US Dealing with Market Functioning Issues in US Treasuries
Posted by Colin Lambert. Last updated: November 10, 2021
The US Inter-Agency Working Group for Treasury Market Surveillance (IAWG) has published an update on its continuing work to better understand the functioning of the market in US Treasuries, which highlights how it continues to struggle with the changing market dynamic driven by regulation and electronic trading.
The IAWG consists of staff from the US Department of the Treasury, the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, the Securities and Exchange Commission, and the Commodity Futures Trading Commission. It’s purpose is to conduct analysis to help ensure that the Treasury market continues to “reliably fulfill its vital role”.
Noting that the structure of the US Treasury market has changed “in important ways”, the IAWG highlights the growth in electronic trading as contributing to a particularly marked shift in the composition of participants in the interdealer cash market. Before the introduction of e-trading, the report observes that dealers had been the main participants in the interdealer market, but its advent has allowed proprietary trading firms (PTFs) to enter the cash market in the mid-2000s. By 2014, PTFs represented the majority of trading activity in the futures and electronically brokered interdealer cash markets, the report further notes.
The role of risk absorption also plays a role in the report, which notes that dealers have historically been able to buy and sell from customers in large amounts, hold a portion of these positions across days, and maintain a large balance sheet to support their positions. In contrast, it points out that PTFs tend to buy and sell frequently in the interdealer market and typically end the day with little net directional exposure.
“Because they take on little net exposure, many PTFs are more thinly capitalised than typical broker-dealers,” the report states. “The electronic interdealer market also does not create client relationships. As a result, PTFs tend to make trading decisions primarily based on immediate profitability and the level of market risk. Increasing concentration among PTFs has resulted in a small number of PTFs playing a key role in price discovery and the provision of market liquidity.”
The report does acknowledge that regulations adopted in response to the Global Financial Crisis and subsequent changes in financial institutions’ internal risk management and business strategies have also influenced dealers’ capacity to intermediate. Following the GFC, reforms were made to strengthen the regulation, supervision, and risk management of the banking sector. US regulators adopted the supplementary leverage ratio (SLR) for large bank holding companies as part of the US implementation of the Basel III reforms, and this has been cited as among the factors motivating banking organisations to dedicate capital to higher-margin businesses and limiting the amount and flexibility of bank and bank-affiliated broker-dealer balance sheets dedicated to low-margin businesses, such as many forms of Treasury market intermediation. “Even when the demand for intermediation in the Treasury market has spiked and potential profits from intermediation have risen, banks and bank-affiliated broker-dealers sometimes have not meaningfully expanded their balance sheets in aggregate to meet the increase in demand,” the IAWG says.
The report also highlights one of the truisms of electronic markets, they become increasingly interconnected, resulting in significantly faster risk and information transmission. In addition, the expansion of PTFs’ role in the interdealer market beginning in resulted in a decreasing fraction of interdealer trades being centrally cleared. The report says that in recent years, approximately one-half of interdealer cash trades (representing about one-quarter of the total cash market) have been centrally cleared, compared with central clearing of virtually all interdealer trades (representing about one-half of the total cash market) before the entry of PTFs in the interdealer market.
The latest report includes an extensive examination into the 2020 liquidity event in Treasury markets that resulted from the first impact of the global COVID pandemic, however it also relates this time to previous events in 2014 – the “flash rally” and the 2019, when a cash squeeze saw repo markets struggle to function effectively.
“A recurring theme is that trading volumes and demand for intermediation can surge suddenly, but intermediaries’ willingness or capacity to respond can be relatively inelastic compared with these surges, potentially leading to rapid deterioration in market functioning,” the report states. “The surging demand for intermediation can include both demand for market and funding liquidity.”
Another recurring theme, highlighted is that the official and private sectors may have limited real-time visibility into the positions and flows driving market dislocations. Potential improvements to data quality and availability are the focus of a second policy workstream at IAWG. “Experience has also highlighted challenges around trading venue transparency and oversight, central clearing, and leverage and liquidity risk management,” the report states.
In the March episode higher volatility, changes in correlations, greater customer flows, and a host of pandemic-related uncertainties all raised the risk of making markets, the report says, adding the higher risks appeared to be particularly relevant for PTFs, whose lower capitalisation relative to dealers may leave them with less capacity to absorb adverse shocks.
It adds that in the first week of March, a large share of the increased trading volume came from PTFs, and on March 9, PTFs’ share of trading on electronic IDB platforms was just over 60 percent, a typical level. “But as heavy net investor sales continued, the balance of activity in the interdealer market shifted,” it explains. “PTFs’ total share of activity fell to a low of 45 percent on March 16. Dealers’ total volumes on electronic IDB platforms also declined, but less sharply than PTFs’ volumes. Additionally, there was substantial heterogeneity in responses among dealers and among PTFs.”
Some dealers were able to swiftly increase these limits to a certain extent, the report days, while others were unable or unwilling to increase their limits.
Another factor was the absence of circuit breakers from the cash Treasury market, which continued to trade during these times, though without the price discovery from futures. “The activation of futures circuit breakers reportedly challenged some trading strategies that rely on high-frequency hedging between cash and futures markets,” the report says, adding that the cost of margin, operational difficulties, specifically the shift to work-from home and a scarcity of treasury bills also contributed to the event.
To meet the challenge of the evolving (some might say evolved) market structure, the report proposes six basic principles.
- A market that has resilient and elastic liquidity, with a diverse and competitive set of market makers and investors. This, the report notes, should foster resilience by rendering market liquidity less susceptible to shocks or environmental changes that affect particular participants or types of participants.
- Greater transparency to help develop a market that is “fair and free of deception”.
- Prices that reflect prevailing and expected economic and financial conditions.
- Integration of the cash Treasury market, the market for Treasury repurchase agreements, and the Treasury derivatives market, which involve closely related instruments and economically connected transactions. Frictions that lead to large or volatile deviations between the prices of economically similar instruments should be limited, the report says, adding, that policies or regulations may appropriately differ across these markets given the particular characteristics of each market.
- Financing that does not represent a threat to financial stability – in particular the report says that leverage, that makes the financial system vulnerable to instability, should be avoided.
- A robust, well-designed and well-managed infrastructure that can support liquidity, transparency, efficient pricing, economic integration across markets, and financial stability. To achieve these ends, market infrastructure should robustly manage financial and operational risks and limit settlement uncertainty, including when trading volumes are unusually high, the report observes. Moreover, operational costs should not be excessive relative to the level of safety and functioning provided.
While the work is ongoing, it is hard to escape the conclusion that the US – as is the case with many other jurisdictions – is caught between the need to create a “safe” financial system, while at the same time ensuring that risk absorption services are available. Regulation has undoubtedly made it harder for banks to maintain what is clearly seen as an adequate level of risk absorption, while newer entrants in the form of PTFs don’t have the balance sheet to provide the service – their role remains more in the guise of a broker-dealer, rather than dealer.
Generally speaking, regulation has done a good job of building resilience in the financial system, but at the expense, perhaps, of the resilience of the markets themselves. The challenge comes from the different purposes of the various markets – namely those like Treasuries and indeed foreign exchange, provide a different, some would say crucial, service to the global economy, while many derivatives markets exist more for traders and alpha seekers. The ultimate solution, one that is probably impracticable, would appear to be to separate, rather than congregate, different markets under the same regulatory umbrella.