As U.S. Probes $12.7 Trillion Treasury Market, Trader Talk Is a Good Place to Start

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Justice Department Probe Turns Towards Treasuries

The U.S. federal probe that ended last month with guilty pleas and $6 billion in fines from global banks began with an open secret -- that currency traders there could talk to each other to coordinate trades.

Now, the Justice Department unit behind those prosecutions is turning its sights on the $12.7 trillion U.S. Treasury market, a world with some of its own open secrets.

Dozens of times a year before the Treasury holds an auction, salespeople at 22 primary dealers field billions of dollars in bids for government debt. Traders working at some of these financial institutions have the opportunity to learn specifics of those bids hours ahead of the auctions, according to several people familiar with these operations.

Traders at some of these dealers also have talked with counterparts at other banks via online chatrooms, according to people familiar with the operations, with one of them adding that the traders swapped gossip about clients’ Treasury orders as recently as last year.

Such conversations, both inside banks and among them, could give traders information useful for making bets on one of the most powerful drivers of global markets, the U.S. debt sales that often sway the prices of trillions of dollars worth of bonds.

The people who described these scenarios didn’t point to specific cases in which bond traders used such information to front-run markets, or accuse any banks of wrongdoing. They also declined to discuss the precision with which client orders may have been discussed between traders at different banks or which online chatrooms may have been used.

Investigation Blueprint

There is new interest, though, in opportunities for information-sharing. Antitrust officials at the Justice Department are investigating trading related to Treasuries, people familiar with the matter said earlier this month, without specifying what sorts of trades are drawing scrutiny.

The recent string of antitrust actions against big banks provides an investigatory blueprint: The inquiries into Treasuries grew out of cases in which prosecutors established that traders were trying to manipulate interbank interest rates and align foreign-exchange trades, people familiar with the probes have said.

In May, JPMorgan Chase & Co., Citigroup Inc., Royal Bank of Scotland Group Plc, Barclays Plc and UBS Group AG all pleaded guilty to charges related to the currency-rigging. Prosecutors claimed that traders engaged in cartel-like behavior by sharing information, such as via chatrooms.

‘Fertile Area’

The issue for regulators in these matters isn’t whether traders have profited, say legal experts. It’s whether they have shared information that has the potential to bring them a benefit.

“In the Treasury market, where you have a small number of participants and the sales volume is very high, it is a fertile area for harmful collusive behavior,” said James Cox, a professor at Duke University School of Law who focuses on financial markets.

Peter Carr, a Justice Department spokesman, and Adam Hodge, a spokesman at the Treasury in Washington, declined to comment.

The Treasury auction system is one of the global financial system’s major crossroads, where primary dealers channel bids from sovereign governments, pension funds and big money managers into the world’s most closely watched fundraisers.

‘Insiders Club’

The dealers represent dependable partners for the government -- ensuring that there will be enough demand for each auction, including by putting up their own funds, and helping officials to plan by providing insights on market conditions. The primary dealers’ customers, for their part, channel orders to them in part as a thank you for providing services such as research, people in the market have long said.

The open secret part of the equation is that some people at these banks can see orders flowing in -- and until now there has been little public insight into whether there are others at the banks who may seek to use or share that slice of market intelligence to improve their positions in the secondary or futures markets.

“Primary dealers are an insiders club where they’re supposed to have more information,” said Mark MacQueen, who started his financial career as a government-bond trader at Merrill Lynch in 1981 and now helps manage $11 billion for Sage Advisory Services Ltd. in Austin, Texas.

Honor System

Bankers have often shared broad guidance, both internally and to clients, on whether demand is slack or strong before auctions, say people familiar with several firms. Many banks have rules prohibiting employees from discussing yields or sizes of client bids before auctions, according to people familiar with them.

In many cases, such guidelines aren’t always followed, monitored or enforced, said several people familiar with these dealers, indicating variance among market participants.

For example, at BNP Paribas SA and Cantor Fitzgerald, there isn’t a consistent understanding among traders and salespeople about whether they can share information about orders before auctions, according to two people familiar with each firm. New York-based Cantor operates on an honor system, one person said. At Societe Generale SA, traders can get a pre-auction rundown of customers’ level of interest, according to one person familiar with the Paris-based bank’s operations.

“Societe Generale follows industry best practices,” James Galvin, a New York-based spokesman, said in e-mail Wednesday. “We specifically prohibit the sharing of any information about customer auction orders ahead of Treasury auctions. Customer auction orders are not shared outside the desk responsible for the auctions and related sales personnel. This policy is closely monitored by Societe Generale compliance officers who are on the desk with traders during each auction.”

Spokesmen for BNP and Cantor declined to comment.

Shifted Message

At least one bank has recently shifted its message to employees on the issue. Zurich-based UBS -- which gained leniency cooperating with U.S. antitrust officials on their foreign exchange and interbank-rate probes -- barred its traders early last year from seeing client orders in the hours before an auction, according to a person familiar with the move. UBS declined to comment.

There are several rulemakers and enforcers in the Treasuries markets, and ample space between them. The Treasury Department can write rules and the Federal Reserve Bank of New York audits auctions, but neither body has enforcement powers. Those duties fall to the Securities and Exchange Commission, the Financial Industry Regulatory Authority or the Commodity Futures Trading Commission, depending on whether a government bond is bought at an auction, traded on the market or packaged in a mutual fund or derivative.

Antitrust Guidelines

The Treasury Market Practices Group, a New York Fed-backed committee of industry executives, provides antitrust guidelines for its group members and makes “best practices” recommendations for traders and investors, including that market participants have “information barriers” in place to separate, for example, loan origination and trading functions.

Tom Wipf, the head of the TMPG and managing director at Morgan Stanley, declined to comment through Morgan Stanley spokesman Mark Lake. Andrea Priest, a spokeswoman for the New York Fed, declined to comment.

Market Losses

The Justice Department’s inquiries come at a volatile time for bond markets. A global sell-off in government debt erased at least $700 billion in market value during the past nine weeks. The first U.S. rate increase in nine years is approaching, the Fed has signaled. And after the Oct. 15 flash rally in Treasury prices, bankers are warning that regulations restricting their balance sheets could cause more volatility.

“Making it more difficult for the Treasury to sell debt -- it’s not the right time to do that,” said MacQueen.

The Justice Department inquiry is in its early stages, people familiar with it have said. Its potential field is vast. In addition to sales of notes and bonds held as often as four times a week, there is the secondary market in U.S. debt -- where dealers trade roughly $500 billion in Treasuries a day, according to the Federal Reserve -- as well as transactions in futures and other derivatives.

Corporate Debt

There are other areas where traders may have the potential to gain advance word on big Treasuries transactions. When a bank underwrites a corporate-debt issuance, it often hedges the company’s interest-rate exposure ahead of the deal, and then unwinds those hedges when the bond is issued. Those trades can move markets. Traders who learn of the deals’ timing could place informed bets on the direction of prices, according to people familiar with these trades.

Wall Street has run into problems with the Treasury market before, including Salomon Brothers’ admission in 1991 that it had been violating bidding rules to control the price of the two-year note.

The Treasury responded with measures making it tougher to fix bidding, including introducing Dutch auctions and setting caps to make sure no single dealer held too much sway at auctions. It also introduced direct electronic bidding, with such orders accounting for 10 percent of the securities awarded so far this year, according to data compiled by Bloomberg.

Chatroom Ban

When the Justice Department began looking into collusion surrounding foreign exchange and the London interbank offered rate, many bank compliance departments were caught off guard, people familiar with these cases have said. That was because the prosecutors weren’t seeking to enforce regulations and statutes, but rather to use antitrust powers to take aim at longtime practices.

To build their case of cartel-like behaviors, the investigations drew attention to traders’ use of online chats to coordinate bids or timing of trades, building their cases on conduct dating back as far as 2007. By early 2014, many of the biggest Wall Street banks had banned employees from using chat rooms to talk to people at other banks.

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