Primary Dealer Woes

February 24th, 2014 7:33 am | by John Jansen |

This is a comprehensive article on the state of the primary dealer business from Bloomberg. I spent the preponderance of my career working as a salesman or a trader at primary dealers or for firms aspiring to be primary dealers. The value of that franchise has eroded over the years and I would assign the blame to technology. When I began my career the dealer held all of the power. That relationship has shifted and now the client is in the driver seat and holds an advantage over the dealer. I would offer two quick points. When I began in the business in the late 1970s the dealer and its salesmen were the focal point for information. Clients needed to have a strong relationship with the primary dealer community because there was very little transparency in pricing and customers literally needed dealers to learn where off the runs traded.  Second quick point. The advent of electronic trading has destroyed relationships. What do I mean? In that bygone era a client would generally call one dealer and get a price. A good salesman would keep the client on the phone and try to find out the price at which the client would deal. A good salesman would cajole and coax a client for a risk free order at a stated price so that his firm would not need to take risk. Now the advent of electronic trading has mitigated the client’s need for a strong relationship with a dealer. Everyone can see a price on Bloomberg or TradeWeb. And that has encouraged clients to execute virtually every trade in competition. So clients will now leave the salesman out of the transaction process and will submit the trade on one of the electronic platforms and execute on the best price received from four or five dealers.  They will do this on trades as small as $10,000. In addition bid offer spreads have collapsed and the electronic trading platforms encourage trading in the middle of the market. So it is not the best of times to be a primary dealer.

I was speaking the other day with a former colleague who is still in the business and he was lamenting the difficulty in selling bonds in the current environment. He posited that dealer firms will eventually cut back significantly on the number of salesman via a change in the coverage model. Now a dealer firm will have one salesman selling liquid interest rate products and another hawking  credit product and someone else marketing FX. My friend thinks that eventually one salesman will cover all of those product sectors.

Via Bloomberg:
Bond Dealers Seek U.S. Treasury’s Help in Regaining Grip on Debt
2014-02-24 00:00:23.0 GMT

By Daniel Kruger, Kasia Klimasinska and Caroline Salas Gage
Feb. 24 (Bloomberg) — The Masters of the Universe
immortalized by Tom Wolfe in his 1987 novel “The Bonfire of the
Vanities” are feeling like mere mortals.
The Wall Street banks known as primary dealers because they
get to trade with the Federal Reserve and raise the money that
the U.S. government needs to operate are concerned that they are
being marginalized because of advances in technology. So worried
are they that the group wants the Treasury Department to curb
the increasingly popular practice by investors of buying bonds
directly from the government without their involvement.
In many ways, the request underscores the changing nature
of the business, where greater access to information has leveled
the playing field between banks and investors, and turned
telephones into little more than paperweights. A record 49
percent of Treasury trading was done electronically in 2013 and
the amount of debt sold directly to investors at auction rose to
17.7 percent of issuance from 2.5 percent in 2008. The number of
primary dealers has shrunk to 22 from the peak of 46 in 1988.
“The Treasury needed the dealer community for its
information, for its distribution,” said E. Craig Coats Jr.,
who was the co-head of the government bond trading desk at
Salomon Brothers in the 1980s, when the partnership was Wall
Street’s biggest bond trading firm. “Today there’s so many
different sources of liquidity and information and distribution
that the dealers become less important to the Treasury.”

‘Breaking Down’

Primary dealers, which include JPMorgan Chase & Co.,
Goldman Sachs Group Inc., Bank of America Corp. and Citigroup
Inc., are seeing their roles diminished just as the Fed begins
to unwind the extraordinary monetary stimulus measures put in
place after the 2008 financial crisis. That includes bond
purchases that swelled the assets on the central bank’s balance
sheet to a record $4.15 trillion from less than $1 trillion.
At the same time, government borrowing has more than
doubled the amount of tradable U.S. government debt to $11.8
trillion. That combination has dealers concerned that there’s an
increased chance of disorder in markets if demand for Treasuries
declines. Forecasters predict higher yields, which would reduce
the value of existing bonds.
“This is an oligopoly that’s breaking down and the
oligopolists are concerned,” said Robert Eisenbeis, a former
director of research at the Federal Reserve Bank of Atlanta and
vice chairman and chief monetary economist for money-management
firm Cumberland Advisors in Sarasota, Florida.

Influential Membership

The request by the dealers was revealed on page 58 of a 74-
page chart presentation accompanying the report that the
Treasury Borrowing Advisory Committee, or TBAC, presented to the
government this month and made public. The 15-member group is
made up of the world’s most powerful and influential banks and
investment firms.
The committee, which makes recommendations to the Treasury
on its borrowings and briefs it on market conditions, suggested
setting curbs on investors’ ability to circumvent the dealers
and buy bonds directly from the government because the
unpredictable nature of that demand “could potentially lead to
increased debt funding costs” for the government.
They also suggested the U.S. consider the potential for
syndicated sales of securities such as ultra-long maturity bonds
due in more than 30 years and granting underwriters the option
to buy additional debt at the Treasury offerings. Those measures
would tighten their grip on the sales process.

Taking Stock

TBAC Chairwoman Dana Emery, the chief executive officer of
mutual-fund firm Dodge & Cox Inc. in San Francisco, declined to
comment, said her spokesman, Steve Gorski. All of the 14 other
members either declined to comment or didn’t return calls.
“We’re always trying to take stock of where we’re at and
make sure we understand how new developments in the marketplace
are impacting our ability to finance ourselves,” Matthew
Rutherford, the Treasury’s assistant secretary for financial
markets, said in a Feb. 20 telephone interview.
Ensuring that the government is getting the best rates
possible on its borrowings is no small matter with the Treasury
selling more than $2 trillion of notes and bonds a year. That’s
up from an average of $659 billion in the five years before the
2008 financial crisis.
Unlike dealers, direct bidders aren’t required to bid at
every Treasury auction. That means their decision to participate
makes government debt sales less predictable, the TBAC has said
in its reports. As a result, dealers may need to reduce their
bids to compensate for the added risk.

Rising Share

Direct bidders submitted $829.2 billion in bids last year,
and were awarded $351.1 billion, or 17.7 percent of the $1.99
trillion in competitively sold U.S. debt, according to Treasury
data compiled by Bloomberg. All were record amounts.
In 2008, direct bidders tendered $25.4 billion and were
awarded $20.2 billion, or 2.5 percent, while dealers submitted
$1.47 trillion of bids for $809 billion of competitively sold
securities, winning $554.7 billion, or 68.6 percent.
The increased availability of data and the advancements in
trading technology have leveled the playing field, giving
investors access once enjoyed only by the dealers.
“I can enjoy a primary dealer level of access to both the
primary and secondary markets,” Jason Evans, co-founder of
hedge fund NineAlpha Capital LP in New York and the former head
of U.S. government bond trading at Deutsche Bank AG, said in a
telephone interview.

Trading Decline

Trading in fixed-income, currencies and commodities at the
10 largest global investment banks declined 19.4 percent in 2013
to $73.9 billion, according to research firm Coalition Ltd. The
“anticipation of rising interest rates, tougher capital
adequacy regulations and concerns over the U.S. Fed ‘tapering’
weighed on the business,” Coalition said in report last week.
Increased regulations after the financial crisis to limit
banks’ risk-taking “is increasingly stifling for the dealers,”
Evans said last week. “Primary dealers have seen the true value
proposition in being a primary dealer eroded over time.”
Even though the amount of debt has expanded, trading
activity is stagnant, with $544 billion of Treasuries on average
changing hands each day in 2013, down from $553 billion in 2008,
Fed data show. Electronic trading has increased from 31 percent
in 2012, according to a survey of institutional money managers
by Greenwich Associates.
Coats, who worked at Salomon when its influence was
caricatured in “Bonfire of the Vanities,” said he trades
Treasuries via exchange-traded funds. The 66-year-old retired in
2009 as co-head of fixed income at Keefe, Bruyette & Woods Inc.

Bond Losses

Treasuries in 2013 suffered their first losing year since
2009, dropping 3.35 percent in value as yields rose, according
to Bank of America Merrill Lynch index data.
Yields on 10-year notes are forecast to climb again this
year, to 3.37 percent, according to the weighted average in a
Bloomberg survey of 74 participants. Last week, the yield on the
benchmark 2.75 percent note due in February 2024 was little
changed at 2.73 percent, Bloomberg Bond Trader prices show.
Banks began to exit the dealership business in the 1990s as
the large number of firms and the increased transparency of
electronic trading cut the spread between offers to buy and sell
debt, making activity less profitable.
“It’s a tricky balancing act about keeping costs as low as
you can but at the same time not disenfranchising dealers,”
said John Fath, a former head Treasury trader at Zurich-based
primary dealer UBS AG. He’s now a principal at investment firm
BTG Pactual in New York, which manages $2.5 billion.

‘Meaningful Intermediary’

Treasury officials understand the difficulty posed for
dealers by the erosion of their dominance at the auctions and as
new regulations limit their ability to commit capital to their
bond businesses, according to Karthik Ramanathan, a former
Treasury debt management director
Dealers still “offer a meaningful intermediary” between
the market and the Treasury, Ramanathan, who is now a senior
vice president at Fidelity Investments, said in a telephone
interview from Merrimack, New Hampshire. “I do not believe at
this point direct bidding or technology is going to completely
disintermediate the primary dealer structure.”
A primary dealership still carries some allure. Toronto-
Dominion Bank’s TD Securities was named one by the Fed on Feb.
12, the first new dealer in more than two years. Stamford,
Connecticut-based Pierpont Securities LLC is interested in
becoming one, according to Mark Werner, its chief executive

‘Certain Distinction’

“Typically, central banks and sovereign funds, the biggest
holders of U.S. Treasuries, will only deal with primary
dealers,” Werner said in a telephone interview. “There’s a
certain distinction that comes with being a primary dealer.”
Werner, who worked at JPMorgan Chase for 22 years, where he
rose to vice chairman before co-founding Pierpont in 2009, and
in 2010 was a member of the TBAC, acknowledges the challenges.
“You’re in a low rate environment, with relatively low
volatility and low turnover in the asset class,” he said. “The
result is a somewhat less profitable environment for dealers.”
The Treasury may face “perception issues” if it adopts
the TBAC’s recommendations, said Dean Baker, co-director of the
Center for Economic and Policy Research, a Washington-based
group funded by labor unions and private foundations.
“The idea that somehow the Treasury would get a higher
price for its bonds with fewer people bidding, that’s not the
economics I learned in school,” Baker said in a telephone
The Treasury’s bailout of the banks during the financial
crisis created the notion that the biggest lenders were too big
to fail and created “implicit subsidies” for them, according
to Cumberland’s Eisenbeis.
“It’s no wonder they’re going to say they’re concerned
about their profitability,” he said. “That’s pure self-
interest and has nothing to do with the efficacy or the
functioning of that market.”

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  1. 3 Responses to “Primary Dealer Woes”

  2. By CGC on Feb 24, 2014 | Reply

    On top of that, a number of Primary Dealers have ‘Algo Groups’, who get to see customer flow before their actual trading desk does.

    If balance sheet does become scarce and rates do rise, with supply holding steady, at record levels, it will be very interesting to see how this model adjusts/evolves.

    Why would you bid/offer paper for the worlds’ larges money managers/official institutions if you have no idea what they do in the Primary market?

  3. By John Jansen on Feb 24, 2014 | Reply

    I could not agree more. Liquidity will be very scarce and very costly.

  4. By Talking their book on Feb 24, 2014 | Reply

    These primary dealers are selling a commodity product with nearly infinite supply. We don’t have milk salesmen anymore, and for the same reason: government makes absolutely certain that the supply exceeds natural demand.

    Treasuries will be a razor thin margin product unless and until the US government gets its spending under control. HA HA!!!

    The bit about ensuring demand in troubling times? That isn’t low tide we are smelling. The existing banks have no balance sheet to risk — they are barely solvent without on going Federal Reserve support.

    Back in the hay day of primary dealers, the banks had stronger balance sheets than customers. There are zero big banks today with a AAA rating. Take away the implied too big to fail implied bailout expectation, it is not clear the primary dealer community is even investment grade.

    That is the real problem. That is why the Treasury side stepped the dealer community in the first place. A financially strong dealer community would be helpful if it existed, a dealer community that needs on-going bailouts and subsidies is not a benefit to any borrower.

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