Bonds Are Not Forever: The Crisis Facing Fixed Income Investors

CHAPTER 4

BOND MARKET INEFFICIENCIES FOR RETAIL

A Simple Market Model

Financial firms rely enormously on information asymmetry to make money. Simply put, knowing more than their clients about the prices of securities and derivatives is a crucial part of the business model. Moreover, perpetuating this advantage in information is in the interests of those who control it, and in a type of game theory there is limited advantage for those who would seek to undercut pricing and provide more competition.

It’s best described with a model. The diagram in Figure 4.1 shows a simple form of a market. There are three types of participant: banks, brokers (labeled “IDB” for interdealer broker), and clients. The banks represent the liquidity pool, where much of the trading gets done. Think of them as the wholesalers. They are connected to one another by the broker (typically, there’s more than one broker, but I’ve limited it to one for simplicity) who deals exclusively with the banks. The clients (shown as circles surrounding the banks) are the end users whose activity is sporadic and is driven by the need to do transactions when it suits their underlying business. Banks seek to make money by trading profitably with one another and their clients. The broker makes a commission when executing trades between two banks. Clients don’t seek to make money from transactions. They instead focus on manufacturing widgets. Clients are end users, doing transactions intermittently.

FIGURE 4.1 Market Structure ...