Via Peter Tchir of TF Market Advisors [11],
Markets have become far less volatile than last year, but many investors remain focused on the Credit Markets for signs and cues as to the next move. With so many people looking to moves in credit markets and trying to determine how successful an auction has been, I thought it would make sense to go through some examples of how credit trades. At one extreme you have a real market like for the E-mini S&P futures. That trades from Sunday at 6pm EST until Friday at 4:15 EST. It is virtually continuous and at any given time you can see the bids and offers of the entire market. Then you have credit trading, which has almost nothing in common with ES futures and their incredible liquidity and transparency.
I will look at some examples of how European CDX Indices trade, a Single Name CDS trades, what an Investment Grade Bond New Issue looks like, and how a block trade in High Yield bonds work. These examples aren’t quite meant to be the norm, but in spite of being simplified with some slight embellishments, they aren’t atypical either.
This is a work of fiction and none of the banks or people mentioned represent real banks or individuals (even if you know who you are).
An hour in the life of the MAIN CDX index in Europe
Cast of Characters
· MAIN CDX Index
o This is a CDS index with 125 Reference Entities. They are all European Investment Grade Credits – a mix of corporate and financials.
· Market Makers
o Big Axed Bank: This bank is a major dealer and for some reason (positioning or client flows) is currently an “axed” buyer of MAIN
o Big Bank 2: A strong market maker and liquidity provider in MAIN but currently indifferent on the market
o Weak Bank: A marginal player in the market trying to retain a presence because they feel they need to be in the business
o Interdealer Broker: Not really a market maker, but not really a client either, they only trade with market makers, and market makers only trade with each other through an interdealer broker
· Clients
o Aggressive Hedge Fund: Looks for opportunities to push the market and profit from making the market “more efficient”
o Fast Momo Fund: A fund that is very momentum driven and is fast to react for quick small trades
o Slow Momo Fund: Looks for trends to develop a bit longer before making decisions, especially in credit where they have less experience
o Caught Short Fund: This fund is positioned short the market with tight stops
o Bank Hedger: This is the desk responsible for hedging a bank’s exposure to credit across all products
Initial Runs or Prices
Each dealer sends out runs via Bloomberg and updates their “screens” for clients.
Big Axed Bank goes out 155.5/156.5 and updates their client screen with that price. They also put up 155/157 on the Interdealer Broker screen just to get something going “in the street”.
Big Bank 2 goes out 155/156. They hear that it is better bid away, but with stocks stable, and if anything, ticking up a bit in spite of mediocre data, they think there are more likely to be sellers than buyers. They decide to join the bid on the Broker screen mostly because they are bored and doubt they will get hit since they are second bid, but figure it will mess up the better bid that is out there.
Weak Bank also goes out 155/156. They checked with some of their “run monkeys” and got colour on where everyone else was. With the stability in stocks they think 155/156 is far safer than going out 155.5/156.5 though they are a bit scared that if they get lifted they can’t immediately cover in the street.
The First Trade
Aggressive hedge fund sees all three screens. He is curious why Big Axed Bank is so well bid. It seems a bit aggressive, especially with stocks ticking up a bit in spite of weak data. He gets on the phone with his salesperson at Big Axed Bank:
Aggressive Hedge Fund (AHF): Hey, how’s it going? You guys seem axed to buy MAIN, anything going on?
Big Axed Bank Sales (BABS): Nah, I was already checked by someone else. Trader wants to clean up a small position. Thinks it might go tighter but just wants to book some profits.
AHF: How much is he looking for?
BABS: I can ask, how much are you looking to do?
AHF: I’m just checking some other positions, but probably not too much if I have anything to do.
BABS: Trader said he was really looking for 100 MM, but would take 250 MM for you if he had to.
AHF: I’m not sure I have 250 to go, but what size would take him out? Last thing I want to do is hit him and have him leave it bid.
BABS: 150 would take him out.
AHF: Done, I sell you 150 MM at 155.5.
BABS: Done, thanks for the trade.
The Next Trade
Big Axed Bank refreshes their screen 155/156 and sends out a run posting the trade and refreshing the market via Bloomberg as well. While this is occurring, AHF is quickly hitting the 155 bid Weak Bank had up on their screens. The screen only worked for 100 MM, but AHF sells 100MM at 155 electronically. This leads to a quick call from Weak Bank Salesperson to thank them for the trade and confirm it is done. A junior trader at AHF asks the senior trader why he didn’t sell more at 155.5 to Big Axed Bank or why he didn’t hit Big Bank 2 at 155 since they do a lot more business with them than Weak Bank. The senior trader just rolls his eyes and explains that he knows Weak Bank has no tolerance for risk and would immediately offer it out in an attempt for a quick profit. Although Big Axed Bank had told him that they were out of the axe, he didn’t think selling them much more at 155.5 or even 155 would have scared them at all. Big Bank 2 also has enough strength it might have taken a lot of size to move them off their bid, but Weak Bank is already scrambling to cover.
Sure enough, Weak Bank immediately refreshes their screens at 154.5/155.5 and updates their Bloomberg distribution with the post that it traded down. They also put in a 156.5 offer on the Broker screen. The Broker screen had been 155/157 with 2 guys on the bid. Weak Bank gives them the 156.5 offer (which is higher than where they are offering it to clients) in the hopes one of the bids steps up to 155.5.
Now It Gets Interesting
Both Big Axed Bank and Big Bank 2 are immediately posted by friendly clients that it traded down at 155 away. Big Bank 2 immediately refreshes his price as 154.5/155.5 for clients and pulls his “street” bid on Broker Screen from 155 to 154 since he really doesn’t want to get hit by another dealer.
The trader at Big Axed Bank puts all his skills to work. While screaming at the salesperson who covers AHF and asking the heck is going on and if it’s his client spraying the street, he is sending out a fresh price of 154.5/155.5 and yanks his bid from Broker screen in disgust. The salesperson who covers AHF comes over and quietly explains to the trader that there is no way AHF is spraying the street, that’s not how that account behaves, and that even if they did, they would never do it to us since we are mates. We were out last week at that new restaurant, he loves us, he was just trying to throw us some biz. If anything he was just helping out since you were axed, so relax. It definitely isn’t our guy out there screwing around, besides stocks are ticking up a bit so someone else probably decided to sell some here too.
Weak Bank is getting a bit nervous now. The “street picture” went from 155/157 with two guys on the bid, and now it’s 154/156.5, his offer and only one bid. He picks up the phone to talk to his broker at Interdealer Broker.
Weak Bank Trader (WBT): What the hell is going on, where did the bids go?
Broker 1: Hey mate, how are you? What you thinking here?
WBT: What am I thinking? I’m thinking you had two bids that you lost and why the hell should I ever use you guys if you can’t keep your markets together.
Broker 1: C’mon mate, you know how hard it is with these screens, let me give em a ring and see if we can get them back, I’m sure we can.
WBT: Fine, just do it. (hangs up the line)
Broker 1 (turns to the other guys on the desk): C’mon you bunch of wankers, get those MAIN bids back. We haven’t done a trade all day, and I can smell this one. I can tell the guy at WBT got hit and has to get out. His boss is already probably freaking out on him since he’s had the position for 12 seconds (laughs and shakes head), so let’s get those bids back and make us some money.
The brokers call their traders at the two big banks seeing if they can’t get their bids back. The trader at Big Axed Bank is mad at himself for leaving money on table and just to share the misery decides to pull his bid completely at broker and actually put up a 156 offer, undercutting the other offer for no reason other than he is annoyed at himself for paying 155.5 when suddenly the market feels well offered. He leaves his price 154.5/155.5 for retail.
Big Bank 2 sees the street suddenly go offered and decides to play it safe. He refreshes his price to retail as 154/155.
Another Player Gets Involved
Fast Momo Fund has seen stocks tick up and seen 155.5 and 155 get hit in MAIN. He watches stocks continue to tick up and is thinking that selling MAIN could be a good trade. Then his screen flashes as Big Bank 2 pulls back to 154/155. He reacts quickly and hits Big Axed Bank at 154.5 before that bid disappears. As he confirms with the salesperson that his trade is done, he smiles as he notices Weak Bank had already refreshed as 154/155 (what a joke, he thinks to himself).
So now Big Axed Bank paid 155.5 for some to cover an axe and is short at 154.5. Weak Bank is short at 155 and thinks it may have traded tighter than that, and can’t find a decent street bid to get out of his position. Aggressive Hedge Fund got a block off at 155.5 and another piece at 155 and knows it just went down at 154.5 so is feeling good about his trades. Fast Momo Fund is long at 154.5.
Price Action and Weak Hands
Each dealer is now out 154/155 to their clients. Big Axed Bank had started the day well, is annoyed for leaving money on the table, but isn’t particularly worried about having being hit at 154.5. Big Bank 2 hasn’t done a trade and is kind of happy, and still doesn’t really have a strong view, but his thinking that he will be a buyer soon. Weak Bank trader is freaking out a bit. His best case now is breaking even if he can get lifted at 155. Interdealer broker is having a rough day. Somehow it went from two bids and a chance of a trade to total bullocks. They now have 2 guys sitting on 156 offers without a bid, and they know that Weak Bank would improve their offer if they could get a good bid.
Slow Momo Fund can’t help but notice the price action. They call each of the 3 market makers and see if anyone will step up and pay them 154.5 for MAIN. All of the dealers just repeat their 154 bid and ask for orders. He doesn’t feel like leaving an order (since if it starts going wider, his whole momentum trade is pointless). He is thinking about holding off for now, but then sees S&P futures tick up 1 point and decides he better smack a bid in case the US comes in and takes everything higher and tighter. Since he had been on the phone, he calls back Weak Bank and tries to sell them 154’s on MAIN. They flake, the salesperson claims they are 153.5 bid best now, and the trader at Slow Momo Fund winces as he sees the Weak Bank Screen refresh as 153.5/155. He quickly hits the 154 screen bid at Big Bank 2 and wonders why the hell he ever tries to deal with that flake at Weak Bank.
Weak Bank is in panic mode. They are calling all potential buyers of MAIN to see if they can get out of this trade. They are willing to sell at 154.5, thinking that is an extremely good offer and thinking losing a ½ bp isn’t the worst thing in the world especially as they are getting some good flows and inquiry.
The Caught Short Fund is getting a bit nervous. They had it marked at 155.5 and now it just went down at 154. Worse than that, it seems like suddenly everyone is a seller. Maybe they should cut the loss and reload later? They are going to hold off for a bit, but are seriously considering cutting.
The trader at the bank hedging desk gets the call from Weak Bank. She is thinking that 154.5 sounds like a decent offer and that she might even be able to get the offer down a bit with the market feeling so strong. They are a bit under hedged so this seems like a good opportunity to take off some risk. Just as she is considering the trade, her boss rings her up and explains that the market feels good and he is worried about losses on the hedges. Exasperated, she tries to point out that if anything they are underhedged, so this move tighter is a good opportunity for them, and that so far the move seems isolated to the indices as neither single name CDS nor the cash markets seem particularly strong. The all knowing manager sitting in the corner office insists that the market is turning and that soon there will be some great bids for their precious bond and loan inventory and that he wants her to take some hedges off in advance of that. She is embarrassed and out of courtesy calls Weak Bank back and explains that not only is she not a buyer of MAIN right now, she would be looking to sell some, and asks Weak Bank if they want some at 154?
Not only does Weak Bank not want any at 154, they are starting to panic. That small 155 trade from the morning is starting to look a bit ugly. They can’t afford to let Bank Hedger trade away though, that would completely mess up their position so they basically beg her to leave an order with them. They point out that they are a seller themselves and if they get lifted, they will sell some along for her. She doesn’t have a good feel about this but decides to leave Weak Bank with an order at 154.25.
The Capitulation
Big Axed Bank and Big Bank 2 are both 153.5/154.5 now. The Broker is now 155 offered (Big Axed Bank cut his own offer in further frustration at his dumb first trade at 155.5). The brokers are “discussing” how to get a decent bid back (“discussing” involves sitting around and calling each other a bunch of wankers and saying the market and the job is total bullocks while lamenting that all the market makers are ungrateful sods).
Weak Bank sends out a Bloomberg message stating that they are an axed seller and have a block to go at 154.25. They figure that is best offer by a ¼ bp and if they get lifted they can probably convince Bank Hedger to trade at 154, so they lose ¾ bp on their original trade, but make back a ¼ bp on the order. Not good but not horrible.
The Caught Short Fund sees the axed seller message from Weak Bank. He knows how weak the Weak Bank is and has this gut feel that they are going to have to puke out of a position soon. He knows that if he calls either of the Big Banks they are likely to flake, so he hits Big Axed Bank on the screens at 153.5. He’s not happy, but thinks it’s the prudent thing to do as market feels so strong and he will be able to reload later.
Bank Hedger sees the 153.5 trade print and gives Weak Bank a fill or kill on her order. They can’t fill her and worse than that, they won’t even provide her with a bid! And sure enough the boss is calling, no doubt to see if she had sold any MAIN. Both of the Big Banks have refreshed their screens as 153/154, but she knows Big Bank 2 hadn’t been hit, so calls them and sees if they will match the trade away and take some at 153.5. Big Bank 2’s trader thinks about it and decides that the move is a bit overdone, so doesn’t mind buying some MAIN here and Bank Hedger is a good and fair client so sure, he will pay 153.5 for some. Bank Hedger is happy. Well happy isn’t exactly the right word, she thinks her boss is clueless and they should have been adding to their hedge on this move rather than selling into it, but c’est la vie.
Big Bank 2 is feeling good about his trades. He owns MAIN down at 153.75 on average and doesn’t see anything in the cash markets to justify such a big move. He is getting colour that Weak Bank needs to get out of a position so decides to mess around with him, plus he is annoyed with his Interdealer Broker constantly bugging him for a bid. He decides to “fix” that problem and gives the Broker screens at 151/154 market. The broker kindly thanks him for the two sided market, knowing that the bid sucks and the rest of the desk is going to be pissed off about the improved offer.
Weak Bank sees the street go 151/154. They hear it is 153/154 away at both Big Banks but can’t get that bid. They know Bank Hedger sold some away, they don’t know what level, but figure someone has an axe. Damn, they wish they had just bought more from her, this is really screwing up their picture.
Aggressive Hedge Fund has seen almost no follow through in stocks, bonds, or single name CDS. The market is okay, but nothing special. He can see that Big Banks are both 153/154 and that Weak Bank is 152.5/154 right now. He saw their plea to find a buyer at 154.25 and decides the time is right and calls Weak Bank’s salesperson.
AHF: Hey, what you think of market here?
Weak Banks Sales (WBS): Feels strong, looks like lots of sellers of MAIN (then in a whisper) I don’t think our trader is too happy about that trade earlier, we can’t find any buyers.
AHF: Tell you what, since we did that trade I shifted some other positions around (total lie) and could actually buy back the MAIN I sold earlier.
WBS: Really?
AHF: Yeah, where do you think you could get it done.
WBS: I checked, the trader would sell them at 154, and I might be able to get him down to 153.75.
AHF: Might? What they hell do you mean might? That is a crap offer. The guy who got hit at 153.5 is desperate to get out of them (total lie) and I’m hearing it was a big seller who may have a lot more to go (total lie).
WBS: Crap, let me see what I can do. What’s your best?
AHF: I will pay 153.25. I’m pretty sure I can get that done away in a heartbeat if you don’t care, though I might hold off because it seems like this thing could run a lot tighter.
WBS: Fine, my trader can sell you at 153.25, but you have to keep us in the flows. This trade hurt, but I told him how important it was to see your flows and that you would work hard to make it up to us.
AHF: Sure, tell you what, I think I can source more of the bonds I’m buying away (total lie), and could upsize the trade at 153.25. I have another block to buy, you want to sell those and increase size of the trade?
WBS: Sure, let me check…..yeah, that’s done. Thanks for the trades. We will do an unwind on our trade from this morning, and is that a new trade on the other piece?
AHF: I think it might be an assignment, I have sold old hedges around, so let me figure it out and give you a name you will face on that second piece.
WBS: Cool, thank a lot, appreciate the trade and keep us up. Glad we are getting business going.
As soon as he hangs up he strolls over to the trader to explain how wrong the trader was about the client and how well this relationship is going to work. The trader can’t understand why the salesperson doesn’t think the 1 ¾ bp loss isn’t a big deal to him, and so far he hasn’t made money on the short he just put on at 153.25.
The Reversal
Weak Bank puts in a call to Bank Hedger letting them know that they can pay 153 now. Bank Hedger is starting to get a little annoyed with Weak Bank and “congratulates” the salesperson for informing her that Weak Bank now has a generic bid. Just to make her day extra special, she gets a call from the boss. Not only doesn’t it look like they are going to be able sell any of their cash inventory, but they are being asked to participate in a new loan, so they need to put that hedge back on. Then a little sheepishly he explains that management wants to run a completely hedged book, so wants them to take advantage of the strength in the market to put on some additional hedge. Typical, she thinks, and then decides what to do. If Weak Bank is now a buyer she knows they won’t make a good offer since they don’t have the limits to take on much risk, let along print her on a double trade. She calls Big Bank 2 and tells them that her boss changed the mind, and she wants to buy back the MAIN she sold earlier and actually wants to buy an additional block. The salesperson is hoping the trader will do it all at 153.5 so that his client doesn’t lose money on the first trade. The trader laughs at that, explains that the market is doing nothing, and if anything it feels like buyers of MAIN are creeping out of the wordwork and he is considering moving the market back to 153.5/154.5 but he would sell the entire piece at 154. Bank Hedger decides that is fair and is almost happy to lose a ½ bp on the boss’s dumb trade idea just so that he will keep his nose out of the day to day trading which he seems so clueless on.
A quick recap of what has gone on so far:
Aggressive Hedge Fund sold MAIN at 155.5 and 155 and covered the entire piece at 153.25 for an average profit of 2 bps on two pieces.
Fast Momo Fund is long at 154.5.
Slow Momo Fund is still long at 154.
Caught Short Fund closed the short at 153.5, but is getting a bit nervous that he covered too early especially since he HATES the market!!
Weak Bank bought 155 and covered it at 153.25 for a loss of 1 ¾ bps and is now long at 153.25.
Bank Hedger lost a ½ bp on one block but now has added to the short on the day and is exactly where they want to be from a risk standpoint.
Big Bank 2, bought a piece at 154 and 153.5 and sold it all back at 154, so made a ¼ bp on average and is back to flat.
Interdealer Broker hasn’t done a trade and just got it shoved in his mush as Big Bank 2 pulled the 151/154 market and said they were going to lunch.
Big Axed Bank covered their axe at 155.5, a trade for which the trader is kicking himself and is short at 154.5 and got shorter at 153.5, which is annoying, but not a particularly big concern yet since they did have buyers the previous day, giving him the axe, but he definitely wants to sell some MAIN here rather than buying more.
Back to Unchanged:
Big Bank 2 goes out 153.75/154.75 fresh. Still no strong view, and made a bit of money, but “for choice” would prefer to buy some more MAIN rather than selling any here.
Big Axed Bank hears about the market away and guesses someone just lifted 154 away, so goes out 153.5/154.5 fresh as they are now getting too short and wants to be an offer.
Weak Bank can’t believe they sold at 153.25 and now seem to be getting topped and turned. They call Interdealer Broker and beg them to get 154 offer back. This time one of the brokers manages to convince Big Axed Bank to flash a 154.25 offer on the screen. Weak Bank lifts the 154.25, the broker pounds his chest and calls the rest of the desk a bunch of losers, and has the guts to ask each of the banks if they want to leave something on the follow. All he gets from Weak Bank is a click as the trader closes the line to think about what a miserable day it’s been, and Big Axed Bank gives him the only order he cares about now, some nice curry for the desk.
While joking around with the broker Fast Momo lifts his 154.5 offer on the screen, taking him out of another block.
Damn I hate these screens he mumbles to himself as he goes out 154/155 fresh. Big Bank 2 comes back from lunch and makes em 154/155 as well. Weak Bank goes out 153.75/155.25 and has no desire to sit there any longer. Caught Short regrets covering since he hates the market so much and comes back to lift 155 from Big Axed Bank. Slow momentum is annoyed but decides to hold on for now, but the market is back to 154.5/155.5 after starting the day at 155/156 with a high print of 155.5 and a low print of 153.25.
What can we learn from this series of trades?
Main moved over 2 bps and not one single trade had anything to do with “valuation” or “fundamentals”. Thinking that all moves reflect a change in fundamentals or a large scale change in risk positioning is just wrong in a market that is as illiquid as this – and MAIN is about as liquid as it gets in the credit markets.
Some clients are just as happy to keep CDS Indices off exchanges as the dealers are.
The salesperson at Weak Bank will be annoyed that the trader is losing money and dropping his clients because how will he get paid on the salescredits and keep his great relationships intact when the trader sucks so bad.
All market makers will go home cursing the screens, wondering why salespeople get anything when their clients just click on a screen, but will not see the irony of hating individual screens and hating the idea of an exchange.
The broker who got the trade done will go home thinking it’s better than the alternative ways of making a living and wondering if he should take the trader to the Gunners match next week.
Aggressive Hedge Fund will go home wondering when the Weak Banks will give up and wonder why other funds spend so much money on research when it is all so easy. Caught Short will go home promising not to second guess himself so quickly. Fast Momo fund will go home breaking even, somehow feeling they could have done a bit better, but not too upset since it was all just a guess and hadn’t worked out badly. Slow Momo just wishes this market would go back to trend following, but has decided that the trade is actually not so much a momentum trade, but a view that the market seemed so strong that fundamentals are better and he will keep the trade on since it should work out well over the next day or two.
Bank Hedger checks out the bank share price before heading home and can only think that if they didn’t leave the idiots in charge the bank would be in a lot better shape.