Treasuries Prove Fertile Ground for High-Speed Arbitrage

  • N.Y. Fed finds turbulence spurs jump in cross-market activity
  • Research stands ``in contrast to the more conventional view''

Arbitrage is alive and well in the $13.2 trillion Treasury market. It just requires computing power, as well as a presence in futures markets.

Federal Reserve Bank of New York analysts found one big way volatile markets differ from calm ones: the ultra-fast trading that happens between securities. Algorithmic traders that maintain tight price linkages between markets are significantly more active when price moves are turbulent, according to a Wednesday blog post.

The researchers studied trading in 2014, and found the best sign of volatility was the amount of transactions that occur in milliseconds between Treasuries and futures prices, as well as equity futures and the Standard & Poor’s 500 Index. That proved to be a better indicator than looking at the dollar volume of Treasuries traded and the number of transactions, they said.

“This pattern is consistent with a positive feedback effect by which an increase in volatility can spur additional trading activity by creating cross-market trading opportunities,” wrote analysts Dobrislav Dobrev and Ernst Schaumburg.

Dislocation Dynamic

That flies in the face of the refrain from bond dealers that algorithmic firms may turn off their computers if markets go haywire. It also underscores the changing nature of arbitrage in U.S. government debt. Wall Street traders claim it’s tougher to maintain historical price relationships between different Treasury securities.

Yet between cash and futures markets, price discrepancies disappear instantaneously on volatile days, according to the post.

The “activity thus appears to be related to variations in market volatility, which can create (short-lived) dislocations in relative valuations as market participants respond to news about fundamentals or market activity itself,” the analysts wrote.

That speed of that trading marks a contrast with the part of the Treasury market where dealers trade with clients. Investors used the phone for about 62 percent of Treasuries trading in April 2014, according to a post from the New York Fed last week.

Wednesday’s post also hints at an answer to a chicken-or-egg question about electronic trading: Does electronic trading boost volatility, or does volatility tend to lure algorithms that profit from brief price discrepancies between markets? The analysts, who didn’t immediately respond to e-mailed requests for comment, suggested the latter option.

The observation about cross-market trading “stands in contrast to the more conventional view in the finance and economics literature which holds that trading activity predominantly influences volatility but not vice versa,” they wrote.

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