Bonds Are Not Forever: The Crisis Facing Fixed Income Investors

CHAPTER 7

MANAGING RISK 1990–1998

Risk-Oriented Market Making

During the approximate quarter century from the 1980 peak in global interest rates to the 2007–2008 mortgage bubble, financial services and investment banks were transformed enormously. Banking evolved from the staid activity of deposit taking and lending to handling unrecognizable financial complexity. The business of channeling savings to productive forms of capital formation, the fundamental purpose of banks, became steadily removed from day-to-day activity. The interest spread—what banks earn on the difference between deposit and loan rates—gradually lost importance. Fee income, whose generation often used very little capital, gained in importance. Market making revenues are analogous to fee income; they tend to be stable, and because the business of making markets involves constant turnover of inventory, the risks are usually handsomely compensated.

However, because market making requires some appetite for risk, it blurs the line between providing a service of liquidity to clients and taking proprietary positions. Indeed, I don’t believe it’s possible to define a discrete difference between them. A risk-averse market maker will do no business because his prices will never be competitive if he has to ensure that every trade can be profitably offset. A proprietary trader indifferent to meeting the liquidity needs of clients will do little or no business, since he’ll only trade with clients where it suits him, which ...