Its hard to find someone not worried about the creaky
plumbing in the bond markets, and the risk that the rusty
system may finally give way and drown investors in securities
they cant sell. Flint, Michigans water
infrastructure comes to mind. When government officials
switched the citys water supply from Lake Huron to the
Flint River, pollution quickly ate away at old water pipes,
poisoning the supply with lead. Now Flint has become a top
issue in both the Republican and Democratic debates as
candidates face off over the responsibility for the debacle and
the dangers of wanting to cut costs in the short term.
And so it goes with markets. Few cared about the aging
market structure for bonds until regulators started
implementing rules designed to prevent another financial
crisis. Increased capital requirements, limitations on
proprietary trading and other restrictions have clipped
banks roles as principal market makers. The result is a
lack of liquidity in the bond markets.
Plenty of new and existing competitors have eagerly stepped
into the void with innovative ideas and proposals. Some have
been successful, such as
electronic bond platform MarketAxess, for small
transactions. Some are still untested, like fixed-income dark
pools from ITG and Liquidnet, both of which are major players
in electronic equity trading. Big mutual fund companies, such
as Wellington Management and Eaton Vance, and institutional
investors are more open than ever to alternatives. In the
meantime, though, the principal-based business of bond trading
is hobbling along.
Michael Erlanger imagines a radically different world.
Erlanger spent the first 30 years of his career in fixed-income
sales and trading at such firms as E.F. Hutton and PaineWebber.
He worked with legends like Bernie Cantor when Wall Street was
up in arms that Cantor Fitzgerald would use electronic systems
to trade U.S. Treasuries and money markets. Last year Erlanger
contacted me after I published
a feature story on how difficult it had gotten to buy and sell
bonds. Erlanger didnt call or e-mail me. In the
comments section of the story, he told me to look at his web
site and decide for myself whether I wanted to talk. When I saw
that, I knew this wasnt going to be a straightforward
conversation, but I went to his site, found his e-mail address
and set up a time to talk.
We talked for two hours, a conversation that included a lot
of personal stories about his mentors, including Gus Levy, a
senior partner at Goldman Sachs & Co. in the 1970s, and Cy
Lewis, who ran Bear Stearns until the mid-1960s. These men were
customers of Erlangers father, who was a senior partner
at a brokers broker called Asiel & Co. Erlanger told
me how he developed a methodology that could bring clarity and
transparency to the markets; his Greenwich, Connecticut,
company, Marketcore, builds and licenses his patented
technology to people who then develop specific products. He
contends that the markets will work again once investors can
get real-time access to risk information on instruments like
residential mortgage-backed securities.
Big blocks of bonds, whether RMBS or investment-grade
corporates, still trade in opaque, almost antiquated, markets
in which a bank and an investor directly negotiate a deal based
on the largely proprietary information each side has. Someone
may get an undervalued asset in these circumstances, but bonds
wont change hands particularly efficiently.
Erlangers method would bring these hidden data into the
Erlanger, who founded Marketcore in 2000, holds nine U.S.
patents, including one that rewards a broad range of market
participants for contributing information that they know about
a given security or transaction, as well as risk scoring, and a
patent that would make a contract a living document. For every
disclosure, participants earn a transaction or system credit.
Hes now pushing for an exchange, an electronic trading
platform or a technology start-up to implement his ideas for
the corporate bond markets, the burgeoning peer-to-peer lending
and other markets for complex risks. Marketcores
solutions can be applied to all areas of finance, insurance and
reinsurance. Marketcore has two clients now developing
platforms in the insurance and reinsurance markets and in
climate and sustainability finance.
Heres how it works: A technology firm develops an
online platform by which the underwriter of a mortgage, say,
enters all information known about the borrower. Its
standard information, including credit scores, salary and ZIP
code demographics. The system rewards everybody involved for
adding information. A mortgage broker, for example, could be
paid with more information from the system or transaction
credits; a neighbor could enter information about the condition
of a home; the borrower could be incented to fess up to missing
a payment. All this information will be permanently attached to
the mortgage, and the data will be passed along and enriched
each time it changes hands.
The entire process is voluntary. Of course, in 2008 banks
owned billions in RMBS, and the inability to move the
securities, or even value them, was a central cause of the
financial crisis. In Michael Lewiss book on the crisis,
The Big Short, his protagonists, including hedge fund
manager Michael Burry, were in search of information like this
on the individual mortgages that had been bundled into
securities. It didnt exist. If such information had been
readily available, perhaps investors would have been willing to
buy the securities that were frozen on the balance sheets of
Wall Street banks. Transparency would also narrow spreads by
making information widely available and expanding the field of
potential buyers. In effect, Marketcore promises to upset the
entire bond-trading ecosystem.
Brad Katsuyama, the co-founder of IEX and hero working for
fairness in equity markets in Lewiss Flash Boys,
Erlanger sees himself as a freedom fighter battling entrenched
interests, including Wall Street traders and huge bond money
managers that profit from inefficiencies in market structure.
Erlangers idea involves a complete reordering of the
market. But just like Katsuyama, whose firm tries to protect
long-term shareholders from high frequency traders, entrenched
interests are not happy with Erlanger. Though banks have
stepped back from fixed-income markets because of regulations,
theyre still hoping that the diminishment of their
dealing roles is temporary. Likewise, hedge funds and many
traditional money managers have little interest in marketwide
transparency. They believe the negotiation process inherent in
todays trading systems give them an edge. Transparency
would slice into that alpha, or profitability.
Erlanger is not letting up and is attracting fans. For one,
Fannie Mae and Freddie Mac have cited Marketcores
inventions in their own patent applications.
Eric Nordman, director of the regulatory services division
of the National Association of Insurance Commissioners, first
met Erlanger at a time when Eliot Spitzer, then attorney
general of New York, was investigating the insurance industry
and the transparency of commissions. If you add
transparency, for the most part, many problems solve
themselves, says Nordman. Because people make
rational choices if they have all the information they need to
make rational choices.
Nordman is calling for the use of Marketcores methods
in finance and in RMBS, in part because insurance companies are
the biggest buyers of fixed-income securities. Insurers need
functioning markets so their bond holdings can retain their
value, particularly during stressed times. To have
information passed along every time an asset changes hands is
very powerful, says Nordman. It would minimize the
risk charge, the price of uncertainty. The closer
investors get to having perfect information on the risks of
holding an asset for example, the frequency of
hurricanes the closer he or she can get to a valid
price. Nordman compares Marketcore to blockchain distributed
ledger technology, which tracks transactions and prevents
cheating by making the accounting available to everyone.
Marketcores innovation tracks information that can then
be accessed by anyone.
Our presidential candidates have spent a lot of airtime
talking about the risks of not taking care of our aging
infrastructure as well as the greed of Wall Street. Maybe
its now time to put politics aside and talk about the
health of our markets. There is a solution.
Follow Julie Segal on Twitter at @julie_segal.