How many of you reading this would trust a banker? In recent years it’s been a closely fought battle between bankers and politicians in terms of who the public trusts less. A seemingly never-ending list of scandals has meant that both groups have suffered a hardening of opinion against them.
The upcoming referendum on EU membership has brought both of these issues into sharp focus for investors. Firstly, politicians on both sides of the debate are vociferously defending their position with seemingly concrete facts and figures; people are obviously confused about whom to trust and, consequently, the markets are nervous. Any fresh poll or news item for either outcome causes asset prices to move. For example, long-term interest rates finished slightly down on Wednesday, but that’s only after a very large intraday swing. Secondly, lots of investors seem to have stepped back until after the result next week, causing a notable drop in liquidity and exacerbating moves.
In normal market conditions, for an average sized trade in a liquid instrument (e.g. Gilts), investors can find the fair price by asking for a quote from a range of counterparties. This process should keep the traders honest as they are competing against each other to provide the best price. The fair price (i.e. the mid-market price) shouldn’t perceptively move on the basis of the quote.
Market makers (i.e. traders at banks) are constantly adjusting their prices as they receive information; if it becomes apparent that there is a significant volume of sell orders, the price will be adjusted down to compensate.
For large volume and illiquid instruments this is always an issue but, in volatile markets (such as now) where even liquidity for government bonds is thin, this issue presents investors with a trust conundrum. Do I show my hand to a wide panel of counterparties and risk that this could move the market against me? Or do I show it to just a single counterparty and trust that they will work to achieve the best price for me and not use the information to move prices in a way that suits them (as by choosing to divulge to only one counterparty I have effectively given them an edge over the competition)?
Unfortunately there isn’t a correct answer, so investors have to balance up a number of factors. Firstly, do I really need to be in the market, trading? The reason for a drop in liquidity is that lots of market participants have decided that they don’t. One of the advantages that pension schemes have as investors is that they can take a longer-term approach (unlike a bank, for example, that needs to continuously hedge its position) and look to trade into a long-term position at times that are the cheapest to do so.
Secondly, do I trust the counterparty on the screen or other end of the phone? This trust isn’t created overnight, which is why it’s important for both sides to work together to earn it. Asset managers, of course, use internal pricing sources to assess what they feel the price should be before execution, but they may not be privy to all the information that a market maker has.
Finally, can I structure the trade in a different way? It may be that trading smaller amounts than normal throughout the day will result in a better overall price or that I can use different instruments to achieve the same result. Flexibility of approach is key in volatile markets.
Whatever the outcome, liquidity will hopefully return to the markets after the referendum result next week. In the meantime though, investors will need to use their skill and judgement when deciding what to trade, and who to trust.