Why the Treasury Market Needs a Lifeguard
If you have a complaint about trading in the $12.3 trillion Treasury market, who are you going to call? That question is surprisingly hard to answer. While the U.S. Department of the Treasury and the Federal Reserve Bank of New York exercise some degree of oversight, there’s no one central authority charged with policing the market to prevent illegal trading activity in what is the world’s largest, most active bond market.
The rules governing Treasury trading were enacted in 1986—before high-frequency trading was common—and haven’t been updated in more than a decade. Taking advantage of those outdated regulations, speed-trading firms outmaneuver less savvy rivals and, some executives at trading firms assert, manipulate prices. A lack of cohesive regulation or adequate technology to monitor high-frequency traders is making the market more dangerous for everyone, they argue. “Understanding the daily movements in the market isn’t that relevant for the Treasury,” says Tony Fratto, who was the department’s chief spokesman during the George W. Bush administration. While officials understand automated trading strategies, “they’re not regulators of that market,” he says. “No one is.”
Safe and efficient trading of U.S. debt is “essential for the Department of the Treasury to borrow at the lowest possible cost and for the Federal Reserve System to effectively execute monetary policy,” regulators said in a 1998 study of how the market is regulated. Treasury bonds are also a major component of many pension plans and 401(k) investments.
One issue that remains unaddressed, according to executives from three of the largest Treasury trading firms, is an electronic bait-and-switch tactic known as spoofing. Spoofers try to make money by feigning interest in buying or selling at a certain price. That creates the illusion of demand and gets other traders to move the market. A spoofer cancels his original trade before it’s executed and profits by buying or selling at the new price. Spoofing has cost traders in Treasury bonds and related futures contracts $500,000 to $1 million a day, according to one of the people. The three executives, who asked not to be named because they aren’t authorized to speak publicly, say they have no idea where to take their allegations of spoofing.
The 1986 Government Securities Act gives bank regulators the authority to prevent fraud and manipulation in the Treasury market. It gave the Treasury Department the authority to write rules, but not to enforce them. For that, Treasury must turn to the Securities and Exchange Commission, which oversees broker-dealers that buy and sell Treasury bonds, or to other groups such as the Financial Industry Regulatory Authority (Finra), the industry’s self-regulatory group.
A review by Bloomberg of dozens of SEC enforcement cases over the past 10 years shows instances of the agency taking action against illegal Ponzi schemes, insider trading, and theft of investor money in the Treasury market, but no case alleging trading manipulation. An SEC spokesman declined to comment.
Finra spokesman George Smaragdis says the group has a rule for Treasury securities that says no broker or broker-dealer is allowed to “effect any transaction in, or induce the purchase or sale of, any security by means of any manipulative, deceptive, or other fraudulent device or contrivance.” Finra’s enforcement record includes actions related to excessive fees and failures to execute trades at the best prices for clients. No case that alleged trading manipulation was found.
Eric Pajonk, a spokesman for the Federal Reserve Bank of New York, declined to comment on the bank’s role in supervising the Treasury market. He referred to the 1998 study, conducted by Treasury, the SEC, and the Fed, which says the Markets Group of the New York Fed has “primary responsibility for day-to-day surveillance of the Treasury securities markets.” No mention is made of this role for the Markets Group on the New York Fed website. The monitoring and analyzing it does is to “inform the formulation and implementation of monetary and financial stability policy,” the site says.
When the Government Securities Act became law, Treasury trading was conducted manually. Now about half of Treasury trading by institutions is done by high-frequency traders, according to David Light, co-founder of CrossRate Technologies, which is trying to create a new electronic Treasury trading platform. In other markets, regulators have taken steps to keep pace with technological changes. The SEC spends about $2.5 million a year on a surveillance system called Midas to help root out bad behavior in the $24 trillion U.S. stock market. The Commodity Futures Trading Commission, the main derivatives regulator in the U.S., requested $115.8 million from Congress this year to fund its market surveillance and enforcement programs.
There’s no such system in Treasuries, nor any plans to create one. “The Treasury, Fed, whoever, have always taken a hands-off role with the government securities market,” says Craig Pirrong, a finance professor at the University of Houston. “It is rather remarkable that the Fed and Treasury have taken little interest in the dramatic change in market microstructure and trading technology.”
The Treasury Department “regularly monitors day-to-day movements of financial markets,” Adam Hodge, a spokesman, said in an e-mailed statement. “We take any concern about market manipulation seriously and routinely monitor developments with our regulatory partners.”
The 1998 study conducted by regulators concluded that the system was working as intended. “The market continues to function smoothly, and the three agencies do not believe it is flawed in any fundamental sense,” the report said. “As a result, we believe no additional rulemaking authority under the GSA, as amended, is required at this time.” The 16-year-old study is the most recent assessment of the market undertaken by the U.S. government. The Treasury Department doesn’t have the tools or computer systems—or the inclination—to police modern markets, according to Fratto, the former Bush official, now a partner in Washington at banking lobbyist Hamilton Place Strategies. “They don’t monitor trade activity,” he says. “They monitor prices to inform their view of the macro economy. They may be afraid to tell you it’s not something they’re very interested in.”
That lack of concern could be a problem next year. Market volatility will rise in 2015 when the Fed finally seeks to raise interest rates for the first time in years, says Pirrong. “The volatility and trading activity will probably be greatest at the time of the Fed’s initial move.”