Dollars and Jens
Friday, February 20, 2004
Brokertec's new cash market
This post has a point, and a relatively short one, but I'm going to puff it up with a lot of background first.

Background : workup state Decades ago, you traded bonds by calling up a broker. If you left an offer with him, and somebody decided to buy at your price, you'd get a call telling you about it. If the other person was looking to buy more than you were offering, the broker would ask whether you wanted to sell more at that price, and you could increase your volume on the phone, even if someone else was offering bonds at the same price. It was logistically easier than to force you to make a new offer and put that behind the other one. When markets went electronic, they retained this system; when a trade executes, the market halts for a time while the parties executing the order negotiate the volume. This leads to strange behavior and occasional games when the market would want to move a lot. Young traders view it as archaic.

Background : price improvement A couple years ago, one of the large tenants at the top of the World Trade Center was Cantor Fitzgerald; while many of its employees were killed, it's still around, and it's still the biggest bond broker. A year or two ago, in search of a new revenue stream, they began offering to let people bump ahead of each other for a higher commission; by buying "price improvements", you could bid at 106-13 and have your order executed ahead of another bid at 106-13, even if the other bid was there first. There would be no market for this if tick sizes weren't so large compared to both the commission and the typical bid-offer spreads, but by letting you effectively bid an extra tenth of a 32, but one that Cantor rather than the other dealer gets to keep, Cantor gets to make a little more money. This offends many traders' views of fairness.

News Brokertec (recently acquired by Eurex US) will soon be offering a market in which the work-up state has been eliminated. Brokertec never had "price improvement", but hasn't had the kind of liquidity that Cantor has; the interesting thing to watch will be whether they draw much flow based on their market design.

Incidentally, one more eccentricity of the cash markets is that each issue really gets two markets, one for bids and one for offers. If you want to sell, you have to specify whether you're trying to sell against a bid or whether you're placing an offer; the markets lock regularly (i.e. the best bid is the same as the best offer), and occasionally the market has actually crossed, though that's arbitraged out pretty quickly. I think Brokertec will still be doing this. (The futures market doesn't do this, nor does it have work-up, nor does it have price improvements. It's frankly normal.)

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