E-trading

I had a client earlier this year who wanted me to investigate a prospectus that was circulating for an electronic exchange of hedge fund instruments.  The prospectus was well written and the backers had the obligatory Harvard MBA credentials and jobs in the securities and commodities markets. Why shouldn't we all be able to run our own hedge funds?  NASDAQ is an electronic exchange where we can run our own stock portfolios.

It took a few minutes to think about the reason why such an idea would or wouldn't work and two phone calls to friends who are hedge fund managers. 

There is no successful electronic exchange for bonds.  That is the clue.  You can look at the market for bonds on computer, but you can't buy and sell them automatically. The reason is that there are not enough identical bonds trading to make an automatic market.  The way bonds work corporate or government bond are issued  at multiple times of the year, with many different call dates or maturity dates and with a variety of interest rates.  The consequence is that each single bond (with a few exceptions) has a very small market at any one moment. Stocks are issued all at one time, so there is usually a big bunch of the same stock on the market at any one time.

I inherited a portfolio when I became a corporate treasurer.  I  looked at the contents which include some 1953-54 Golden Gate Bridge bonds maturing in 1993, 2003 and later with coupons of 2.35%, 3.11% etc.  I immediately sought to dispose of them, assuming I could get a better return in equities.  It took a month to find buyers for the whole lot and the lot had to be sold as a unit. That is a realistic picture of the bond market.  Whether the GG bond lot was bought by a market maker or a final buyer, I don't know.

Bonds are traded by market makers who buy whatever is offered on the market and hold those bonds until they sell. If the market were an automatic e-trading system, you would put in your bonds to sell at a price fixed by you or offered at the last traded price and wait for someone to buy it.  It could take seconds, minutes, hours or you could be watching your bond sit on the market for a week.

My client's prospectus dealt with hedge fund instruments, proposed for an electronic exchange.  A hedge fund is made up of many investments designed to have little or no risk, which allows the investor to borrow on the hedge and get greater leverage.  For example: I buy SBC stock for $25 and buy a put and call for six months to make sure I can sell it for $26 if the price goes down or cover a short for $24 if the market goes up.  I am assured of a $1 gain, whatever the market does, less the costs of buying the puts, shorts, calls, borrowing interest and trading the stock.   For this certain deal, I borrow 80% of the funds.  I do this by putting the whole package in a contract and selling it to a bank or investment banker. The original hedge can be anything -- stock, bond, a bet on interest markets (called a LIBOR), or a bet on currencies. The point is to take out the risk, borrow on the hedge and sell the resulting package. Or buy the package if someone else created it.

That is precisely the kind of instrument for which a market is difficult to make and an electronic exchange is impossible.  Each instrument, usually created by an investment banker (Morgan Stanley, for example) is one of a kind or a few dozen of a kind.  It would be many times harder to make an electronic exchange for hedge fund instruments than for bonds. 

Don't invest in an electronic exchange business for anything unless the market for each item traded  is large or the seller and buyer are happy to wait days or weeks for each transaction (think eBay).