Any discussion of the innovations most responsible for change in the futures and derivatives markets should begin with financial futures in general and Treasury futures in particular. Financial futures reshaped the entire financial market, not just futures and derivatives.
The 30-year U.S. Treasury bond contract, which began trading on the Chicago Board of Trade some 30 years ago, redefined how the underlying government securities market was traded, who traded them and how much it cost to trade. Considering that the U.S. government securities market is arguably the largest cash market in the world, Treasury futures were a profound, even revolutionary, innovation.
If today’s cash Treasury market still traded on the bid/ask spreads that existed prior to the introduction of futures, those spreads would have cost the American taxpayer and non-dealer market participants at least $200 billion more in transaction costs and slippage in new Treasury debt issuance (see “Fat spreads”). Actually, my assessment of the financial impact of long-term Treasury bond futures is too narrow. While pricing in the Treasury bond contract has most directly affected pricing in the underlying government securities, that impact also ripples out to most other debt markets. Almost all debt issuance — private, public, U.S. or foreign — is priced off the U.S. Treasury yield curve and so to the extent that financial futures trading has narrowed the bid/ask spread in Treasury issues, it has also affected the pricing of almost every other debt instrument.
In today’s world, with trading screens on desktops, laptops and wristwatches, investors can get a quote on everything from shares of General Electric to the red/purple 90-day Eurodollar spread immediately. Many market participants find it hard to believe that just 30 years ago, there was no way to get a current quote on any government security without calling a primary dealer. And if you called two dealers at the same time, you would likely get two different quotes. Even though this was the world’s largest, most liquid market, there was no published quote, no last price and no ticker. This was a negotiated market where price was what we said it was. So if you wanted a quote, you called a primary dealer.
To fully appreciate how the price-transparent centralized market has given us today’s robust markets with narrow bid/ask spreads, just look back 30 years to a time before financial futures. In the early 1970s, the Federal Reserve designated Wall Street firms like Merrill Lynch, Salomon Bros., First Boston and Aubrey Lanston & Co. as “primary dealers” in the issuance and market making of U.S. government securities. The idea being, the Fed would use these “primary dealers” to help distribute government securities, the dealers would maintain a continuous two-sided market for buyers and sellers and the Fed would manage monetary policy by financing and trading government securities directly with these primary dealers. The primary dealers gained the ability to trade with the Fed, a deep pocket trading partner whose mission is something other than making a profit. Back then, government bonds traded with a bid/ask spread of 4/32nds for active new issues, and upwards from 8/32nds for aged agency issues. Even though U.S. government securities were the world’s most liquid, they traded in a negotiated, over-the-counter market, without any centralized price reporting. One dealer’s price on a particular bond could be quite different from another’s. Price was a mystery. Or more accurately, price was a mystery to customers.
I shouldn’t say there wasn’t any central price reporting. The primary dealers needed a means of anonymously communicating their market interests to each other. So they employed the bond brokering services of firms like Fundamental Brokers, RMJ and Garban to create a network of quote screens connecting the trading desks of all the primary dealers. Voila…centralized pricing, sorta. It’s not that the primary dealers didn’t appreciate the virtues of price transparency; they did, as long as it didn’t extend to customers.
Back then Merrill Lynch and, to my knowledge, all the other primary dealers, arranged their trading floor in such a way that the traders sat in a row, backs to the wall and facing their brokers’ screens and the sales force. Conversely, salesmen faced the traders and the backs of the brokers’ screens. Heck, we couldn’t have those confederates getting a peak and telling their customers the best price. Salesmen and customers just needed to know our price.
Yes, those were the salad days of wide spreads, mixed pricing and a growing but ill-informed customer base. It proved to be a nice recipe for profits for many years. And because none of the primary dealers were publicly held, customers and non-primary dealers didn’t know how profitable the system was. Perfect! Then in 1971, Merrill Lynch went public and graphically represented overall earnings in the shape of a bull. Earnings from interest and government securities covered the bull’s entire hindquarter and much of its rib cage!
Apparently a 4/32nd bid/ask spread was a pretty good trading margin, or at least that’s what the futures industry thought. And so, the bib-overalls crowd, out somewhere west of Newark, invented and started trading something called financial futures on the open central market of a futures exchange. Can you imagine folks who trafficked in corn and cows — hog butchers to the world — thinking they could crash our profits party?
Damned if it didn’t catch on. How could that be?
Well, first of all, if a customer was going to get any kind of sales coverage from a primary dealer, they needed at least $50 million in footings. The futures market took business from a much wider audience. Second, it was problematic for most customers to sell short a government bond. The dealer had to lend the customer the security for the customer to sell it. And then, while the customer was short, we (the dealer) had to monitor the position to make sure the position was properly margined. What a pain. Our idea of a good customer was one who sold to us bonds they already owned for a fair price and bought bonds from us we already owned for a fair price. Or bought bonds from us we didn’t own for a slightly unfair price. In the futures market, it’s just as easy to sell short as it is to buy. Customers, who wanted to sell Treasury bonds short as a hedge against rising rates found a better home for such activity in the futures market.
Of course, the biggest reason for the success of Treasury futures was price transparency. It enhanced competition, and almost immediately telescoped the bid/ask spread down to 1/32. Treasury futures, being basis substitutes for their underlying government securities, resulted in bid/ask spreads for Treasury bonds and notes shrinking to match the narrower spreads on futures contracts. Primary dealers were dragged kicking and screaming from behind their shroud of price secrecy into the light of day where they had to match this tighter market or lose their business.
I estimate Treasury futures have saved market participants $200 billion in transaction costs and new issuance slippage. Not surprisingly, the primary dealers want that money back! And it would be naïve to think they would not continually be pushing non-competitive practices at the exchanges and the Commodity Futures Trading Commission in an attempt to get it back. They have literally billions of reasons to do so.
Today’s dealer sponsored non-competitive initiatives include block trading, call-around markets and “fungibility.” They are all attempts to reroute futures contracts away from the price transparent futures markets, towards the more opaque pricing dealers enjoy in a negotiated market. So far they have not been successful, but what happens when order flow is allowed to trade away from the central market at prices above or below the current market? Those thousands of futures market participants, who have driven bid/ask spreads to the narrow levels we enjoy, will lose confidence in price. The price they see trading in the central market may not be the best price. What then?
The more damage the dealer community can do to the certainty of price, the more the central market participants will have to widen their bid/ask spreads to accommodate their increased risk. And while the overall market is damaged and volume is reduced, dealers will not mind. Their share of volume and their profit margin on negotiated transactions with their customers will only increase, and we will soon be right back where we were before the futures market messed up a very profitable dealer business.
It was the intergalactic economist, Yoda, who said, “Once you start down the dark path…consume you, it will.”
Make no mistake, when we destroy price discovery, we are destroying the central futures market’s most valuable asset. CME Group management may boast of the exchange’s marvelously constructed clearing and execution capabilities, the spotless record for guaranteeing contract performance and the value of risk transference; but it is price that has brought all these competing hedgers, traders, dealers, non-dealers, investors, risk managers and speculators to this one place.
The advantage the central market enjoys over every other market is price, period. Financial futures were not just an innovation, it was a revolution and those who benefited from the previous model would love to have it back.
Bill Dudley has more than 40 years experience trading both cash and futures government securities. He worked as an institutional government securities salesman with Merrill Lynch from 1967 to 1977 and later traded futures at the CBOT, specializing in trading the cash/futures bond basis. Currently he writes a syndicated humor column.
