Us treasury market liquidity and trading
I'm very pleased to be here to discuss the current structure of the Treasury markets. Some of you will recall the Salomon Brothers auction bidding scandal that broke in the summer of That event required those of us with oversight responsibilities to do a thorough evaluation of the structure of the primary Treasury market, and ultimately to propose a series of reforms.
Some of the ideas that came out of that conference eventually led us treasury market liquidity and trading changes in the way primary auctions were conducted, changes that I believe were beneficial to the efficiency and integrity of the Treasury market. The issues we are discussing today relate to the secondary market rather than to the auctions. Although the Treasury market remains deep and resilient, there are nonetheless reasonable questions as to whether market functioning can be improved.
The events of October 15 last year have been folded into the more general debate about market liquidity across a number of markets. I take the concerns about a decline in market liquidity seriously. Hard evidence on the level of liquidity in secondary Treasury markets is mixed, with some measures at or above pre-crisis levels and some suggesting a reduced ability to buy or sell large positions without material price effect--a reasonable definition of liquidity.
On October 15, for example, market depth declined sharply, and we saw a sudden spike in prices that was without precedent for a period with little relevant news. Other events--such as the "taper tantrum," the "bund tantrum" last spring, and the sharp moves on March 18 in the euro-dollar exchange rate--all broadly show the same pattern: Is this the new normal?
Current macroeconomic and market conditions are unprecedented in many respects. For now, what we have is a small number of broadly similar us treasury market liquidity and trading that bear careful consideration. Most of these considerations apply across markets, us treasury market liquidity and trading they are particularly important here because of the crucial role that Treasury securities play within the global financial system. In addition to serving the financing needs of the U.
Treasuries serve as high-quality liquid assets HQLA for a wide range of financial institutions, including dealers in the Treasury market, and as collateral in myriad transactions conducted bilaterally and through clearing houses and exchanges. Treasury securities are a global reserve asset, and Treasury markets are a key vehicle through which market participants manage their interest-rate risk.
The integrity and continued liquidity of the Treasury markets affect nearly everyone. Treasury markets have undergone important changes over the years. The footprints of the major dealers, who have long played the role of market makers, are in several respects smaller than they were in the pre-crisis period.
Dealers cite a number of reasons for this change, including reductions in their own risk appetite and the effects of post-crisis regulations. At the same time, the Federal Reserve and foreign owners about half of which are foreign central banks have increased their ownership to over two-thirds of outstanding Treasuries up from 61 percent in These holdings are less likely to turn over in secondary market trading, as the owners largely follow buy and hold strategies.
Mutual fund investors, who are accustomed to daily liquidity, now beneficially own a greater share of Treasuries. Perhaps the most fundamental change in these markets is the move to electronic trading, which began in earnest about 15 years ago.
It is hard to us treasury market liquidity and trading the transformation in these markets. Only two decades ago, the dealers who participated in primary Treasury auctions had to send representatives, in person, to the offices of the Federal Reserve Bank of Us treasury market liquidity and trading York to submit their bids on auction days.
They dropped their paper bids into a box. The secondary market was a bit more advanced. There were electronic systems for posting interdealer quotes in the cash market, and the Globex platform had been introduced for futures. Still, most interdealer trades were conducted over the phone and futures trading was primarily conducted in the open pit. Today these markets are almost fully electronic. Interdealer trading in the cash Treasury market is conducted over electronic trading platforms.
Algorithmic and high-frequency trading firms deploy a wide and diverse range of strategies. In particular, the technologies us treasury market liquidity and trading strategies that people associate with high frequency trading are also regularly employed by broker-dealers, hedge funds, and even individual investors.
Compared with the speed of trading 20 years ago, anyone can trade at high frequencies today, and so, to me, this transformation is more about technology than any one particular type of firm.
Given all these changes, we need to have a more nuanced discussion as to the state of the markets. Are there important market failures that are not likely to self-correct?
If so, what are the causes, and what are the costs and benefits of potential market-led or regulatory responses?
Some observers point to post-crisis regulation as a key factor driving any decline or change in the nature of liquidity. Although regulation had little to do with the events of October 15, I would agree that it may be one factor driving recent changes in market making.
Requiring that banks hold much higher capital and liquidity and rely less on wholesale short-term debt has raised funding costs. Regulation has also raised the cost of funding inventories through repurchase agreement repo markets. Thus, regulation may have made market making less attractive to banks. But these same regulations have also materially lowered banks' probabilities of default and the chances of another financial crisis like the last one, which severely constrained liquidity and us treasury market liquidity and trading so much damage to our economy.
These regulations are new, and we should be willing to learn from experience, but their basic goals--to make the core of the financial system safer and reduce systemic risk--are appropriate, and we should be prepared to accept some increase in the cost of market making in order to meet those goals.
Regulation is only one of the factors--and clearly not the dominant one--behind the evolution in market making. As we have seen, markets were undergoing dramatic change long before the financial crisis. Technological change has allowed new types of trading firms to act as market makers for a large and growing share of transactions, not just in equity and foreign exchange markets but also in Treasury markets.
As traditional dealers have lost market share, one way they have sought to remain competitive is by attempting to internalize their customer trades--essentially trying to create their own markets by finding matches between their customers who are seeking to buy and sell.
Internalization allows these firms to capture more of us treasury market liquidity and trading bid-ask spread, but it may also reduce liquidity in the public market. At the same us treasury market liquidity and trading it does not eliminate the need for a public market, where price discovery mainly occurs, as dealers must place the orders that they cannot internalize into that market.
While the changes I've just discussed are unlikely to go away, I believe that markets will adapt to them over time. In the meantime, we have a responsibility to make sure that market and regulatory incentives appropriately encourage an evolution that will sustain market liquidity and functioning. In thinking about market incentives, one observer has noted that trading rules and structures have grown to matter crucially as trading speeds have increased--in her words, "At very fast speeds, only the [market] microstructure matters.
If trading is at nanoseconds, there won't be a lot of "fundamental" news to trade on or much time to formulate views about the long-run value of an asset; instead, trading at these speeds can become a game played against order books and the market rules. We can complain about certain trading practices in this new environment, but if the market is structured to incentivize those practices, then why should we be surprised if they occur?
The trading platforms in both the interdealer cash and futures markets are based on a central limit order book, in which quotes are executed based on price and the order they are posted. A central limit order book provides for continuous trading, but it also provides incentives to be the fastest. A trader that is faster than the others in the market will be able to post and remove orders in reaction to changes in the order book before others can do so, earning profits by hitting out-of-date quotes and avoiding losses by making sure that the trader's own quotes are up to date.
Technology and greater competition have led to lower costs in many areas of our economy. At the same time, slower traders may be put at a disadvantage in this environment, which could cause them to withdraw from markets or seek other venues, thus fracturing liquidity.
And one can certainly question how socially useful it is to build optic fiber or microwave networks just to trade at microseconds or nanoseconds rather than milliseconds. The cost of these technologies, among other factors, may also be driving greater concentration in markets, which could threaten their resilience. The type of internalization now done by dealers is only really profitable if done on a large scale, and that too has led to greater market concentration.
A number of observers have suggested reforms for consideration. For example, some recent commentators propose frequent batch us treasury market liquidity and trading as an alternative to the central limit us treasury market liquidity and trading book, and argue that this would lead to greater market liquidity.
Rather, I am suggesting that now is a good time for market participants and regulators to collectively consider whether current market structures can be improved for the benefit of all. Questions about market structure also arise in the funding markets for Treasuries. As many have noted, there is a link between funding liquidity and market liquidity, and for Treasury markets the links to funding in the repo market are especially close.
Greater use of central clearing could potentially lower these costs by allowing participants to net more of their transactions. Authorities have emphasized a greater use of clearing for a wide range of products, and I believe there could be benefits to greater clearing in repo markets as well.
There are several private proposals to accomplish that, and any solution will have to satisfy demanding regulatory requirements. To wrap up, we need more us treasury market liquidity and trading on the implications of structural changes in these critical markets for market liquidity and function. This is a good time to hold another public conference to discuss Treasury market structure. In fact, that is one of the recommendations in the October 15 report released last month.
My hope us treasury market liquidity and trading expectation is that it will bring market participants and regulators closer to an understanding of whether there are changes in trading and risk management us treasury market liquidity and trading, regulation and market structure that could make our Treasury markets even more liquid and more resilient. These remarks represent my own views, which do not necessarily represent those of the Federal Reserve Board or the Federal Open Market Committee.
References to the "Treasury markets" refer to the interdealer cash and futures markets, unless otherwise specified. Government Printing Office, January.
The formation of an interagency working group, which in July published a joint staff report PDF on the events of October 15,was among the reforms noted in the report. The joint staff report on the U. Treasury market on October 15, see note 2includes measures of benchmark order book depth in the cash market that have declined since although they are comparable to levels in the early s.
Measured trade sizes in both cash and futures markets are lower than levels in the early s. Between April and June of this year, interest rates on longer-dated German bunds rose sharply and amid considerable volatility on certain days, an event that observers coined the "bund tantrum. EDT and two hours after the release of the March Us treasury market liquidity and trading monetary policy statement, the euro rose over 3 percent against the dollar in a four-minute period and then reversed most of its gain over the next three minutes.
In order to promote the smooth clearing of Treasury and agency securities, the Federal Reserve offers a securities lending program to primary dealers. Many automated trading firms are now able to directly access these platforms.
There is also a sizable amount of trading between dealers and their customers that does not take place on these platforms. While much of that us treasury market liquidity and trading is still by phone, an appreciable share is also electronic. Marcia Stigumin describing the secondary bond market, noted that trades could be completed in a matter of seconds.
Currently, trading can occur at speeds below one microsecond. StigumThe Money Market, 3rd ed. Dow Jones-Irwinp. See, for example, Elaine Wah and Us treasury market liquidity and trading P.
University of Michigan, Junepp. National Bureau of Economic Research, October. In Treasury markets, the ability to conduct repo agreements can provide market makers a flexible channel to fund their inventories and can help to lower the costs of providing market liquidity.
Create account Login Subscribe. Tobias Adrian, Michael J. Fleming, Or Shachar 14 September The potential adverse effects of regulation on market liquidity in the post-crisis period continue to receive significant attention.
Nonetheless, there is little evidence of a wide-spread deterioration in market liquidity. The stagnation of dealer balance sheets that began after the financial crisis of has persisted, as shown in Figure 1 below. Figure plots the total financial assets of security brokers and dealers at the subsidiary level. Leverage peaked at Leverage remained fairly steady untilbut has since trended down, reaching The figure shows the leverage of security brokers and dealers at the subsidiary level.
Consistent with stagnant dealer balance sheets, arbitrage measures suggest less abundant funding liquidity. Figure 3, for example, plots the credit default swap CDS -bond basis, calculated as the average difference between each bond's market CDS spread and the theoretical CDS spread implied by the bond yield.
The figure plots the CDS-bond basis for investment grade orange and high-yield blue corporate bonds. In a recent paper Adrian et al. Many commentators attribute the funding market pressures and purportedly reduced market liquidity to the Dodd-Frank Act and the Basel III regulatory framework.
Those regulatory reforms include higher bank capital requirements, new leverage ratios, and liquidity requirements. While these regulations are intended to make the US and the global financial system more resilient, some market participants argue that they also hinder market making by raising the cost of capital and restricting dealer risk taking.
Such factors include voluntary changes in dealer risk management practices and balance sheet composition since the crisis, us treasury market liquidity and trading growth of electronic trading, the evolving liquidity demands of large asset managers and changes in expected returns associated with the economic environment.
Identifying how any one factor affects dealer balance sheets and liquidity must account for these other factors, which is especially difficult given that many are highly interrelated and driven by other developments.
Turning to market liquidity, we find mixed evidence for the Treasury market. As of lateaverage bid-ask spreads for benchmark notes in the interdealer market were narrow and stable — and comparable to pre-crisis levels, as shown in Figure 4 us treasury market liquidity and trading. The evolution of the price impact of trades, shown in Adrian et al csimilarly suggests a modest deterioration in liquidity since early The figure plots day moving averages of average daily bid-ask spreads for the on-the-run notes in the interdealer market.
The figure plots day moving averages of average daily depth for the on-the-run notes in the interdealer us treasury market liquidity and trading.
Depth is summed across the top five levels of both sides of the order book. In the corporate bond market, liquidity appears to have diverged depending on trade size, which is often associated with investor type. Figure 6 below thus shows that average realised bid-ask spreads which are based on transaction datahave fallen below pre-crisis levels for retail-sized trades, but remain above pre-crisis levels for institutional-sized trades.
Regardless, corporate bond trading and issuance volume have been robust, reaching record highs in The spreads are computed daily for each bond. Trade size grouping are calculated as the difference between the average volume-weighted dealer-to-client buy price and the average us treasury market liquidity and trading dealer-to-client sell price, and then averaged across bonds using equal weighting.
Although liquidity under normal market conditions may not have significantly worsened, it might be that it has become more fragile, or prone to disappearing under stress see, for example, Powell To address that prospect, we consider three case studies on the resilience of market liquidity since the crisis.
In all three instances, the degree of deterioration in market liquidity was within historical norms, suggesting that liquidity remained resilient even during stress events. While we do not find clear indications of a widespread worsening of bond market liquidity, our analysis faces several limitations, including important limits to available data. For example, our Treasury market metrics are from the interdealer market, and hence do not gauge us treasury market liquidity and trading in the dealer-to-customer market.
Moreover, our corporate metrics are based on transactions data, and cannot account for the time required to trade or the liquidity of bonds that do not trade. Indeed, as discussed in Flemingregulators will soon have access to a broader set of transactions data for the US Treasury market.
In addition, dealer balance sheets have changed dramatically, and some funding cost metrics, such as the CDS-bond basis, imply increased balance sheet costs, suggesting important changes in dealer behaviour. Exploring the determinants of such behaviour and how dealer attributes affect market liquidity is a promising avenue of us treasury market liquidity and trading work. The views expressed here are those of the authors and do not necessarily us treasury market liquidity and trading those of the institutions with which they are affiliated.
Financial markets Financial regulation and banking Global crisis. Market liquidity after the financial crisis Tobias Adrian, Michael J.
Fleming, Or Shachar 14 September The potential adverse effects of regulation on market liquidity in the post-crisis period continue to receive significant attention. The financial crisis, ten years on. Stephen Cecchetti, Kim Schoenholtz. Resilience of market liquidity. Luis Brandao-Marques, Gaston Gelos. Liquidity in the financial crisis: New insights on the lender of last resort. Understanding liquidity risk and its role in the crisis.
Figure 1 Dealer balance sheets stagnated after the crisis Note: Figure 2 Leverage has continued to decline Note: Less abundant funding liquidity. Figure 3 CDS-bond basis is negative after the crisis Notes: Drivers of the changes In a recent paper Adrian et al. Evolution of market liquidity Turning to market liquidity, we find mixed evidence for the Treasury market. Figure 4 Treasury bid-ask spreads are narrow and stable Notes: Figure 5 Treasury depth is below all-time high Notes: Figure 6 Corporate us treasury market liquidity and trading bid-ask spreads have diverged Notes: Liquidity case studies Although liquidity under normal market conditions may not have significantly worsened, it might be that it has become more fragile, or prone to disappearing under stress see, for example, Powell us treasury market liquidity and trading Concluding remarks While we do not find clear indications of a widespread worsening us treasury market liquidity and trading bond market liquidity, our analysis faces several limitations, including important limits to available data.
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