TradeWeb’s Mantra in TBA: Liquidity, Liquidity, Liquidity

TradeWeb LLC, a network of 13 of Wall Street’s top debt dealers, joined the growing ranks of online mortgage-bond trading Wednesday by taking its Web site live after a two-month test involving 40 investors and dealers.

The New York company, which boasts the participation of powerhouse dealers Credit Suisse First Boston, Goldman Sachs, Lehman Brothers, Salomon Smith Barney, and Merrill Lynch, trades to-be-announced securities — or forward contracts of mortgage-backed securities — Treasuries, and agency debt.

The only other online trader of to-be-announced, or TBA, securities is Washington-based Pedestal Inc. By contrast, about a dozen companies are in the more structured mortgage-backed market.

Because TBA trading is dominated by dealers, sources said, it has high entry barriers and thus low participation. These observers say TradeWeb, established in 1997, is focusing on TBAs because establish a large dealer base.

“The advent of electronic trading has not changed the basic infrastructure of fixed-income markets,” explained Michael Decker, vice president for research and policy analysis at the Bond Market Association. “Pricing and trading still depend on dealers’ willingness to risk capital and to assume trading positions.”

TradeWeb’s trading volume was $45 billion during the beta period of its TBA platform; Pedestal has done $119 billion of trading since its March 2000 platform launch.

Mr. Decker, who estimates that agency mortgage-backed securities trading is about $69 billion daily, said the Pedestal and TradeWeb volumes indicate “that we are still in the early levels of this industry.”

And given the comparatively large number of platforms competing in mortgage-backed securities trading, several observers said, that market’s online trading has room for just a handful of companies.

“There are a number of vendors chasing relatively small transaction volumes, causing liquidity to spread thin,” Mr. Decker said. “When the liquidity is concentrated on a relatively small number of systems, that will beget more interest and trading activity.”

He said that, while “no hard data” are available on Internet MBS trading volume, association members are saying that “deals are getting done. I think they are a viable concept for sure.” Few companies, however, are willing to release any numbers.

Jack Mahoney, a principal at Greenwich Associates, a financial consulting firm in Greenwich, Conn., said the personality of the Web exchanges’ target audience is problematic.

“Fixed-income investors are conservative,” he said. “It is not a real pioneering or aggressive crowd” so the exchanges “need to prove that they have liquidity before a lot of people put their reputations and positions” on the line.

Mr. Decker said it is crucial to generate trader participation and volume early in the game. “It has almost become a criterion for success for a trading platform vendor to obtain enough dealer participation in order to generate trading volume and liquidity.”

Pedestal’s president and chief executive, Stuart McFarland, said developers of online trading platforms are trying to specialize. Their thinking, he said, is that they can use their niche strength to strengthen participation and then expand to other areas.

“Without liquidity, a platform or system won’t work,” Mr. McFarland said. “In developing any e-business, you need to do it in a measured way, so that evolution is in line with the market demand.”

Pedestal and TradeWeb have followed similar strategies: Start in the most liquid markets and the move progressively to the less-liquid ones. TradeWeb CEO Jim Toffey said, “Once you have the liquidity and the critical mass in one market, you can then expand that and offer that liquidity and model into many other fixed income markets.”

Meanwhile, Visible Markets Inc., in Boston, has specialized in the less-liquid MBS products. The company declined to report its trading volume, it announced in December over $1 billion of MBS activity.

Bill Martin, Visible Markets’ vice president of marketing, said complex MBS bonds trade more on information than on liquidity. As a result, Visible Markets’ MBS platform specializes in providing profiles of every security in their system so they can match trades to their cash-flow needs.

Mr. Mahoney said that a key issue for the complex MBS market, however, is whether “Wall Street firms are willing to move their positions and their information on to an electronic platform in the spread mortgage market. It hasn’t been done yet.”

With the less-liquid markets, he said, there are wider spreads and more profit potential for the dealer community; more transparency can affect the bottom line.

“There will always be caution in the markets when it comes to transparency, because that implies more efficient pricing, which potentially implies less profitability per trade,” Mr. Mahoney said.

Mr. McFarland said there is ongoing debate over whether a for-profit setup is best or whether the market would be better served by a consortium of institutions working together to build their own platform to trade with one another.

An MBS trader requesting anonymity said his firm recently started trading mortgage-backed TBAs online and that such exchanges “give you a nice forum to see bids and offers from dealers all at once.”

But online exchanges “are going to have a tougher time” with enrollment for the more complex securities, the trader said. “They are trading right now, but at a very low volume. You need the buy side to have more interest in this before it gets moving.” Without dealer involvement, he said, people are a little hesitant to trade among themselves.

Mr. Mahoney offered, “The jury is still out.”

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