Photographer: Joshua Roberts/Bloomberg

Once-in-4,800-Year Shock Is Bond Market’s Cold Case Two Years On

  • Regulators say market safer now than before 2014 flash rally
  • Analysts say next sudden swing could be even more extreme

Two years since a burst of unprecedented volatility shook the $13.7 trillion U.S. Treasuries market, regulators still haven’t worked out what triggered it, let alone how to prevent a recurrence.

The Oct. 15, 2014 flash rally saw yields move by almost five standard deviations -- analogous to an event that should occur about one day every 4,800 years. A 2015 report by five government agencies found no smoking gun, and with insufficient data on trading at the time of the surge and then slump in Treasuries prices, the trail is running cold.

What is clear, analysts say, is that the next sudden swing could be even more extreme as algorithmic and electronic trading account for a greater share of transactions. Trading volumes are on the decline and liquidity -- the ability to trade large amounts of securities without triggering volatility -- is also waning. By one measure, the market’s depth makes it 50 percent more sensitive to price fluctuations than it was five years ago, according to JPMorgan Chase & Co. research.

“Shocks to the system are resulting in much bigger moves than they ever had,” said Ralph Axel, a rates analyst in New York at Bank of America Merrill Lynch. “As it’s moved all into electronics, it’s become that much more mysterious.”

While liquidity appears adequate under normal circumstances, it’s what can happen during times of distress that concerns investors. Average daily trading volume in Treasuries fell to $491 billion over the past year from around $600 billion in 2011, while daily market turnover has declined to 3.7 percent, the lowest in more than two decades, JPMorgan analysts led by Jay Barry wrote in an Oct. 7 report.

Market depth in 10-year Treasuries tends to decline by $38 million for each increase of one basis point, or 0.01 percentage point, in the intraday yield range, versus a $25 million decrease five years ago, according to the report.

Based on Bloomberg’s U.S. Government Securities Liquidity Index, which measures how much yields on U.S. government bonds are deviating from where a fair-value model indicates they should be trading, liquidity conditions have deteriorated over the past four years.

Shock Absorber

Before the financial crisis, banks with large trading desks were the principal market makers for U.S. debt. That changed after regulations curtailed banks’ willingness to hold certain securities on their balance sheets and discouraged risk taking. Non-bank principal trading firms, many of which use algorithms to execute high-frequency computer-driven transactions, have stepped into that void.

“Headline liquidity seems to be just fine but if you go a little deeper, some of the fundamental things have changed,” said Krista Schwarz, assistant professor of finance at the Wharton School of the University of Pennsylvania in Philadelphia, who studies asset pricing and the effects of liquidity in fixed-income markets. “There has been this dramatic shift in the Treasury market between who’s transacting, how they’re transacting.”

The shift may intensify market moves, according to Haoxiang Zhu, an assistant professor of finance at the Massachusetts Institute of Technology’s Sloan School of Management in Cambridge, because high-frequency firms are less likely to take the other side of a prevailing trade.

Trade Direction

“Dealers can accommodate a one-way flow, but high-frequency traders don’t want to take inventory because they are very lean,” said Zhu, who studies asset pricing and financial-market structure. “Matched orders are easier to execute. Huge one-way flows could be trickier.”

On Oct. 15, 2014, benchmark Treasury 10-year yields plunged as much as 34 basis points before reversing direction to finish the day six basis points lower at 2.14 percent. The 2015 investigative report found that so-called principal trading firms that employ high-frequency trade strategies were the primary contributors of liquidity throughout the episode, even though liquidity was broadly depressed.

“When you have government policy makers trying to limit the participation of banks, you have to ask yourself, where will the liquidity come from?” said Bill Harts, chief executive officer of the Modern Markets Initiative, an HFT advocacy group. “If there’s any regulatory response at all, it’s to incent more PTF activity in these markets so that there can be more liquidity.”

Liquidity Gauges

Bid-asks spreads, a traditional liquidity measure, have been stable since the financial crisis, according to data from the New York Fed. Still, regulators say more data are needed to capture all aspects of market liquidity.

"Structural changes mean that our interpretation of some liquidity measures must adapt, and that we may also need to search for new ways to measure liquidity,” Nathaniel Wuerffel, senior vice president at the New York Fed, said in a speech delivered in May. “In other words, both the interpretation and measurement of liquidity must evolve as market structure evolves."

The Treasury declined to comment for this story but referred to previous statements on the topic. In a May 2016 blog post, officials rejected Wall Street’s complaints that trading conditions have worsened, pointing to measures such as trading volumes and bid-ask spreads that remain near historic averages.

“While no individual metric is dispositive, these measures together suggest that liquidity in the Treasury market is consistent with historic levels,” James Clark, Treasury deputy assistant secretary for federal finance, and Gabriel Mann, policy adviser in the Office of Debt Management, wrote in the post.

Flash Events

Treasury Counselor Antonio Weiss told the Senate’s banking committee in April that there was no evidence of deterioration in liquidity in fixed income and that markets are better equipped to respond to volatile events as a result of post-financial crisis regulation.

The New York Fed referred Bloomberg to a statement issued in August in coordination with the four other government agencies involved in the 2015 report.

While agencies are still collecting data related to the flash rally, regulators aren’t waiting to introduce new rules to increase market transparency. In August, the U.S. Securities and Exchange Commission asked for comment on a proposal that would require members of the Financial Industry Regulatory Authority to report Treasuries trades to officials.

Treasuries have avoided any repeat episodes over the past two years, but such flash events have occurred elsewhere in financial markets. Earlier this month, the British pound plunged during two chaotic minutes of Asian trading, with traders saying computer-initiated sell orders exacerbated the slump.

“My guess is we see more of these mini flash crashes and flash rallies,” said Zhu. “It may not be at that huge scale we saw two years ago, but it’s also up to the regulators to look more closely at what’s going on. The small ones may become big ones.”

— With assistance by Liz McCormick, and Brian Chappatta

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