn't really change until years later when in the mid-90s when the dealers were accused of collusion. So were they eventually able to make up the tighter spreads in volume, in other words? Yes, by far. Okay, well, let's fast forward many decades to the bond market, because Chris, as we've all discussed before, in many ways.

the bond market is where the stock market was many years ago. In fact, I remember talking to one bond dealer who said it was like the last ages of the Roman Empire, and the dealers are essentially trying to protect the profits that they can make from bond trading. Well, I think that similar to the fall of the Roman Empire when finally I think it was the Goths or some tribe of barbarians that stormed the walls, there was deterioration for some time. I think if you just look at even how the top five dealers have been performing in market making for corporate bonds, ever since 2009, they've seen declining results year over year. So I think a lot of people are starting to question the efficacy of the traditional model.

One of the things that's fascinating about the way Les talks about the fears of the market makers in unlisted stocks prior to NASDAQ as they sound very similar to a lot of the fears that we're hearing. when we talk about transparency in the bond market, we're having issues around secondary trading. And yet there are some people in the market who are actually saying that less information in the form of delaying the post-trade tape would bring market makers back into the market, which I think that we've looked at all the other markets that have modernized. And they've done so by actually adding more information, not less. So I think that culturally we're at the same inflection point that the equity market was in almost 46 years ago. So how do we get over that hump then? Because it seems like it's not only a business model change, it's also a cultural change. And there are people who will fight it every step of the way. Well, I think it's really good to understand history and really what happens. I mean, what less is telling you is true. Anyone who is trading NASDAQ stocks and who went through the change of the actual NASDAQ platform, which stands for,

National Association Securities Dealers automated quotation system. At first they were afraid, but then they found that it was beneficial not only to the customers but to the market makers as well. So I think that if you look at the history of other markets, for example, the FX market started with a consolidated quote board and something called the Reuters Market Data Service in 1985. The listed market had to organize into its consolidated quote service in 1974, 75. Treasury market after recovering from the Solomon Brothers government bond scandal had to produce a consolidated quote system in 1991, something called GovPix. So it seems to me, and the more I talk to less and other people who have worked in those markets, that organization around

pre-trade information is a key piece of architecture for modernizing a market. Let's take a quick break for a word from a sponsor. Put knowledge to work and grow your business with CIT. From transportation to healthcare to manufacturing, CIT offers commercial lending, leasing, and treasury management services for small and middle market businesses. Learn more at CIT.com. Put knowledge to work. We're talking to Chris White and Les Cef about market structure and how the bond market is arguably decades behind where the stock market is in terms of getting into the modern era. So, Chris, I want to return to the point that you made before the break. Your basic argument is that sure, bond market participants like stock market participants

decades ago are resistant to change, but that from your perspective, the current model is already broken. It's already not working for them as it was several years ago. So they should see the benefit to modernizing, essentially. Well, I think that there's universal acceptance within the institutional market that something needs to change. I think the way that we're trying to change the market is missing a step. Just to ask you less, when the NASDAQ board was put into place in 71, was it a trading system or a bulletin board? Like, could you actually complete a trade by pressing a button on the screen?

No, no, it wasn't interactive. It wasn't until after the 87 crash that there was any electronic interface where you could press a button and get an execution through the NASDAQ system. That was called the SOS system, small order execution system. So explain how the process of trade worked. You then got your quote through the NASDAQ system but then went back directly to the market maker for the actual call in the trade? You were back to calling him up on his phone. and if you were lucky, you had a direct wire to them, in which case you flicked a switch and you were into him and you saved five seconds.

So I bring this up because Les just told you that there was a 16-year gap between the introduction of NASDAQ and actual robust electronic trading in the equity markets. So when you look at a lot of the unstructured fixed income markets, people are trying to fix them or reform them using. modern electronic trading protocols and ideas. But I think we've missed something. And I think that what illustrates the fact that we've missed this piece of architecture is a lot of the attempts to fix the market with electronic trading have failed in the corporate bond market. I myself, the G-Session system for Goldman Sachs had some fundamental flaws with it. And it's only seeing those

flaws that I started to think that maybe there was something missing. And then when you look back in history, there is something missing. Every other market that we consider modernized today had to organize their pre-trade quote information before they started trading electronically. Well, how come we made that leap then? Why did we avoid the step of sort of centralized pricing and just jump straight off to pure electronic trading in corporate bonds, which, as you point out, doesn't seem to necessarily be working? I think it's a combination of two things. One, I think it's a misunderstanding in market structure, believing that electronic trading is not market structure. It's really the result of having a good foundation of market structure. And then, quite frankly, a lot of

the people who saw this history in the equity markets are either no longer on this earth or, you know, just not available to help people in the bond market. That's why I think that, you know, less is a treasure because he can actually speak to the before and after of a key part of the equity market structure history that I think just a lot of people are not aware of. But, you know, at some point in time, market's traded out of a magazine. And if you look at old newspapers, you'll see if you wanted to understand what your stock was worth, you were just looking through the quote page, which sounds funny to us now that you could pull up anything on a Bloomberg screen and see information around it. But it really did function as a market back then, but eventually they had to change it. And

it seems like the path that they created was mimicked by other markets. But what about the argument that the bond market is in some way fundamentally different to the stock market because stocks, you know, you buy a share of Apple, it's a share of Apple. But if you buy an Apple bond, it could have a different maturity, different coupon, whatever. And that's what people say is often holding back the bond market from becoming standardized in some way. Well, yes, I mean, it is different. And I think that is a solid argument. But when we're talking about the sequence to market modernization, it's happened in different products, but the same way. Meaning that you do didn't see robust electronic trading in the Spotfx market until they organized their quotes. You certainly did not see electronic trading in the U.S. Treasury market before they organized their quotes. So I think what we're really arguing about is semantics. Nobody is saying that the corporate bond market is going to trade in an order book and you're going to have high-frequency trading coming anytime soon. But we do have an issue that those other markets

faced in which those markets had reached an inflection point in terms of the size and popularity of the market that now necessitated people knowing what something was worth on a screen. I think that what we're really looking at is any market that's modernized has done so by decreasing ambiguity around the trading process. And seeing Best Bid Best Offer is something that just doesn't exist in a lot of the unstructured fixed income markets that are now begging to be reformed. Les, when the NASDAQ first took off and there was this sort of a bulletin board where you could see all the prices everywhere, was it clear that that was a first step towards a new way of trading or at the time did that seem like, okay, this is the new reality?

Because obviously in the telling of history, it's a first step, but at the time you don't really know which way things are going to evolve. We thought that that was about as far as things could go. And months or years later, I don't remember exactly when they started talking about reporting volume, that was another seismic shift in the marketplace. The fact that now your competition could deduct what your volume was was offensive to the trader and scary. and ultimately real-time reporting, that was also an evolution that occurred years later. There was no price reporting at the time that the trades were done in the early NASDAQ environment. Chris, it's been about a year since we last had you on. What are the chances that...

Have we been doing this that long? Almost, yeah. I know, it's scary, right? Wow. What are the chances if we had you on again in a year, which I'm sure we will. But if we have you on again in a year, what are the chances that something will actually have changed in the corporate bomb market? Because I feel like we have this conversation continuously, and we're always talking about the inflection point that's coming, and we're inevitably left disappointed. Well, I think conversations like this are a part of the change.

A lot of the times, you know, with the exception of the people that I read at Bloomberg and a couple of the, other publications. I read people telling a story about markets. It's not exactly accurate in terms of the history and sequence of things. So I think first, there's a bit of knowledge that needs to be built up around how do markets reform. Number one, number two, I'm willing to place a bet that people are going to push forward with ideas that may start to change the way we're thinking about markets. I think one of the main reasons why I feel so confident about this is you're seeing a lot of people who've been sitting in traditional seats at Wall Street firms now on the street and trying to become innovators and entrepreneurs. Most of the people

leading new initiatives right now are people who actually were sitting in the seats. And I think that that's a step in the right direction because obviously they have some experience as to what the actual problems are and therefore they know what solutions would be most helpful. All right. Well, Chris, we'll have to have you on again in a year. Hopefully, hopefully I will have cashed in my bet at that time. And we can talk about how the bond market is actually changing. And I look forward to it. All right, Chris and Les, thank you so much for what's really a fascinating dig into the lost history of financial market modernization.

Thank you. Thank you for having it. Well, Tracy, I'm really, I like the idea of doing this episode once a year and sort of watching this. Our annual bond market. Yeah, our annual look to see if anything's changed in the bond market. I'm excited about having this be a reoccurring feature. I mean, I feel like people are as much hopeful about reforming that market as they are also wary. Like, you talk to the guys on the street, and there's still this huge, huge resistance to any form of change,

which, again, is kind of amazing because we have seen the corporate bond market explode in size. It's something like $7 or $8 trillion now. one of the hot areas on Wall Street. Yeah, I get, I mean, ultimately, it's sort of understandable that nobody wants change in an industry, particularly if they're making money in that industry, though given the direction of a lot of things, maybe the lack of making money will be an impetus. I thought that was just this sort of timeline point that Chris made in hearing less talk about it, the idea that you can't just say, all right, we're going to make it all digital

now and everyone put up your bids and asks and start trading. and how important it is to first in the history of the stock market, first just establish that there's a singular place to go and get a quote from securities is a fascinating point. Yeah. All right. Speaking of change, shall we change the topic and say goodbye? Sounds good. I'm Tracy Allaway, executive editor of Bloomberg Markets. You can follow me on Twitter at Tracy Allo.

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