Make the Treasuries Market Safe at Any Speed
One of the greatest responsibilities of U.S. financial regulators is to preserve confidence in the market for our federal debt, the world’s deepest and most liquid financial market.
There are $19.8 trillion dollars of federal debt outstanding today, of which the public holds $14.4 trillion. This debt finances the federal government, and it plays an irreplaceable role in financial markets -- facilitating the transmission of monetary policy, providing the world’s risk-free benchmark, helping businesses to manage their risks, and providing a reliable store of value to savers around the world, from sovereigns to retirees. In short, everyone you know relies on well-functioning Treasury markets.
How could confidence in this market be shaken? One obvious way is through reckless brinkmanship over the debt limit, which must be raised by the end of September to avoid the perils of default. A more insidious, if less cataclysmic, route would be a failure to modernize the oversight of the secondary market for U.S. Treasuries, in which investors and intermediaries trade already issued securities.
The market for Treasuries has undergone radical technological change. High-frequency trading, which started in equity markets in the 1990s, has expanded to all standardized securities, including foreign exchange contracts, futures, and, over the last decade, the most liquid cash treasuries. It now accounts for a majority of trading in inter-dealer Treasury markets, which in turn represent about half of all trading in Treasuries. (The other half consists of traditional dealer-to-customer orders.) High-frequency trading allows for fully-automated transactions, carried out in nanoseconds, and is widely deployed by banks, broker-dealers, and independent trading firms called “PTFs” (principal trading firms).
High-frequency trading has also been associated with a number of so-called “flash events,” from the infamous flash crash in U.S. equities in 2010 to the sudden 9 percent drop of the British pound on Oct. 7, 2016. Certainly few observers of U.S. Treasuries will soon forget the “flash rally” of Oct. 15, 2014. The yield on the benchmark 10-year U.S. Treasury traded in a 37-basis-point range (0.37 percent), only to close six basis points below its opening level. Moreover, between 9:33 a.m. and 9:45 a.m., yields dropped 16 basis points and then fully recovered, without any apparent catalyst. Treasury markets had experienced similar moves just three times in the preceding 20 years, and always as a result of a clearly identifiable economic event.
In the absence of an explanation, theories abounded. “The machines turned off,” traditional brokers reported. “A single, mammoth volatility trade was unwound,” others said. In fact, it took five federal agencies nine months to analyze the data and issue a Joint Staff Report that concluded there was no single cause of the volatility. The agencies found that, during the flash rally, PTFs accounted for more than 70 percent of trading in inter-dealer markets, and there was a higher incidence of order-stuffing at the open (whereby multiple orders are placed and then canceled). There was also more self-trading than usual (whereby one firm trades with itself). Notably, the machines never turned off. Many kept making money.
Perhaps more troubling than the events described was the better part of a year that federal agencies needed to gather and analyze the data (and, even then, just a limited sample).
Following the Joint Staff Report, the Treasury Department initiated its first exhaustive review of Treasury markets in decades and issued a request for information to the public. Two key findings of this review were the need to provide appropriate oversight of all entities transacting in Treasuries and to ensure official sector access to data. Respondents to the request for information were nearly unanimous in calling for the official sector to have complete, real-time access to all transaction-level data.
Two years later, where do we stand?
Regulators now share the data they have in related Treasury markets, such as cash and futures. And last month, the Financial Industry Regulatory Authority launched the reporting of Treasury transactions by its member firms to Trace, its Trade Reporting and Compliance Engine. This important step will allow Finra to monitor markets and apply its own algorithms to detect prohibited activity.
However, there remains substantial unfinished business:
- The SEC must close the archaic loophole that allows PTFs to avoid oversight and reporting requirements. Firms that transact solely in government securities are today not required to register as broker-dealers or report their trades to Trace, which prevents Finra from monitoring a significant portion of the market.
- The Federal Reserve must ensure that bank-dealers report to Trace, as initially indicated in October of last year.
- Government agencies must ultimately decide whether to make Trace Treasury transaction data transparent and available to the public, as I have previously urged, and, if so, on what basis.
- The trading platforms themselves must be registered. The U.S. can no longer exempt Treasury trading platforms from basic regulatory standards designed to ensure market resilience, integrity and adequate operational risk controls.
- The Commodity Futures Trading Commission must move in tandem to address operational risks in algorithmic trading in the futures market, which is inextricably linked to cash Treasuries.
To be sure, market participants and regulators face other significant tasks. They must, for instance, re-examine clearing and settlement of Treasury transactions in a high-speed world, such as whether PTF Treasury traders should clear through the Fixed Income Clearing Corporation, just as broker-dealers do today. But the first step is to ensure access to data and appropriate oversight of all entities that transact in Treasuries.
Importantly, none of these actions requires action by Congress. They are all administrative or regulatory in nature. They are fundamentally nonpartisan. Moreover, senior officials from the Federal Reserve Board, the Federal Reserve of New York, the SEC and the CFTC have all voiced support for the measures. The regulatory community must now finish the job. Confidence in the world’s deepest and most liquid market is at stake -- a matter that affects us all.
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James Gibney at firstname.lastname@example.org