Flash Boys of the Bond Market

For 20 years, David Light ’86 worked in fixed income, starting his career with Salomon Brothers and Citibank, eventually landing at the Royal Bank of Canada in 2010. Around that time he began to notice significant changes in the bond market. It was more heavily regulated, less entrepreneurial, more specialized and not as much fun as when he began. In addition, there was a mystery: returns were down for large and small players. Light wanted to know why. He found the answer when he bumped into Brad Katsuyama at the RBC.

NYSE Building in New York CityMichael Lewis wrote about Katsuyama’s work in the book, Flash Boys: A Wall Street Revolt. Katsuyama found that the stock market was being exploited by high-frequency traders, affecting small and big players, figured out how they did it and found a way to thwart them.

Light said, “If I didn’t bump into Brad, I would have not fully understood what was going on in the marketplace. Traders did not understand why they could not buy and sell at their desired levels. Many thought that their own systems were flawed, but in fact, technology had changed the market structure so that it worked against the dealer investor.”Substitute the word “dealer” for “investor” in Katsuyama’s work and you make the jump from stocks to bonds. Bonds (known as “fixed income” because of the fixed coupon payment structure) are a product that is mainly traded by institutions, not individual investors. Light and his colleagues have created a system that bypasses inefficiencies in the bond market in the same way, but through different means than Katsuyama and his crew did for the stock market.

Here is David Light's account, told from the expert's point of view.
By David Light '86, co-founder and principal, CrossRate Technologies

I met Brad Katsuyama, the inspiration for the Michael Lewis book, Flash Boys, while at Royal Bank of Canada. I worked in bonds, he in stocks. We had similar ideologies on what was really going on in our respective markets. In the past, smaller players in the bond market had profitable franchises, but could no longer make acceptable returns. Larger players dominated the market but were also underperforming. It didn’t make sense – something had changed to cause this and very few market players knew why. It was clear there was an underlying riddle in the market that needed to be explored and possibly solved – dealers were doing the same thing they had always done, but their approaches no longer yielded the traditional profitable results.

We knew that something had changed. The short answer was that technology had caused a sea-change shift in the way dealers were interacting in the marketplace. They make money by engaging in transactions with their clients and then off-loading those transactions by trading amongst themselves (and others) in certain venues – most commonly known as exchanges. They trade bonds and make money by buying and selling them at (hopefully) a profit. For instance, a large fund sells securities to a dealer who then goes into the trading venue and anonymously sells it to another dealer. If he sells it for more than he paid for it, that is a trading profit. In other words, a dealer puts a price on the client trade that he or she believes will give them the opportunity to make a small spread in exchange for their service. Unlike the stock market, bond traders do not receive a commission – they must take risk and can make or lose money depending on their ability to extract value from the market. The problem was that other entities with superior technology entered these “exchanges” and were able to extract the value that the dealers used to create – value that, in essence, they were entitled to.

New entrants to the market, high-frequency and algorithmic trading firms, adversely affected the dealers business. They had faster and more precise models that could take advantage of the slower technology of the dealers and the inefficiencies of the market where the dealers transacted. In other words, the exchanges became a feeding ground for these high-frequency firms, and dealers became the prey. It became a vicious circle for the dealers, trading venues where they traditionally conducted their business started to cater to these high-frequency players instead of the dealer.

To deal with this phenomenon, my partners and I formed CrossRate Technologies. CrossRate is a result of studying the market microstructure – knowing what really is going on as opposed to taking things at face value. The focus is the U.S. Government bond business, one of the most widely traded markets in the world. More than $500 billion, yes billion – securities are traded on a daily basis. The market has gone through many changes over the past decade, most of which have been driven by technology. As a result, the roles of the dealers as they relate to each other in the marketplace changed dramatically. Interestingly, many dealers did not realize that underlying changes had adversely influenced their profitability or were unaware of how they allocated their resources. They were no longer able to make money in the manner to which they became accustomed. The market structure had shifted, making it much more difficult for them to serve in their critical role of intermediary between institutional clients (mutual and pension funds, hedge funds, government institutions, etc.) and the market. CrossRate is a trading platform that allows dealers to capture this previously lost value and gain market advantages through its unique business model.

The CrossRate model is not unlike a lot of the businesses we presently engage with in our daily lives. In its simplest terms, it’s an aggregation strategy, similar to what Amazon, Priceline, Expedia, OpenTable and Uber are doing on a smaller, more specialized scale. They take a bunch of smaller entities and put them in one place, producing favorable economies of scale. The whole becomes more valuable than the sum of its parts. CrossRate separates the market into a defined set of providers and consumers. Providers are large dealers with broad franchises in the bond market and the consumers are the smaller franchises. We take the aggregated business of the consumers and allow providers to price their transactions in a venue (“exchange”) away from the feeding grounds.

This is beneficial to large and small dealers. Large dealers are better set up to price market transactions. They have sophisticated risk and trading systems and robust technology that harnesses their broad franchises. Small dealers, by nature, have none of this, but instead have valuable client business that they presently cannot monetize efficiently. One small dealer’s flow means very little, but combining their business is of considerable value to the providers. CrossRate creates a safe environment where these two sets of dealers can interact and make money based on their specific strengths. It’s a win-win for them – large dealers see business that they normally wouldn’t see in a format that fits their models. The small dealer gets the opportunity to make money on business that they had no longer been able make money on. Effectively, this cuts off the interference of high-frequency traders who have been taking advantage of the dealers and the client business the dealers work so hard to attain. Keeping with the analogy, CrossRate can be looked at as a nature preserve instead of a predatory feeding ground.

This model is different from the one portrayed in “Flash Boys.” At the risk of oversimplifying things, Brad’s firm, IEX, tries to link up investors with each other in the stock market to eliminate the inefficiencies caused by high-frequency trading and other exchange-specific factors. We are doing something similar by linking dealers in like fashion. However, we don’t believe the bond market is “rigged.” There is nothing presently going on that is morally objectionable. Our thoughts are that the market structure has just evolved to the point where a specific species of market participants have developed certain undeniable technological advantages over others in an environment that encourages them to do so. We are just leveling the playing field, so to speak, by providing a venue with the technology and trading rules that allow those who create the value (the dealers) to best realize it.

Though there is a glaring need in the marketplace for CrossRate, “disruptive” technologies are always met with some resistance, as changing the status quo comes with its challenges. The key is convincing people what the value proposition is and to put it in simple form, allowing them to see what they gain by participating. With any startup, it’s a work-in-progress. You can have the best idea in the world and still not be successful. Hard work and execution, in addition to a well thought out strategy, is critical. We have the reputation, credibility, business plan and technology in place to be successful. We are now putting together our consortium of liquidity providers (large dealers) and liquidity consumers (small dealers), some of which will become equity partners. As you can imagine, there are a lot of moving parts along with many ups and downs. However, we remain very encouraged and have a lot of support within the dealer community. Hopefully, in a few months’ time we will be up and running and will have a lot more to talk about. You will be hearing about us. Finally, a little luck doesn’t hurt either. Fingers crossed. For more information visit www.crossratetechnologies.com.