Fixes sought for flaws in US Treasury market as volatility intensifies

Within the past eight years, the US Treasury market has experienced severe stress on three occasions due to liquidity issues: in October 2014, September 2019 and March 2020. These necessitated intervention from the US Federal Reserve to restore normal trading.

This has left policy-makers worried that more severe stress events could erupt. US monetary policy has made its biggest shift in over a decade, and deep economic uncertainty and inflationary pressures reign.  

Diagnosing the cause of the Treasuries market’s faults and finding a remedy are difficult because there are many factors at play. Yet the US Treasuries market is deep, liquid and the safe haven asset of choice when investors seek shelter from economic storms.  

“I don’t think people know exactly what the causes are. There’s certainly been significant changes to the market,” says Brandon Hammer, counsel at law firm Cleary Gottlieb. He cites the rise of proprietary principal trading firms (PTFs) through to the pullback of the traditional bank market makers as examples of that transformation. 

“PTFs have a very different trading outlook to the banks,” he says. “They’re principally trading for their own account, rather than facilitating client orders, and they like to end the day flat, while the banks are really using their balance sheets.”

Solutions are being proposed. These include improving transparency, extending the Fed’s repo facilities to more market participants, relaxing the capital surcharges for primary dealers, introducing all-to-all market platforms and broadening the scope of clearing. However, it is not clear whether these suggestions would address the problem. 

Stress causes 

The drivers behind the October 2014 event may have partly self-corrected. “I think that was an eye-opener for most of the marketplace,” says Colm Murtagh, head of institutional rates at Tradeweb, an electronic trading platform. “It was the realisation that high-frequency trading firms had a massive influence on the wholesale US Treasury market.” Essentially, they suddenly stopped trading, liquidity dried up and the market gapped lower, which stunned other market participants who were unsure how to react. 

However, Mr Murtagh does not believe a repeat of that event is likely as there are now many different types of trading models, some which would take advantage of such a situation.

But there are unresolved issues around the subsequent two stress episodes, which were different in nature. 

“In 2019, there were a couple of reasons why a lot of cash left the market all of a sudden,” says an industry source who asked not be named. This saw overnight money market rates go through the roof due to a cash drain related to corporate tax payments and a net-issuance of Treasuries.  

The source added that in March 2020, it was evident that the turmoil was caused by regulatory balance sheet constraints on dealers while other market participants were unwinding basis trades. This related to urgent liquidity needs of mutual funds, hedge funds and foreign agencies as the West went into Covid-19 lockdowns. The source is unsure if the proposed solutions would have stopped the market seizing up.

However, lack of transparency is seen by some industry sources as a major Treasuries market flaw. 

In a report on April 5, advocacy group the Bank Policy Institute (BPI) argued that more transparency could make the Treasuries market more resilient. It would allow market participants to better evaluate market conditions. The BPI is not pushing for total transparency, recognising that large ‘block’ trades in less liquid issues could benefit from incremental reporting. It added that opacity favours the largest market participants, namely the dealers. 

Information asymmetry 

Could the EU have the answer with its Markets in Financial Instruments Directive (MiFID)? It is laden with rules governing pre- and post-trade reporting. But US industry sources are sceptical, arguing that MiFID is so riddled with waivers that it allows ‘dark’ trading to flourish. 

The US Treasuries market divides into two main segments: dealer-to-dealer and dealer-to-customer. Each has its own particular characteristics.

The dealers are members of the Financial Industry Regulatory Authority, obligating them to report their transactions to the Trade Reporting and Compliance Engine (Trace) under Securities and Exchange Commission (SEC) rules.   

Though only regulators have full access to Trace data, the dealers tend to be better informed than their customers because they process so much of the trade flows. 

The BPI noted that Trace data is only made public in certain weekly reports, unlike for corporate bonds where data publication is instant.

A number of industry sources remarked that a key feature during these episodes of extreme market volatility is that there was a lot of stress in the dealer-to-customer segment of the market. They believe that insufficient attention was paid to this part of the market in various reports that have been published analysing what went wrong. They partly blame this on the opaqueness of that market segment making it harder to understand. By contrast, the inter-dealer market is more transparent and there are central limit order books enabling participants to see where trading is happening and to observe current price levels. 

But regulators have taken notice of this uneven playing field. The Inter-Agency Working Group on Treasury Market Surveillance (IAWG) report in November 2021 indicated that making public the Trace data for the Treasuries market is being considered by the agencies. On April 26, SEC chair Gary Gensler called for more transparency in US fixed-income markets, adding that Trace reporting delay times should be shortened. 

Sal Giglio, chief operating and markets officer at GLMX, an electronic securities financing trading platform, says there is a challenge around the dealer-to-customer segment of the market that is not often discussed. “Dealer-to-dealer flow tends to be standardised,” he says. “The buy-side-to-dealer flow seems to have more nuance to it, whether it is to do with risk management, credit intermediation or directional trading.” The buy side comes in many shapes and sizes, while the dealer community tends to be larger and more concentrated. 

Mr Giglio explains that the buy side often focuses on ‘off-the-run’ Treasuries. Freshly minted Treasuries are known as ‘on-the-run’ and are the most liquid issues, and this is where most dealer activity happens. An issue becomes ‘off-the-run’ when a new Treasury with the same tenor is issued. The liquidity of off-the-run bonds tends to decline over time.

“So it becomes more of a bespoke transaction and there’s more risk and there tends to be wider bid/offer spreads for the less liquid securities,” says Mr Giglio. “A lot of my conversations are about liquidity. There are solutions coming into the marketplace, but none of them is a panacea that solves every situation.” One of them could be to encourage peer-to-peer trading. He says this would work in stable markets, but the jury is out on whether this would stand up to intense volatility. Mr Murtagh believes making Trace data more available could help the less liquid segments of the Treasuries market. 

Buyers left unfilled 

There is evidence that the Treasuries market struggles to match orders under abnormally large trading volumes and price volatility. 

That much was revealed at an annual Treasuries market conference hosted virtually in September 2020 by the Federal Reserve, the US Department of the Treasury and other regulators. Several conference participants, who included leading institutional investors and dealers, agreed that primary dealers were not sufficiently engaged in the market to intermediate at the most acute moments of the crisis. Indeed, some were not even willing to do business, much less carry out market making.

Others only transacted if they had another client they could quickly sell the bonds to. As such, some buyers looking to take advantage of the drop in prices were actually unable to acquire Treasuries due to the reluctance of some primary dealers to transact. 

Post 2007-9 financial crisis reforms are blamed for shrinking dealer balance sheet capacity. Capital surcharges on the big banks and the supplementary leverage ratio (SLR) constrain how much inventory they can carry. There have been calls for Treasuries to be excluded from the SLR to ameliorate liquidity. 

The IAWG advised regulators to review some of the capital rules, such as the SLR, as they disincentivise market intermediation. 

However, there are doubts in the industry about whether this would work, because market-making is a relatively low-margin activity. But it would have helped them cope with the March 2020 volatility, according to industry sources. 

At the 2020 Treasuries market conference, several participants said there was a drop-off in the ability to trade electronically, which led to less efficient trading. This was likely exacerbated by the population lockdowns that kicked in at that time to stop the spread of Covid-19. The public health measures forced participants to work from home, which saw some of them resort to trading over the phone for larger transactions. This introduced friction into the market. 

Besides capital constraints on the primary dealers, there is another twist. “The US Treasuries market has quadrupled in size since 2008, so it’s only logical that we need to find solutions to enhance intermediation capacity. It’s unrealistic to expect that a dozen or so banks could continue to effectively intermediate a market that has grown so significantly,” says Jonah Platt, US head of government and regulatory policy at Citadel.

Some industry sources noted that a greater diversity of players should be allowed to more fully participate in the market to reflect its growing size, rather than leaving it to a group of large banks to do all the intermediation. That liquidity gap has largely been filled by the PTFs. 

Estimates suggest that around a quarter of the Treasuries market is cleared, which mainly happens for inter-dealer transactions. Mr Platt believes that extending clearing to more market participants, including on the buy side, would make the market more robust and less prone to  problems during high-stress events. He says more clearing would significantly reduce credit risks, which would comfort market participants during periods of extreme volatility. He believes that it would also support measures such as an all-to-all market platform, which is an option many buy-side firms would like to have available.

The IAWG recommended that all Treasuries trades on electronic interdealer trading platforms should be cleared. 

But there is no complete agreement on the matter. “As central clearing pertains to easing a liquidity crisis, like we saw in March 2020, it’s not really clear what it would have done to help with liquidity,” says Elisabeth Kirby, head of market structure at Tradeweb. “I think probably SLR reform would have actually been more helpful in that specific scenario.” 

Ms Kirby warns that central clearing introduces additional costs, which might undermine the PTFs’ trading models. “If they decide it’s no longer economical to participate in the market … then we have a liquidity vacuum and it is not abundantly clear that banks are that motivated to step back in and play that role anymore,” she says.  

Possible quick wins

Industry sources mostly agree that there are some adjustments that definitely would improve the market. 

One is around how customer margins are treated for regulatory purposes. “One of the weird quirks right now is that broker-dealers essentially have to fund initial margin for their customer trades using their own assets. They can’t reuse customer assets due to a quirk of SEC rule 15c3-3, which is the US segregation rule. Banks can do it, but broker-dealers can’t and that’s just a drag,” says Mr Hammer. He explains that broker-dealers have to charge more to their customers and that effectively disincentivises clearing. 

A second industry source who asked to remain anonymous says rule 15c3-3 is a big disincentive for broker-dealers to clear client activity. “If that is solved a lot more activity would be cleared,” they say, adding that the Options Clearing Corp got that relief back in the 1970s. “For the most part regulators are amenable to the idea,” they add. 

Another potential quick win for the market, according to industry sources, would be to drive netting efficiencies between cleared positions for cash Treasuries and Treasury futures, which would promote capital optimisation. The problem is that cash Treasuries are cleared by the SEC-regulated Fixed Income Clearing Corporation. Futures are cleared by the CME Group, which is regulated by the Commodity Futures Trading Commission. This regulatory separation appears to have slowed progress around driving netting efficiencies. 

But one possible fly in the ointment, according to industry sources, is an SEC proposal to make more market participants, such as PTFs and even some buy-side firms, register as broker-dealers. 

“If it were to be finalised it could significantly negatively impact market liquidity, efficiency and resiliency in a significant way because large customers would be left with a choice of either reducing investment, trading and hedging activity or registering as a dealer,” says Mr Platt.

The Treasuries market has deep liquidity and real-time pricing is readily available via various vendors. However, activities such transaction matching could be improved by allowing more participants to trade directly with each other. Also, making more granular data on those transactions available to all market participants would help. Some market participants believe the steady move towards greater electronification, which should improve data flows, trade matching and transparency, will go a long way towards alleviating the market’s flaws. 

This article first appeared in The Banker's sister publication Global Risk Regulator