"Internal Crossing" - The Unintended Consequence Of Dodd-Frank That Is Crushing Bond Liquidity And Transparency

A couple of weeks ago we wrote about the curious case of the 34-year old Goldman Sachs high-yield trader, Tom Malafronte, who has managed to make $100mm "trading" with Goldman clients so far in 2016 while somehow also complying with Dodd-Frank regulations that prevent proprietary trading.  Here is what we wrote:

Back in 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act which was intended to shut down proprietary trading desks at the big wall street banks while allowing them to hold just enough inventory to satisfy market making requirements.  Which is why many are now questioning how a 34-year-old Goldman Sach high-yield trader, Tom Malafronte, managed to make $100mm while maintaining compliance with federal banking regulations.  As a senior trader of Skyland Capital told the Wall Street Journal, “It goes against everything we’ve been seeing the last three years."


The gains were the work of Tom Malafronte, a managing director on the bank’s high-yield-bond desk in New York. The 34-year-old trader bought billions of dollars in junk corporate debt on the cheap starting in January, then locked in profits as prices recovered, according to people familiar with the matter.


The windfall is a throwback to a previous era on Wall Street, when big banks were more eager to step in as markets turned and bond traders took bigger risks. Those bets have become less common since the crisis. Hoping to make the financial system safer, Congress passed rules that curbed banks’ ability to wager with their own money and required them to hold more capital.


Wall Street responded by shutting down its proprietary-trading desks and shrinking inventories of securities like bonds. The government allowed banks to continue trading securities in their capacity as market makers, serving as intermediaries between buyers and sellers. Regulators have said banks must show that the amount of bonds and other securities they hold on their balance sheets don’t exceed what they need to meet “reasonably expected near-term demand.”

Dodd Frank


Of course, that news is even more shocking when considering the growing volume of bond trades that are circumventing market makers altogether.  As Bloomberg points out, the volume of bond sales being "crossed internally" (i.e. sold between different entities that are ultimately owned by the same parent company) and growing rapidly which is serving to further exacerbate the lack of liquidity in the $100 trillion global bond market.

Proponents of internal crossing -- as the practice is known -- say it can reduce costs, while detractors say it’s riddled with potential conflicts of interest and is exacerbating the decline in bond market liquidity. The trades are on the rise at funds including BlackRock Inc. and Legal & General Investment Management, which now trades more with itself than any other firm. The trend is the latest sign of a shift of assets and influence to the buy side from the sell side.


“Asset managers are getting bigger, so they are increasingly crossing internally,” said Elizabeth Callaghan, London-based director in the secondary markets group at the International Capital Market Association. “Where is all the liquidity? It’s sitting in their back garden.”


Internal trading at LGIM has grown to account for about 20 percent of the firm’s fixed-income trades, according to a person familiar with the matter. At Standard Life Investments it’s increased to about 8 percent of deals, said head of trading Steven Swann. At Union Investment it’s risen to more than 10 percent, said Hock.


The growth of the practice is a product of the increased might of the buyside in the $100 trillion global bond market as well as a recognition it’s becoming more difficult to trade as dealers pull back.


“If we sell a bond to the market and try and buy it back, the cost will be higher and we’re not sure we can get hold of it again,” said Yann Couellan, Paris-based head of trade execution for fixed income at AXA Investment Managers, which oversees 679 billion euros ($755 billion) of assets. “It makes sense for us to keep the bond internally.”

Unfortunately, while this practice may help alleviate some of the liquidity issues for large investment managers created by Dodd Frank, it only serves to further limit market transparency which can only be bad news for their clients. 

Others are steering clear of the practice because their clients may not like it. Brandywine Global Investment Management, a $70 billion Philadelphia-based asset manager, has made it policy not to cross trades between its own funds, according to Regina Borromeo, a London-based money manager at the firm. That’s because the practice can give the appearance of unfair treatment of investors, she said.


“Firms that cross bonds may open themselves up to questions on best execution, transparency and fair prices for clients,” said Borromeo. “Cross trading can present a conflict of interest since it can favor one client to the detriment of the other.”


For Hock, who is head of multi-asset trading at Union Investment, internal crossing is beneficial and can be justified so long as traders can prove they transacted at a fair price.


“You have to be able to know the fair price so that both funds benefit,” said Hock, who is responsible for matching buyers and sellers -- in-house or externally -- for government and corporate bonds, equities, currencies and derivatives. “You need to have a proper pricing mechanism.”

But Dodd-Frank was intended to help the little guy, right?


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