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 open.
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.
Like 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.