How Wall Street Rolls - Part 2 Intermediation/Arbitrage

Please Read Part 1:

tradersutra.blogspot.com/2009/08/how-wall-street-rolls-continuing-series.html

tradersutra.blogspot.com/2009/08/how-wall-street-rolls-part-1-front.html

How do trading desks make money? By making a market in a security correct? Brokering buys and sells correct? Acting either as principle or agent for investors correct? Well on the surface all of this is correct, but the most money or real trading profits are made via intermediation. What is intermediation? Simply put, its acting as a middleman in bringing together short/long positions.

Much more simply put, most of the big money comes from arbitrage/convergence/pairs trades that offloads the risk away from the trading desk unto the general public.

From my years at various trading desks, 75% of a trading desk profits comes from intermediation not brokering. Brokering gets the regulators and the press off your back, supports research, investment banking business, and sales trading.

The trading desk generally has two areas. A retail order desk and institutional desk. Retail dialing for dollars broker orders get filled by the retail order desk. But on the institutional fixed income side, most of the trades are done via some sort of quantitative model. These models basically uses proceeds from short sales to fund the long position. Even though the desks I worked on had access to billions in capital, rarely it was used because of intermediation. Very rarely I would go out and build a position in a certain tranche or bond. It simply wasn't worth the risk and loss of sleep. So after carefully studying and tweaking the models, a long/short position would be established. Now of course a certain amount of margin is needed to maintain the position, but its all relative. 90% of my trades historically were from the pairs/arbitrage/convergence realm. It was always about two like assets that were temporarily miss priced that would converge over time.

My view is that traders at proprietary desks sit all day long and watch prices. Some times they create prices by finding morons and suckers to hold the risk of a position they used to own. More often than not, they will manipulate the price of a bond so that the day to day risk of being in that position is minimized. They are always contemplating long/short strategies. They see if they can go long some sort of bond or exotic (MBS/Corp) piece of debt, buy the corresponding credit default swap, which transfers the risk of owning that exotic debt to the sucker selling it to you. After that, hedge out the interest rate rate risk with more swaps, and fund the entire position by going short the most liquid security in the world - US TREASURIES. All in all day after day making an arbitrage profit. What basically is happening here is you are buying exotic/risky debt and having it funded by risk less debt which is treasuries. Remember that treasuries are borrowable up to 90% of there underlying value, where equities are 50%.

They were times that the trade was done in reverse, but the markets were always biased in the long exotic/short treasury trade. So what happens when these type of transactions are so prevalent? simply, the supply of treasuries or sovereign debt explodes. There is just tremendous demand for US Treasuries as well as great demand for exotics.

So the demand is there for these securities because of Wall Streets appetite for these type of trading strategies. Wall Street acts as a intermediation for the US Treasury/FRB. The Treasury Market is partially funded by foreigners like Japan, India, and most importantly China. To create lore liquidity is where Wall Street comes in. The business of brokering and making markets is secondary to intermediation.

As you can imagine, the leverage here is enormous. More and more exotics are created because US Consumer spending needs to be subsidized. More cars/more auto loans - more asset backed securities. More credit cards more asset backed securities. More homes - more mortgages - more arm/sub prime/mortgage securitization. These type of securities were created becauese the end market demand was there. But the real reason they were so successful was that Wall Street was able to find a way to off load the risk on to someone else along the supply/demand chain. Sooner or later the chain ended and it wrapped around back to the originator....BOOM.

You cant keep splitting atoms and hoping for less damage. What the end result was there was too much garbage being securitized, too much arb/intermediation done. When things fell apart, The whole planet went to cash which led to investors buying treasuries, selling anything exotic. The Arb/Convergence/Pairs/Intermediation trade went poof.

Who was left holding the bag? Investors, not Wall Street.