Wednesday, September 5, 2012

Two Tears for Two-Tiers

Over a number of years I had professional involvement with two-tiered markets. I’m not sure I can remember them all. Spanish A and B Pesetas come to mind. There was a two-tiered French Franc for a bit. I think Belgium had two markets as well. South Africa was two-tiered for years; Venezuela and the Philippines the same. At one point or another, all of the countries in South America were two-tiered. One of the more famous two-tiered markets was the Russian Ruble.


My interest in two-tiers was that they were (generally) exploitable. The markets had these features:


- Tier (A) was priced controlled by the central bank. There were limits on who could access this rate, and for what purpose.


- Tier (B) was not supported by the central bank, and floated freely in price; subject to supply and demand and the whims of the market.


- The price of A was always “rich”.


- B always traded very cheap relative to A.


- Liquidity for B was weak (hence exploitable).



Of course all this business of As and Bs is 25-30 years old (and long since forgotten), so you might ask why am I writing about it today?

The reason is that Mario Draghi is a few days away from creating the biggest two tiered market in history. The Arbs will make a fortune. And like all two-tiered markets, Mario’s will ultimately fail.


Draghi has hinted that his “I’ll do anything” plan was to cap yields on Spanish and Italian short-term paper. There have been recent “leaks” (bullshit – this was deliberate) that Super Mario will target the ECBs firepower to maturities of three-years and under.


I believe the leaks will prove true. Draghi is going to cap the short end for Spain and Italy. I think those caps will be generous (high caps do not get the monetary transmission Draghi wants). To have a measurable effect, the Spanish curve would have to be: 1Yr =<1%, 2Yr = <1.5%, 3Yr = < 2.0%.


If Draghi was bent on destruction, he could (temporarily) achieve these results for the Spanish bond market. In this modern example, the “A Tier” would be Spanish – < 3-year paper. The price would be controlled by the ECB; it would trade “rich” relative to the bond spreads today. It would trade very rich relative the bond yields on paper with maturities 5 years and out. There would be limitations on the Spanish Treasury on how much new paper they could issue in the three year window.


Existing bonds with maturities > 3-years would be the “B Tier”. Those bonds (and any new ones Spain tries to sell) will be tainted. There will be no promise of any price support. Long-dated paper will be functionally subordinated to shorter-term issues. This will be reflected in the price. The long-end for Spain will be sacrificed. In this environment, liquidity dries up. Spreads widen out. “Sharpies” will make bucks.


Did I mention that two-tiered markets don’t last very long? That they are a clear and present sign of economic disease? And they always end badly?



  1. Bruce, another great post – this is fast becoming one of my favourite blogs.

    I agree in all you say but I wonder what happens as time goes by. You say a 5 year bond is uncapped by the government but it will become capped in two years.

    People who buy now know that there is guaranteed profit should the country and the ECB policy last until that point. This intrinsic value must be shown by private investors piling into back month bonds.

  2. Bruce, you rock, thank you for your insight / post.

    “Sharpies” = smart money?

    Also, do two-tiered markets ultimately fail becuase the sponsor of the rich tier can’t sustain the richness of the peg? Maybe you could elaborate on what broke some of the old two-teared markets back in the day?

    I had no idea two-tiered markets even existed. It’s fascinating to learn that they’ll likely be used again now despite the fact that they’ve failed on many occasions in the past.


    • I second this comment, Bruce. It would be fascinating to get your take on previous 2-tiered markets, how they started, progressed, and failed.

    • Sharpies are folks who take advantage. Not necessarily smart money.

      Two-Tiered markets are the result of a crisis. They have all been stop-gap measures. They have been initiated in turbulent economic times.

      It is the last desperate effort to control prices. (In the case of the EU in 2012 it is the price of credit for the peripherals). Price control regimes work for a bit, then they get stressed, and finally they blow up.

  3. The Arbs will make a fortune, but, in time, the Arabs will make an even bigger fortune.

  4. Bruce,
    Obviously the ECB theory is that if they buy enough time things will work out. Without pointing out that hasn’t worked in the US for 6 years and Japan for 20, I have a question. Obviously the longer dated securities will trade at deep discounts to face value but Spain, Italy, etc still have long dated notes that are constantly maturing. If the ECB caps short issuance how will the nations redeem at face value?

  5. As Rob Dawg highlights, the story continues to be the ECB kicking the can down the road hoping that each sequential crisis allows the politics to further simplify so thast eventual union might be reachedpolitically as well as economically.

    Very few folk thought the Euro would survive this long given the enormous stress put on it by the PIIGS, I’ve been a naysayer up to this point as well, but I’m becoming convinced that Merkel is a far better politician than many of us had thought. The game is still on, and I’m now hedging my own bets (and I’m pretty sure I’m in good company on this)

    Your insights, Bruce, are keen here, but I’m not sure it matters if the two tiers eventually collapse if they last long enough to allow further political gain for the unification crowd. The Arbs may well make a bundle here, but if political union is managed alongside the economic one, a lot of folks are going to take a huge hit (as well as many being utterly saved from disaster).

  6. Well that’s great post, keep it up I really like your view’s being a Florida short seller, and Orlando Short Sales I totally agreed on this point.

  7. Not to mention the military geo-politic money machine.

    As a young lad entering the fleet, there where tails of girls 7 to 1 in Olongapo. They were wrong! It was more like 12 to 1. Beautiful girls. The entire 7th Fleet could touch that ground and there wouldn’t be a sailor without 5 girls to choose from.

    Some sailors with stronger moral character, stayed on the boat; took tours. Managed to save 10K – 1980. Bought some land in their hometown. Ran for Mayor.

    ALot of them didn’t, including me. The only thing I had was the satisfaction of knowing I did my thing in the most righteous way I could. I did, I have good stories. But looking back, I didn’t do all that well.

    The point I am trying to make, even if I have to endite myself is, I was part of a world wide program of military economic control.

    I will confess that is my crime. Might be someday, the World Counsel will call that a penalty of death. Ok, I get it. I have confessed, and I will go willingly.

    Don’t think about hanging the international bankers or the politicians…just focus your wrath on me.

  8. I’ll have to reread my copy of “The rotten heart of Europe” by Bernard Conolly. Especially the part where George Soros busted the BoE after said BoE had pledged to “do whatever it takes” to keep the ERM alive.