Every time we have a sort of financial crisis that has something to do with settlement, and collaterals, and weird instruments, people start questioning why more instruments are not traded on exchanges. They cite the example of equities, which world over are exchange traded, centrally settled, and whose markets function rather efficiently.
After the 2008 Financial Crisis, for example, there was a move to take Credit Default Swaps (CDS) to exchanges, rather than letting the market go over the counter (OTC). Every few years, ideas are floated about trading bonds on exchanges (rather than OTC, like they are now), and the blame falls on “greedy bankers who don’t want to let go of control”.
There is an excellent podcast by Bloomberg Odd Lots where Chris White, a former Goldman Sachs banker, talks about how the equity markets went electronic in the 1970s with NASDAQ, and how the “big bang” in the UK markets propelled equities into electronic trading everywhere.
A lot of these ideas have also been discussed in my book on market design. 
In any case, I think I have the perfect explanation of why bond trading on exchanges hasn’t really taken off. To understand this, let’s look at another market that I discussed extensively in my book – the market for relationships (that chapter has been extracted in Mint).
The market for relationships is in the news thanks to this Netflix documentary called Indian Matchmaking. I started watching it on a whim on Saturday night, and I got so addicted to it that yesterday I postponed my work to late night so that I could finish the show instead.
Marriage can be thought of as a sale of “50% of the rest of your life“, paid for by 50% of the rest of someone else’s life.
There are two ways you can go about it – either “over the counter” (finding a partner by yourself) or “exchange traded” (said exchange could be anything from newspaper classifieds to Tinder to Shaadi.com). Brokers are frequently used in the OTC market – either parents or friends (who set you up) or priests.
The general rule of markets is that the more bespoke (or “weird” or “unusual”) an instrument is, the better the likelihood of finding a match in the OTC markets than on exchanges. The reason is simple – for an exchange to exist, the commodity being traded needs to be a commodity.
Read any literature on agricultural markets, for example, and they all talk about “assaying” and “grading” the commodities. The basic idea is that all goods being traded on a marketplace are close enough substitutes of each other that they can be interchanged for each other.
Equity shares, by definition, are commodities. Equity and index derivatives are commodities as well, easy enough to define. Commodities are, by definition, commodities. Bond futures are commodities, since they can be standardised on a small number of axes. We’ll come to bonds in a bit.
Coming back to relationship markets, the “exchanges” work best if you have very few idiosyncrasies, and can be defined fairly well in terms of a small number of variables. It also helps you to find a partner quicker in case many others in the market have similar attributes as you, which means that the market for “your type of people” becomes “liquid” (this is a recurring theme in my book).
However, in case you are either not easily describable by commonly used variables, or in case there are few others like you in the market, exchanges are likely to work less well for you. Either of these conditions makes you “illiquid”, and it is not a great idea to list an illiquid asset on an exchange.
When you list an illiquid asset on an exchange, unless you are extremely lucky, it is likely to sit there for a long time without being traded (think about “bespoke exchanges” like eBay here, where commodification is not necessary). The longer the asset sits on an exchange, the greater the likelihood that people who come across the asset on the exchange think that “something is wrong with it”.
So if you’re listing it on an exchange, its value will decay exponentially, and unless you are able to trade soon after you have listed it, you are unlikely to get much value for it.
In that sense, if you are “illiquid” for whatever reason (can’t be easily described, or belong to a type that few others in the market belong to), exchanges are not for you. And if you think about each of the characters in Indian Matchmaking who come to Sima aunty, they are illiquid in one way or another.
- Aparna has entered the market at 34, and few other women of her age are in the market. Hence illiquid.
- Nadia belongs to a small ethnicity, Indian-Guyanese-American, which makes her illiquid.
- Pradhyuman has quirky interests (jewelry and fashion), which his parents are trying to suppress as they pass him off a liquid “rich Maadu boy”. Quirky interests mean he’s not easily describable. Hence illiquid.
- Vyasar, by Indian-American standards, doesn’t have a great job. So not too many others like him. Illiquid, even before you take his family situation into account.
- Ankita is professionally ambitious. Few of those women in the Indian arranged marriage market. Illiquid.
- Rupam is divorced with a child. Might be liquid by conventional American markets, but illiquid in an Indian context. And she is, rather inexplicably, going the Indian way despite being American.
- Akshay is possibly the most liquid (characterless except for an overly-dominating mom), and maybe that’s why he’s shown getting engaged.
All of these people will be wasting themselves listing themselves on exchanges. And so they come to a matchmaker. Now, Sima Auntie is both a broker and a clearinghouse (refer to Chapter 3 of my book 😛). She helps find matches for people, but only matches within her own inventory (though she decided Ankita has no matches at all in her own inventory, so connected her with another broker-clearinghouse).
This makes it hard – first of all you have illiquid assets, and you are trying to fulfil them within limited inventory. This is why she is repeatedly showing saying that her candidates need to “compromise” (something that seems to have triggered a lot of viewers). By compromise, she is saying that these people are so illiquid that in case they need to get a deal in her little exchange, they need to be willing to accept an “illiquidity discount” in order to get a trade.
Back to bonds, why is trading them on an exchange so difficult? Because each bond is so idiosyncratic. There is the issuer, the exact date of expiry and the coupon, and occasionally some weird derivatives tacked on. The likelihood that you might find someone quickly enough to take the other side of such a deal is minuscule, so if you were to list your bond on an exchange, its value would drop significantly (by being continuously listed) before you could find a counterparty.
Hence, people trade this uncertain discount to a certain discount, by trading their bonds with market makers (investment banks) who are willing to take the other side of the deal immediately.
Unfortunately, market making is not a viable strategy when it comes to relationship markets. So what do you do if you can either be not defined easily in a few parameters, or if there are few others like you in the arranged marriage market? You basically go Over The Counter. Ditch the market and find someone for yourself, or ask people you know to set you up. Or hire a matrimonial advisor who will tell you what to do.
If this doesn’t convince you on why matchmakers are important, then may be you should read what my other half has to say. If she’s the better half or not, you figure.