Severe dislocations in the US Treasury market are set to be addressed by new regulatory measures aimed at boosting transparency, and a range of trading solutions that attempt to restore liquidity across the curve.
On March 22, the US Treasury Department closes its Request for Information that forms part of the biggest fundamental review of the Treasury market in almost 20 years.
The review, which is expected to result in new reporting requirements for Treasury traders, aims to address the events of October 2014, when 10-year yields plummeted from 2.23% to 1.86% and jumped most of the way back in a matter of minutes.
A number of market initiatives are also being prepared to address rising execution costs and a dearth of liquidity across large parts of the curve after dealers slashed market-making capacity to comply with new Basel III rules on capital requirements.
”There are big concerns about the ability of traditional providers to offer adequate liquidity at all times,” said Christian Hauff, CEO of Quantitative Brokers, a best-execution algorithm firm that last year extended its futures product to cash Treasuries.
“We’re starting to see the emergence of a new business model and new initiatives that include not only bank liquidity pools but alternative liquidity providers and agency solutions that optimise the execution process.”
OpenDoor Trading, a start-up platform for off-the-run Treasury and TIPS notes, is being prepared for a post-summer launch. The venue will offer session-based all-to-all trading that sees dealers sponsor their clients onto the platform where they can trade anonymously.
“The traditional model of principal trading by the dealer community as the sole source of liquidity has been materially impacted by increasingly stringent regulations creating balance-sheet constraints and decaying returns,” said Chris Ferreri, COO of OpenDoor Trading. “Technology can provide us with alternative places to unlock this liquidity. The industry is looking for new ways to deal with these challenges.”
Off-the-run Treasury bonds have taken a severe liquidity hit as traders migrate towards six electronically traded benchmark maturities that now trade at a chunky liquidity premium to older issues. On-the-run 10-year Treasury benchmark bonds currently yield just 1.877% while comparable off-the-run paper yields 1.8801% on wider bid/offer spreads.
“Liquidity in the Treasury market is now bifurcated; there remains ample liquidity for the six benchmark bonds but rapidly declining liquidity in the hundreds of off the runs,” said Ferreri. “The Treasury market needs a fully functioning curve to retain its position as a rates standard. Without a standard, you run the risk of further decrease in activity and liquidity.”
Those wider liquidity concerns have played out in negative swap spreads. Treasury bonds currently yield more than comparable interest rate swaps across maturities from four to 40 years.
The issue has been exacerbated by the Federal Reserve’s monetary easing measures. The central bank is currently sitting on US$2.46trn of Treasury securities – more than 18% of total outstanding. In some off-the-run securities, however, Fed ownership is as high as 70% – effectively shutting down trading opportunities in portions of the curve and causing bid/offers in those securities to jump by 300% in recent years.
The platform is already finding support with some second-tier dealers that have been shedding market share to their larger competitors as part of a widespread liquidity concentration. Ferreri said that the top five primary dealers now account for 65% of Treasury trading volume compared with 40% just five years ago.
“One of the key objectives of post-crisis regulation was to reduce the risk of banks that were ’too big to fail’, but the unintended consequence has produced quite the opposite. We have actually seen an increase in risk concentration among the top firms,” said Ferreri. “The dealer community as a whole is struggling with this transition and we believe OpenDoor has created a model where we can serve clients as both principal and agent which helps to re-liquify the off-the-run market and preserve those deep and valuable relationships.”
As the search for solutions gains traction, Quantitative Brokers doubled its cash Treasury activities over the last four months as more firms adopt algo technology that slices orders into smaller parts to reduce slippage (the difference between expected price and executed price) by aiming to execute at mid-price or better across multiple venues.
“Traders in cash Treasuries are used to instantaneous completion, but to improve on paying the spread, they need to move towards intelligently working the order over a period of time,” said Hauff.
* Updates paragraph 10 to correct for Treasury yields as of March 18.