Bond Traders Club Loses Cachet in Most Important MarketChristine Harper and Daniel Kruger
Primary dealers, the select group of banks and brokers that have held a seat at the center of the U.S. government debt market since 1960, are losing influence.
More than 20 percent of the $538 billion of Treasury notes auctioned this year have been awarded to bidders who bypassed the dealers by using a website to place their orders, according to U.S. Treasury Department data compiled by Bloomberg. That’s almost double the 2011 level and up from 5.6 percent in 2009.
In the same way technology eroded the middleman role once played by travel agents and stock-market specialists, increased use of the direct-bidding system threatens government-bond traders at firms ranging from Bank of America Corp. to UBS AG. It also has eaten into profits from a business that’s among the least affected by the regulatory changes and new capital requirements reshaping the industry.
“You’ll see clients do a lot more things in a self-sufficient manner than they used to do before,” said Richard Prager, global head of trading at BlackRock Inc., the world’s largest asset manager with $3.8 trillion. “It’s just the realities of today.”
Traders at primary dealers have complained to the Treasury and the Federal Reserve Bank of New York about direct bidding, which they say is reducing their profitability, according to seven government-bond traders who requested anonymity because they weren’t authorized to comment publicly. Their job is becoming more frustrating, and sometimes money-losing, now that they’re competing in auctions against anonymous investors who can show up at any time and at any price, the traders said.
“A lot of the value of being a dealer is being at the nexus of the information flow,” said Jason Evans, a former Treasuries trader at Goldman Sachs Group Inc. and Deutsche Bank AG who started his own fund, Ninealpha Capital LP, in 2009. “That is being eroded through electronic trading and direct access to exchanges, and it’s also being eroded in the primary market through Treasury direct access. It’s just an erosion of their competitive advantage.”
As the deepest and most-liquid bond market in the world, U.S. Treasuries have served for decades as a shelter for investors fleeing risks such as the 1987 stock-market crash, the Russian government’s 1998 debt default, the Sept. 11, 2001, terrorism attacks and the 2008 financial crisis. The default investment of governments such as China and Japan, Treasuries serve as a benchmark for everything from corporate borrowing costs to home loans.
Primary dealers are required to bid for no less than their pro-rata share at Treasury auctions -- 4.76 percent for each of the 21 dealers currently designated by the New York Fed. Bids must be “reasonable” compared with the range of prices in the so-called when-issued market before an auction, according to New York Fed rules. The dealers also provide market commentary and analysis helpful in conducting monetary policy and act as counterparties when the Fed buys or sells bonds.
Direct bidding was introduced more than a decade ago by then-Undersecretary of the Treasury Peter R. Fisher, according to Timothy S. Bitsberger, assistant secretary for financial markets at the time. Fisher thought the auctions should be free and open and that forcing institutions to route orders through primary dealers undermined that goal, Bitsberger said. Fisher, now at New York-based BlackRock, declined to comment.
“The system works well for the dealers if all the bidding is channeled through them,” said Bitsberger, now head of official institutions coverage at Paris-based BNP Paribas SA, a primary dealer. “On the other hand, the investors feel, why do they have to give up this information?”
The Treasury doesn’t reveal the identities of direct bidders. A February analysis by New York Fed Vice President Michael J. Fleming found that other dealers and brokers, investment funds and foreign investors have increased their participation in auctions. The share awarded to depository institutions, pension funds and individuals hasn’t changed.
One strategy for primary dealers is to sell Treasury debt to clients in advance with the intention of buying at a lower price at auction, said the traders. The strategy has failed in some cases when direct bids came at a higher price than dealers hoped to pay, saddling them with a loss, they said. That’s leading traders to become less aggressive in bidding and could result in higher yields at future auctions, some warned.
Dealers have won 22 percent of the securities they have bid for this year through the end of March, compared with 26 percent in 2009, according to the Treasury data compiled by Bloomberg. Their share of the auctions has shrunk to 46.4 percent from 49 percent in 2009.
The Treasury hasn’t seen any indication that the increase in direct bidding has reduced primary dealers’ appetite at auctions, according to a senior official in the department. The official said firms are still applying for the designation.
Even with record debt, higher demand for U.S. Treasuries has helped suppress borrowing costs as a percentage of the country’s gross domestic product.
“Our basic view continues to be that having broad access to the auction process generates competition,” Matthew Rutherford, assistant Treasury secretary for financial markets, said in an interview.
Pacific Investment Management Co., the world’s largest active bond manager with $2 trillion, likes direct bidding because of the anonymity it offers and because it has reduced the price swings that used to occur before auctions as dealers reacted to the bids they received, said Steve Rodosky, who runs Treasury and derivatives trading at the Newport Beach, California-based firm.
“One of the weaknesses in the old-fashioned model was the fact that with five or 10 minutes to go you share information about size and price with somebody else in the market,” Rodosky said. “And from time to time that information would be used to somebody else’s advantage because they would know that people were eager to buy or that nobody was eager to buy.”
Pimco still places most of its auction orders through dealers because they’re better set up than the direct-bidding system to handle bids for funds with multiple accounts and custodians, Rodosky said. If that technical issue could be resolved, Pimco would use the system more, he said.
BlackRock, by contrast, doesn’t bid directly because it wants to reward primary dealers for their research and other trading help, according to Prager.
“While we can go direct, most of the time we don’t,” Prager said. “We feel that the dealers provide us with a lot of services. Our philosophy at this point is, to the extent we can share some of that information with trusted partners who won’t misuse that information, we prefer to reward the primary dealers that provide us all that value.”
The latest version of the direct-bidding system, introduced in 2008, is used by 266 investors, according to data provided by the Treasury. Ninealpha’s Evans said he doesn’t bid directly, in part because “we have a limited number of primary dealers that we interact with and we value the relationships.” Still, most dealers know their biggest clients use the system, he said.
“The primary-dealer community has a pretty good idea that all of the big accounts probably have the lines set up so that they can bid directly,” Evans said.
The Treasury’s borrowing needs have soared since the financial crisis, climbing to a peak of $2.25 trillion in 2010 from $581 billion in 2007. In 2009, the Treasury adopted a schedule of monthly sales of notes with maturities of two, three, five, seven, 10 and 30 years, as well as one auction a month of inflation-protected securities in maturities from five to 30 years. The government also sells short-term bills weekly.
The Treasury plans to auction $32 billion of three-year notes on April 9, $21 billion of 10-year securities on April 10 and $13 billion of 30-year bonds on April 11.
The record debt sales, combined with the Federal Reserve’s quantitative easing policy of buying Treasury bonds, have boosted interest in the market. There are five more primary dealers today than at the end of June 2009, as U.S. units of Royal Bank of Canada, Nomura Holdings Inc., Societe Generale SA, Bank of Montreal and Bank of Nova Scotia won the New York Fed’s approval. The 21 dealers today compare with 18 when the program started and with a peak of 46 reached in 1988.
The increase in outstanding debt hasn’t translated to the jump in trading some dealers anticipated. An average of $548 billion of Treasuries has traded weekly this year, according to primary-dealer transaction data compiled by the New York Fed. That compares with an average $546 billion weekly in 2006 and 2007, before government borrowing ballooned.
There are multiple explanations for why direct bidding has soared. Pimco’s Rodosky attributes it to investors’ greater comfort with electronic trading. Firms including BlackRock and primary dealers Citigroup Inc. and Goldman Sachs have started electronic bond-trading platforms in the last year. Bloomberg LP, the owner of Bloomberg News, also operates a platform.
Darrell Duffie, a finance professor at Stanford University near Palo Alto, California, said investors have been driven to place direct bids by increased competition for the notes and bonds. The Fed’s purchases, new collateral rules that require more trades to be backed up with Treasuries and a desire for safety from risks in Europe have all whetted appetite in the market, Duffie said.
Ninealpha’s Evans said the rise in direct bidding may have more to do with the size of some Treasury investors, including foreign central banks, money managers and hedge funds. Any change in strategy can have a big effect on the market, he said.
The Fed is the biggest holder of U.S. Treasury debt, with more than $1.79 trillion, according to central bank data through March 27. China holds $1.26 trillion, Japan $1.12 trillion and the Organization of Petroleum Exporting Countries $262 billion, Treasury data through January show. Among U.S. investors, Vanguard Group Inc. has $155.6 billion, Pimco $148.6 billion and BlackRock $62.9 billion, data compiled by Bloomberg show.
For large investors, “to make a meaningful change in their investment portfolio or to reinvest requires the movement of large positions,” Evans said. “There’s some concern about tipping their hand to the broader marketplace.”
Banks around the world have been cutting jobs and selling units as they struggle to adapt to new requirements imposed after the 2008 financial crisis. The $11.3 trillion U.S. government bond market offers some sanctuary. Regulators assign zero credit risk to Treasuries, and trading in the bonds is exempt from the so-called Volcker rule, which prohibits banks from making proprietary trades on their own behalf.
The desks that trade Treasuries still need capital to guard against potential losses from market movements or operational mistakes. That adds to a bank’s risk-weighted assets, or RWA, increasing the capital required, BlackRock’s Prager said.
“Even something that sounds benign like a Treasury market-making operation actually has much more RWA than is obvious at first glance,” Prager said. “We’re all in this big financial-services ecosystem, and everyone’s choosing what activities they want to be excellent in and what activities they want to exit.”
Credit Suisse Group AG, the second-biggest Swiss lender, eliminated about eight jobs on its U.S. government-bond trading desk last month, including the former head of the group, Jim O’Brien, according to a person with knowledge of the matter. While some traders at competing primary dealers said the cuts reflected pressures on Swiss-regulated firms, others said it was a sign of the reduced return on capital from the Treasury desk.
Banks and broker-dealers don’t report how much profit they make from trading Treasuries, let alone from auctions, instead lumping those gains into a category called rates that encompasses all government bonds and related derivatives.
“The markets are, because of the tight ranges, very quiet,” said John Fath, a former head Treasury trader at Zurich-based UBS who’s now a principal at investment firm BTG Pactual in New York, which manages $2.5 billion. “Then to add insult to injury you have direct bidding going on in the Treasury, where that’s at least one part of the market where you’re able to make a little money, and now that’s not even giving you an edge.”
The yield on 10-year Treasury notes has remained between 1.58 percent and 2.06 percent over the past six months, a narrow range for traders trying to book profits on price swings. That’s also made it difficult for banks trying to justify the cost of employing 30 traders in a primary dealership, Fath said.
“The primary dealers are kind of in a bind here in the sense that they’re being required to buy securities from the Fed, but they’re doing so with a lot less information than they’ve had in the past,” said Bitsberger of BNP Paribas. “Maybe the Fed needs to look at primary dealers differently and not necessarily require them to bid in all auctions.”
Jonathan Freed, a spokesman for the New York Fed, declined to comment.
BlackRock’s Prager said trading Treasuries eventually will become a more electronic market and that the role of primary dealers will change.
“Primary dealers play a critical role, but it’s much reduced,” said David Jones, 74, who rose to vice chairman during 30 years at Aubrey G. Lanston & Co., one of the original primary dealers before it closed in 2002. “The world has changed. The technology itself has changed so much.”