Group Co.
We Lose Money on Every Trade, But Make It Up on Volume
Traders Magazine Online News, July 7, 2017
One of the things that make bonds unique relative to stocks is the way compensation is collected for trading. The lion’s share of equity trades involve an explicit commission charged to the client. Be it a flat rate per ticket, as is common among online and retail brokerage, or a ‘cents per share’ commission, as is common among institutional trading arrangements, this figure is explicitly reported on trade confirmations and has become a source of competition among brokers.
Fixed income securities generally incorporate a mark-up or mark-down in their price to compensate dealers for trading activities. That is to say that dealers usually adjust the price of the security rather than separately charge a commission. For example, they may be able to buy a bond for 100 in the Dealer to Dealer market. Rather than sell the bond to their retail customer at 100 with a commission of 0.10, they simply sell the bond to their customer at 100.10. The economics of the trade are identical either way. This is just meant to illustrate that there are differences in the industry conventions.
This nuance also leads to differences between the way trades are reported to the respective tapes. All equity trades are reported without commission (which is not to say without compensation as there are other ways to make money than just commissions, but that is well beyond the scope of this piece). However, many fixed income trades are reported with commissions embedded. Beginning July, 2016 the fixed income trade reporting services included a field that designates whether a trade has a commission charged separately or if the price includes a mark-up for customer buys or mark-down for customer sells.
As the names imply, a retail customer purchase that has been marked-up will have a higher price than the price the dealer paid to acquire bonds to sell to that customer. And vice versa. When a retail customer sells a bond, they receive a price that has been marked-down below where the dealer is able to sell the bonds to other dealers. There is nothing unusual about this activity. Again, this is just a way of charging commissions for brokerage services.
Where the activity becomes unusual is when the apparent compensation on a riskless principal trade turns negative. In that scenario, a broker is effectively paying a customer to do a trade. They lose money, but, presumably they make it up in volume. For the month of May 2017 BondWave calculates that 163 riskless principal trades were initially reported with a negative mark-up or mark-down. Purchases by retail customers were executed at lower prices than where the bonds were sourced in the dealer to dealer market. And sells to retail customers were executed at higher prices than where the bonds were sold in the dealer to dealer market.
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