Sometimes I think that the financial crisis is driven by a collapse in the meaning of words. The whole financial industry has gone completely post-modern on us: Derivatives are “investments”, even when they are as likely to be liabilities as assets. The asset side of a synthetic CDO is effectively an insurance obligation. In a world where liabilities are assets and assets are liabilities, it can be far from clear how to interpret a balance sheet.
So I guess I shouldn’t really be surprised that the term “market maker” doesn’t mean what you think it means any more. For a little history lets start with the definition of “market maker” from NASDAQ, one of the earlier OTC markets.
A market maker is a NASDAQ member firm that buys and sells securities at prices it displays in NASDAQ for its own account (principal trades) and for customer accounts (agency trades).
Traditionally market makers were always required to post bid and ask prices for the securities they quote — but there are exceptions to that rule. For example, on Thursday in the midst of the stock market crash of 2:45, for several minutes there were no quotes on some option contracts. Also, for a NASDAQ listed company the market must have at least three market makers quoting the stock.
Now for a view of the post-modern version of “market making”, let’s look at the discussion of the CDO market in the risk factors section of Goldman’s Abacus prospectus (thanks to Danny Black for pointing me here).
Limited Liquidity and Restrictions on Transfer.There is currently no market for the Notes.Although the Initial Purchaser has advised the Issuers that it intends to make a market in the Notes, the Initial Purchaser is not obligated to do so, and any such market-making with respect to the Notes may be discontinued at any time without notice. There can be no assurance that any secondary market for any of the Notes will develop, or, if a secondary market does develop, that it will provide the Holders of such Notes with liquidity of investment or that it will continue for the life of such Notes. Consequently, a purchaser must be prepared to hold the Notes for an indefinite period of time or until Stated Maturity.
Here Goldman is making it clear that no market exists for the Abacus CDO and there is no reason to believe that a market will exist. At the same time Goldman states that the firm “intends to make a market” without entering into any obligation whatsoever to do so.
Here are my questions: Given our understanding of what a market maker is based on the NASDAQ OTC market,
(i) Does it make any sense to state that a single firm will “make a market” where no market exists? What Goldman appears to mean in its statement is that Goldman intends to quote bid and ask prices for the CDO on demand.
(ii) Does the statement that a firm “intends to make a market” in a security have any meaning whatsoever when it is followed by the qualification that “any such market making may be discontinued at any time without notice”?
In short, Goldman is (appropriately) disclosing that there is no secondary market in the Abacus CDO, and that, while Goldman may choose to buy the CDO back in the future, the firm is under no obligation to do so.
The mystery is why the terms “make a market” and “market-making” are used in the disclosure that there is no market. The effect of this new usage is to create a new definition of “to make a market”:
To quote a bid price at which a security will be purchased and an ask price at which the security will be sold.
In other words, market making has gone synthetic too: It’s no longer necessary to maintain inventory and buy and sell an asset class in order to make a market in it; in the financial world’s newspeak all a firm needs to do to make a market is to quote bid and ask prices — without actively trading in the product class at all.
And one consequence of this synthetic market making is that a new asset class was created — the ABS CDO — that for accounting purposes could be marked to a market that the prospectuses stated very clearly did not exist. Only to be marked down to zero, when the little matter of cash flow entered the picture.
Maybe Ann Rutledge is right: the first step in fixing financial markets is to clearly define the words we are using.