Treasury's Complaint Box Overflows as U.S. Bond Market Splinters

  • Concern bubbles up in answers to survey on market evolution
  • Respondents call for centralized clearing in some letters

For traders of U.S. Treasuries, the easy part was agreeing some corners of the market need to be more centralized. Now comes the real challenge: figuring out how.

The basic structure of the $13.4 trillion market -- the way dealers trade with each other and with clients -- is splintering. The majority of business on dealer platforms is now done by automated firms, which aren’t required to clear their trades centrally. What’s more, there are at least seven new trading venues in the works, each with a different method for connecting buyers and sellers. And the largest Wall Street dealers have their own systems.

That fragmentation is creating a sense of disorder beneath the surface of the world’s safest and deepest bond market, which serves as the benchmark for most global financial assets and a haven during times of tumult. The concern emerged in responses to a recent Treasury Department survey on the market’s structure. Technological advances and balance-sheet pressures are transforming the mechanics of the $500-billion-per-day marketplace, which for decades resisted the change that swept through other asset classes.

“The market has changed -- technology has changed it; regulation has changed it,” said Craig Pirrong, a finance professor at the University of Houston who focuses on derivatives markets and risk management. “The primacy of the dealers has been eroded.”

Splintering Market

This evolution is a critical issue because Treasuries are regulated in a patchwork fashion that hasn’t kept up with market participants. In fact, the opacity of the market makes it tough to assess how the landscape is changing. It took months for U.S. regulators to coordinate and collect data after a “flash rally” in Treasuries on Oct. 15, 2014, that had no apparent trigger. In a span of 12 minutes, benchmark 10-year yields slid 16 basis points then rebounded, prompting the first government review of the market since 1998.

Federal Reserve Bank of Chicago President Charles Evans recommended regulators coordinate to make the market’s rules more consistent. In a letter to the Treasury, he said the regulators that monitor trading of U.S. debt should coordinate with the Treasury Market Practices Group, an industry advisory committee backed by the New York Fed.

Much of the debate in the 52 letters the Treasury received over the past few months from dealers, investors, central banks and academics centered around which activities should get more regulation as the market changes. High-speed trading firms made up more than half of dealer-only platforms last year, up from about 20 percent a decade ago, according to a 2015 report from research firm Tabb Group LLC. Last year, 16 percent of institutional investors did all their trading over the phone, down from 39 percent in 2005, according to Greenwich Associates.

Treasury officials wrote in a blog post last week that trading in U.S. debt doesn’t appear to have suffered as a result of the shifts.

“We find little compelling evidence of a broad-based deterioration of Treasury market liquidity using traditional metrics,” wrote James Clark, deputy assistant secretary for federal finance, and Gabriel Mann, policy adviser in the Office of Debt Management.

Yet some parts of the market have grown outside of U.S. officials’ reach. One of them is the clearing of trades from high-speed automated firms. While Wall Street bond dealers clear transactions through a central platform run by the Depository Trust & Clearing Corp., there’s no regulatory requirement to do so, according to the letters. Clearing platforms are central intermediaries between buyers and sellers that assume responsibility for completing transactions.

Clearing Role

Automated trading firms often don’t clear centrally, which poses a risk to other market participants, according to a joint letter from the Securities Industry and Financial Markets Association and the American Bankers Association, two bond-dealer trade groups. The main concern cited in some letters was that if a market swing or technology malfunction leaves one of those high-speed firms with too much exposure to Treasuries, the losses may end up being absorbed by members of the central clearing platform.

Others warned about the risk of such an event as well, including primary dealer TD Securities (USA) LLC, hedge fund Ronin Capital LLC and startup trading platform LiquidityEdge LLC, which facilitates one-on-one Treasuries trading between dealers and investors.

Platform Regulation

Treasuries trading platforms are another area that may operate outside the purview of regulators. That’s because venues that trade solely U.S. debt are exempt from Securities and Exchange Commission rules for alternative trading systems if those venues are registered as broker-dealers. Bloomberg News parent Bloomberg LP offers electronic trading for Treasuries.

The level of oversight of Treasuries-only platforms may make the markets less resilient, according to letters from Nasdaq Inc. and Citadel LLC. ICAP Plc and the joint letter from Sifma and the ABA also recommended boosting oversight of such venues. The two bond-dealer trade groups said “the exemption for Treasury-only platforms may have little to no relevance today.”

Nasdaq, which runs Treasuries trading platform eSpeed and plans to partner with startup CrossRate Technologies LLC to develop another venue, said all trading systems should be monitored and required to develop risk controls.

“Without consistent rules and oversight of all liquidity pools, including private venues, fragmentation may lead to reduced levels of liquidity and wider spreads for those ineligible” to participate in those venues, wrote Joan Conley, a Nasdaq senior vice president.

Fairness, Fees

The question of fairness is central to the debates over clearing and platform regulation. Dealers, automated trading firms and platforms say the rules for all participants should be more consistent.

“The standards to which Treasury market participants are held to ought to be uniform,” wrote representatives from Credit Suisse Group AG, another primary dealer.

Executives from Chicago-based Ronin Capital wrote that the lack of a central-clearing requirement is at least unfair, and at worst dangerous. High-speed trading firms “profit from the safety and efficiency” provided by a central clearing platform “without contributing to it” by paying transaction fees and agreeing to share losses in the case of member defaults, they wrote.

Yet those fees are the main reason automated firms don’t join the central clearing organization, wrote Jim Greco, founder of Direct Match LLC, a startup that plans to offer exchange-style trading for U.S. debt.

While central clearing may help make the market less fragmented, he wrote, “the economics of central clearing, as it’s currently conducted, are cost prohibitive” for most automated trading firms.

Regulatory Lineup

The Treasury’s request for information, issued in January, included questions on whether the market needs more central clearing. And the Treasury and four other regulators listed clearing and settlement as a risk of automated trading in a July report on the October 2014 episode.

Yet the list of regulators on that report shows why it’s a challenge to set consistent rules. The entities -- the Treasury, the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, the SEC and the Commodity Futures Trading Commission -- each oversee a different segment of the market.

“There’s multiple regulators and multiple standards,” said Gennadiy Goldberg, a New York-based interest-rate strategist for TD Securities. “That’s a sign of the times,” and the survey “was an outlet for complaints on that.”

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