Treasuries market under the spotlight as US finance ministry takes stock in one of the most sweeping reviews of its kind. Anna Reitman reports.
The US Treasury’s market structure review saw a call from buy- and sell-side firms to extend the existing rules to include high-frequency trading (HFT) firms more explicitly, over concerns about ephemeral liquidity and counterparty risk.
Buy-side firms also called for equal access to the interdealer market and greater transparency through post-trade reporting.
“Quotes and orders should be reported as this may reveal how the price and quantity for orders may change while they are live,” wrote Erik Schiller, principal at Prudential Fixed Income, which has US$621 billion assets under management (AUM). “Electronic orders are more easily monitored than voice orders. The reporting of quotes being submitted for Treasury securities could allow the official sector to monitor the validity and dependability of liquidity being presented on electronic trading platforms.”
But there were also warnings against simply cutting and pasting solutions from other markets, many of which face similar challenges in an electronic age.
In a comment letter, Guggenheim Partners, an asset manager with some US$240 billion AUM, cautioned against following regulatory approaches used in other asset classes: “Instituting order price and quantity controls, circuit breakers, kill switches and similar controls may in some circumstances impede price discovery and reduce liquidity.”
Still, increased regulatory reporting, added Guggenheim, will help assess the functioning of the markets and behaviour of participants in order to decide what risk management controls are right for the treasuries market.
Buy-side firms also highlighted the benefits of access to the interdealer market. Regulators are leaning towards all-to-all marketplaces for fixed income having supported them in the swaps markets, and platforms provided by firms like Direct Match, Liquidity Edge, Tradeweb and MarketAxess, all of which submitted comment letters, are angling for market share along with ICAP’s BrokerTec.
One fixed income professional based in the US at a fund said that all-to-all “is what should happen”. Dealers used to have access to free, unregulated money, the source said, which meant if the market hit a bump in the road there was a kind of “shock absorber” to lessen the impact.
“If anything went off by fair value by one or two basis points, they were able to basically put that position on and revert it back,” he said. “Is it the right thing to have in the market? I think the regulators were probably right in cutting down some of this, because it was forced liquidity.”
He compared the situation to the European covered bonds market, where dealers were forced to carry balance sheets. It ended up with firms overreaching and regulators intervening. “Regulators didn’t want those banks to be that shock absorber, and if you remove that shock absorber from the car, it will still run down the road, but the ride is going to be much bumpier.”
Those bumps hit the treasuries market on 15 October, 2014, an event which is still the subject of intense scrutiny across the industry.
In today’s market, liquidity is illusory, said Josh Galper, managing principal at Finadium, a US-based consultancy with expertise in fixed income markets. “What looks like a liquid market today can disappear tomorrow due to the high involvement of principal trading firms – high-frequency traders (HFTs), small brokers, hedge funds and other non-banks – which can pull back from the market in times of stress.”
He pointed to the Joint Staff Report in the wake of the treasuries flash crash, which showed that principal trading firms represent between 50% and 60% of the market depending on the product (5-year, 10-year, 30-year). Banks are somewhere between 30% and 40%.
Across all categories of the market review’s respondents, this shift in balance among market players was a recurring theme.
“If you are truly looking for liquidity today in US treasuries markets, your odds are only 30% to 40% that you are going to get it from a bank,” Galper said. “Market participants support electronic trading venues that accept both the sell- and buy-side as direct members because they are locations where there is likely to be the most liquidity for US treasuries in today’s market.”
HFT and dark pools
Credit Suisse wrote that it anticipates a “further shift towards increased HFT”, meaning a larger portion of liquidity providers that cannot warehouse overnight risk.
“The benefits of a greater number of liquidity providers is that bid/ask spreads should stay tight,” the bank noted. “However, the nature of these new sources of liquidity is such that it will likely mean even greater negative correlation between liquidity and market volatility.”
In other words, liquidity is likely to be least available when it is most needed. Credit Suisse’s recommendation is along the lines of uniform standards for everyone, particularly adhering to those standards already laid out by the Treasury Markets Practice Group (TMPG).
In addition, liquidity providers should have a minimum capital requirement, the bank said.
Morgan Stanley echoed some of this sentiment, saying that internal risk controls should be reviewed and monitored by TMPG, and that pre-, intra-, and post-trade controls should reflect the increased risks of automated trading. That could mean order message limits, kill switches, stress testing enhancements and surveillance around market conduct practices.
“There is an opportunity to increase consistency and transparency across trading platforms (e.g., order-to-trade ratios) in line with TMPG’s best practices,” the bank wrote.
Prop traders, meanwhile, took a swipe at over-the-counter trading. While calling for a best execution mandate as a solution to “enhance liquidity and safeguard the interest of the market’s participants”, Virtu Financial pointed to research showing that trading in the dark markets is presumed to be equal in size to the lit markets. Moreover, some 60% of the volume in dealer-to-client trading is on-the-run.
“This fragmentation impedes price discovery. Whereas market data for on-the run Treasury securities is available in real-time from the main lit markets for a fee, the dealer-to-client market is effectively opaque,” Virtu said.
In its submission, US Financial institution, Citadel made several recommendations towards improving market structure: introducing real-time public reporting; registration of multilateral trading venues; non-discriminatory access to platforms; and ultimately the expansion of repo clearing. Of such recommendations, repo clearing proved to be the most popular with a broad swathe of industry players.
Centrally cleared repo, explained Prudential Fixed Income’s Schiller, would limit dealers’ capital needs for existing repo positions and “economically incentivise” greater participation. Counterparty risk, meanwhile, would marginally decrease since clearing houses would have better credit than any individual firm, Prudential said.
But that would require that enough firms be allowed to participate, like insurance companies, REITs, supranationals, foreign central banks, asset management companies, money market funds, regional banks and securities lenders, for example.
“As each entity enters the central clearing house, liquidity will increase in the financing market as more of the market activity is removed from dealers’ balance sheets,” Prudential wrote.
The problem is that cost of entry might be prohibitive for some of these groups. Also, there could be a continuation of the migration towards futures contracts in lieu of cash treasuries given the anonymity, liquidity and implicit access to leverage, Prudential noted.
Finadium’s Galper said that central clearing of both treasuries and repos could mitigate some balance sheet constraints for dealers and provide liquidity to the market: “If you’re going to be trading interest rate products, like derivatives and repo, on the same CCP, the bank can net down its cross product exposure.”
For the buy side, that could mean better pricing and liquidity, he added. The buy side view is that more transparency is better and the US treasuries market is sadly lacking in this regard, particularly when compared to the corporate bond market, said the source from a buy side fund, adding that regulators are still catching up to what is actually going on.
“A lot of the large investors are right that transparency is something that would be very positive for the market…, but some of these things, like all-to-all, are already happening in the market.”
Schiller noted that changes in market structure alongside the increasing use of electronic platforms and tools were likely to affect how Prudential Fixed Income trades in the market, mirroring the direction of travel in equities. “Our trading practices could potentially shift to smaller lot sizes, fewer block trades, and more frequent trading,” he wrote.