BlackRock Is Getting Into The Bond-Trading And Adverse Selection Businesses

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What are you planning to buy from BlackRock? They have bonds for you:

BlackRock Inc. is planning to launch a trading platform this year that would let the world's largest money manager and its peers bypass Wall Street and trade bonds directly with one another. ... The trading platform would be run by the New York-based company's BlackRock Solutions arm and offer 46 clients—including sovereign-wealth funds, insurance companies and other money managers—the ability to trade in corporate bonds, mortgage securities and other assets, company executives say.

Under the plan, the platform would seek to match buyers and sellers of the same securities, in a process known as "crossing trades." BlackRock Solutions would charge a small fee for the service that would be much lower than Wall Street's trading commissions.

Some of the transactions would effectively cut out the Wall Street dealers that have long acted as middlemen in the credit markets. BlackRock's asset business, which oversees $3.5 trillion, would also use the platform.

So why wouldn't you use this thing, whose working title is "Aladdin Trading Network"?* It's pretty tautological that if you can cross a bond with another investor at a price that, with BlackRock's small fee, is inside the market that you can get from dealers, you should do that. And presumably BlackRock's $3.5 trillion AUM, plus whatever its clients post on this platform, provides a good opportunity for crossing. And from the Journal article there seems to be plenty of low-hanging fruit, e.g. BlackRock's own funds only cross about 3% of their trades and are aiming to move that to 6-8%, so presumably that is possible in the basic sense that 6-8% of its trades are matchable with each other, so in a perfect-information world it's kind of weird they're not matching those already.

Of course the answer to why you wouldn't use this is that there are so many bonds each of which is special in its own way, and you have your little heart set on a particular bond that is green with pink polka-dots and will accept no substitutes, and BlackRock either doesn't have the one you covet or doesn't want to part with it and neither do the 46 other folks on the system and so you have no choice but to source it from a dealer who will charge you a big nasty spread. Actually BlackRock will facilitate that for you too, which is perhaps a clue about how robust the matching will be:

The firm also has been in talks with Wall Street dealers, which may provide price quotes to the system. The banks also could be called upon to respond to orders that can't be matched directly between investment firms.

You can be sort of pessimistic about this thing's ability to cannibalize Wall Street on the usual mutual-coincidence-of-wants grounds: corporate bonds are relatively illiquid and there are just so dang many different kinds of them, so what are the odds that a buyer and seller of the same amount of the same kind come to market in the very same microsecond or for that matter day? And as Joe Cotterrill points out this sort of crossing system has been discussed - by BlackRock - for a while with pretty meh results. So you can continue being pretty meh about Aladdin.

The case for being optimistic, though, is along the lines of mumble mumble mumble Volcker Rule. The Journal notes that dealer bond inventories are down 70% in the last five years, presumably due mostly to economic risk-off decisions; the Volcker Rule's likely restrictions on market-making - limiting dealers to reasonably related to expected customer demand, etc. etc. - should cut that further. Instant liquidity from a dealer is a real service that is perhaps worth paying a spread for, but if your dealer is slashing inventories and can't provide instant liquidity, I'm not sure leaving an order for a dealer to work is obviously better than leaving it for BlackRock's magically named magical system to cross automatically but next week.

If Aladdin sort-of works, though, it seems like it would lead to an adversely selected world. Very liquid bonds will cross between institutions - why pay a spread to buy or sell a bond that trades many times a day and that you can be pretty confident of crossing quickly and efficiently? Less liquid bonds - well, if you're idly curious about the price you can get but are in no rush, maybe you'll post them on Aladdin and wait a week. If you're axed to sell, though, you'll be willing to pay a dealer's spread to get rid of them. Extrapolate from that and you get a world where dealer inventory notionals are decreased by the Volcker Rule, but risks don't decrease much because the bonds that require market-making are sort of by definition the least liquid ones, and at least plausibly the riskiest ones.

If I were a regulator with a deep and abiding interest in promoting the aims of the Volcker Rule, whatever they are, I guess I'd be doing things like encouraging non-BHC-owned broker-dealers and hedge funds and whatevers to get into the market-making business so as to shift some inventory risk from government-quasi-backstopped banks to small-enough-to-fail non-deposit-taking nonbanks. My goal might be able to shift a cross-section of inventory risk from the banks to the nonbanks; in fact, I'd expect the spivvier risk to move to the nonbanks as small firms are more likely to want to make markets in $40mm bond issues of $500mm TEV private companies. Shifting the best inventory risks away from banks and into BlackRock's Aladdin seems, on the other hand, like a less attractive way to go.

BlackRock's Street Shortcut [WSJ]
Aladdin’s bond cave [FTAV]

* Because BlackRock will be front-running you? Meh.

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