Revisiting the Regulatory Framework of the US Treasury Market

Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Aguilar’s recent public statement; the full text, including footnotes, is available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

Yesterday [July 13, 2015], staff members of the federal agencies that comprise the Interagency Working Group for Treasury Market Surveillance (“Working Group”) issued a joint report concerning the so-called “flash crash” that occurred in the U.S. Treasury market on October 15, 2014 (the “Report”). I commend the staff of all the agencies for their hard work in putting together the Report, which examined the events of that day and the broader forces that have changed the Treasury market in recent years. This was a difficult undertaking, but the report does an excellent job of discussing the known factors, while acknowledging that more work needs to be done.

The remarkable events of that day, which cannot yet be fully explained, have dispelled any lingering notion that the Treasury market is the staid marketplace it was once thought to be. The transformative changes that swept through the equities and options markets in the past decade have vastly reshaped the landscape of the Treasury market, as well. As a result, the structure, participants, and technological underpinnings of today’s Treasury market are far different than they were just a few years ago.

The full significance of these changes has yet to become clear. But there can be no doubt that the current regulatory framework for the Treasury market should be reexamined in light of these new realities. The last time the agencies responsible for overseeing the Treasury market undertook a comprehensive review of this regulatory framework was 1998—well before the changes described above took hold.

This statement calls upon the Commission to spearhead a new inter-agency review of the Treasury market’s overarching regulatory framework. Such a review is appropriate given the tremendous changes the market has witnessed in recent years. Importantly, this review needs to be willing to question long held assumptions about the Treasury market and how best to oversee it. The Treasury market now faces many of the same challenges that confront the equity market, including the ascendancy of high frequency trading and a diminished role for traditional liquidity providers. Accordingly, just as the Commission has begun a “comprehensive” review of the equity market, so, too, should the appropriate regulatory agencies examine the Treasury market, from top to bottom.

In addition, this statement sets forth a number of concrete proposals that could buttress the integrity and resiliency of the Treasury market. The Commission and the other regulators responsible for the Treasury market should consider these proposals as they conduct the aforementioned review.

The U.S. Treasury Market

The Role of the Treasury Market

The U.S. Treasury market remains the largest and most liquid sovereign debt market in the world. As of last month, there were more than $12.6 trillion worth of marketable U.S. Treasury securities (“Treasuries”) outstanding. The U.S. Treasury market is also the most actively traded market in the world: more than $530 billion worth of Treasuries changed hands each day, on average, in the first quarter of this year. By contrast, the average daily trading volume of equities in the U.S. market during the same period was only $193 billion.

Treasuries represent an essential building block of the U.S. economy—and, indeed, of the entire global financial system. In fact, foreign investors and governments hold roughly half of all Treasuries currently outstanding. The Treasury market’s role, therefore, is not limited to financing the federal government’s deficit spending. The market also underpins the U.S. dollar’s status as the global reserve currency, provides a safe haven for investors in the U.S. and abroad, facilitates U.S. monetary policy, acts as a key pricing benchmark for other assets, and serves as a low-risk hedging instrument for financial transactions around the world. In sum, Treasuries have been woven into the very fabric of the global financial system, perhaps inextricably so.

Liquidity

Given the unique and indispensable role Treasuries have come to play in global finance, it is vital that the Working Group consider how best to protect the integrity, liquidity, and efficiency of the Treasury market. Each of these characteristics is important, but liquidity merits special attention—and concern. Broad, deep, and resilient liquidity in the secondary market ensures continuous price discovery, and gives investors comfort that they can quickly purchase or sell even sizeable amounts of Treasuries at minimal cost. Liquidity is the lifeblood of a vibrant Treasury market, and abundant liquidity has been one of the Treasury market’s principal competitive advantages over the years.

Yet, there is a growing concern that the secondary market for Treasuries is far less liquid than is widely perceived, and at least one market participant has gone so far as to opine that the secondary market is “not functioning as normal.” Critics point out that one common measure of liquidity, trade volume, has dropped considerably in recent years. Since its peak in 2006, daily trading volume in Treasuries relative to the total size of the market has fallen by 70 percent. This decline in trading activity is also reflected in a stark drop in turnover. In fact, by one estimate, only 4.1 percent of Treasuries changed hands last year, the lowest figure since 1998.

Further sharpening the Treasury market’s predicament is that the depth of its liquidity has shrunk, with fewer bonds being offered at any given price. According to one study, market depth declined by 35 percent last year. To put this in perspective, just one year ago, it was possible to trade roughly $280 million worth of Treasuries without causing prices to move. Today, that figure has fallen to only $80 million, according to one major bank. Market participants have suggested that this diminished ability to quickly trade large blocks of Treasuries could potentially undermine the stability of the Treasury market by magnifying price volatility

To be sure, the Treasury market remains one of the most liquid markets in the world, in absolute terms. This is reflected in bid-ask spreads, which remain at or near pre-financial crisis lows. The true measure of a market, however, is how it performs under stress, and liquidity in fixed income markets has proven fleeting in past market crises. According to one Federal Reserve Governor, one gauge of how well liquidity responds to stress, its resiliency, remains troublingly low in the Treasury market, and may even be falling. This is evidenced, in part, by an increase in the frequency of spikes in bid-ask spreads.

The apparent deterioration in the depth and resiliency of the Treasury market’s liquidity would be a matter for concern at the best of times. But it is especially inopportune now, as it comes just as the Federal Reserve is contemplating an historic rise in interest rates. One potential concern voiced by market participants is that a rate hike could trigger another so-called “taper tantrum,” like the one that occurred in the spring of 2013. As that event showed, major dislocations in the Treasury market can have far reaching consequences, including a slowing of the housing market. Clearly, the stakes are high.

October 15, 2014

These concerns regarding the overall health of the Treasury market were crystallized by the events of October 15, 2014. The 10-year Treasury bond experienced record-high trading volumes that day, as well as a severe decline in the depth and resiliency of its liquidity. Trading that day was also marked by a dramatic rise in volatility, with the yield on the benchmark 10-year Treasury bond trading within an intraday range of approximately 37 basis points.

An especially puzzling feature of that day’s events involved a 13-minute window of trading that began at 9:33 ET that morning. During that period, yields initially plummeted by 16 basis points within a six-minute period, only to rebound almost completely in the following seven minutes. According to the Report, the sharp swing in yields witnessed during this “event window” was “unprecedented…in the recent history of the Treasury market,” because it was “not driven by a significant policy announcement.

After months of careful and thorough study, the Report was unable to identify “a clear, single cause of the price movement during the event window… .” And, indeed, there may not have been a single cause. Accordingly, the Report examines in detail the day’s events, and the broader market forces that helped shape them. In particular, the Report reviews the significant changes in the Treasury market’s structure over the past two decades, and discusses how those changes may have led to a trade-off between improved average liquidity, on the one hand, and “severe bouts of volatility” that can “strain liquidity,” on the other.

The Structure of the Treasury Market

The Report underscores that the Treasury market’s behavior in recent years is deeply rooted in the complexities of its evolving structure. A comprehensive discussion of the Treasury market’s current structure is beyond the scope of this statement, but it is necessary to briefly outline that structure in order to understand the need—and the benefits—of revisiting the market’s regulatory framework.

As in the past, the secondary market for Treasuries operates on an over-the-counter basis, rather than through exchanges. During the past decade, however, nearly all trading among dealers has migrated to electronic trading platforms. Furthermore, most of this trading is now automated, which means that trading decisions are executed by computer algorithms. Proprietary trading firms employing algorithmic trading strategies are believed to account for more than half of the volume conducted on the electronic trading platforms. At the same time, various factors, including the historically low interest rate environment, have led traditional dealers to curtail their market making activities, and to shrink their inventories relative to the total size of the Treasury market.

The shift to electronic and algorithmic trading has brought numerous benefits, such as more efficient price discovery and lower trading costs. But it has also introduced new risks to the Treasury market, as it has in other markets. Some of these risks are more obvious, such as the risk that an algorithm will malfunction, as we have seen too often. Others are more nuanced. For example, it is believed that electronic trading makes it easier to engage in and conceal manipulative trading practices, such as spoofing, that subvert liquidity and market integrity. In addition, the proliferation of algorithmic trading has resulted in a more anonymous trading environment, where market participants may be more acutely focused on short-term gains than was the case in the past. In such circumstances, market participants may be more likely to withdraw their liquidity during periods of market stress, leaving markets more prone to severe bouts of illiquidity, as was witnessed on October 15, 2014.

The Need to Revisit the Treasury Market’s Regulatory Framework

The events of October 15, 2014 sharpen and clarify the need to reexamine the Treasury market’s current regulatory structure. As the Report makes clear, this structure is now fundamentally different than it was in 1998, when the Working Group last examined it. A new review is appropriate in light of recent events, and the Commission should lead the way by reviewing its own rules and regulations with an eye toward enhancing oversight of the Treasury market.

Set forth below are several proposals regulators should consider as they look to update the Treasury market’s regulatory framework.

  • First, the Commission should consider revising Regulation ATS to make it applicable to alternative trading systems that trade Treasuries exclusively. In addition, the Commission should consider how Regulation ATS may need to be tailored to the activities of alternative trading systems that handle Treasuries. Currently, BrokerTec and eSpeed are the two electronic platforms that handle the majority of the dealer-to-dealer trade flow in on-the-run Treasuries. I note that BrokerTec, which trades securities in addition to Treasuries, has filed a Form ATS with the Commission.
  • Second, in addition to expanding Reg ATS, the Commission should consider revising Regulation Systems Compliance and Integrity (Reg SCI) to make it applicable to trading platforms that handle Treasuries exclusively. As the Report makes clear, the majority of dealer-to-dealer trading in the Treasury market is now driven by computer algorithms. In light of this new environment, it is appropriate for the Commission to examine whether additional safeguards are warranted to ensure that the technology used by these entities has sufficient integrity, capacity, safety, and resiliency.
  • Third, the Report and other sources indicate that regulators presently lack a comprehensive source of trade data for the Treasury market. Just as in the aftermath of the equity market’s flash crash on May, 6, 2010, the Working Group staff had to rely on a patchwork of market data that was drawn from various sources. In a sense, it was déjà vu all over again, but in this case it was actually far worse. The data that regulators needed in the wake of the equity market flash crash had already been collected by the equity exchanges and the Financial Industry Regulatory Authority (FINRA), and just needed to be provided to the regulators. But no such collectors of data exist in the Treasury market. Accordingly, the Working Group had to harvest the trade data it needed from individual market participants. The Working Group should, therefore, consider ways to help develop a mechanism, similar to the consolidated audit trail that equity market participants are creating, that will give regulators the ability to properly monitor the Treasury market.
  • Fourth, regulators should work with electronic trading platforms to develop appropriate market safeguards for the Treasury cash market, and should consider measures such as circuit breakers and kill switches, as appropriate. As trading in the Treasury cash market now occurs at “blink of an eye” speeds similar to those witnessed in the equity market, such protections are warranted. And the market seems to agree. In fact, BrokerTec has reportedly begun discussing with its clients the possibility of implementing circuit breakers. But, as the IMF recently noted, such circuit breakers must be carefully calibrated to the Treasury market. It is noteworthy that the volatile trading on October 15, 2014 did not trigger existing circuit breakers in the futures markets.
  • Fifth, the Commission, as well as the Working Group, should consider ways to enhance oversight of market participants in the Treasury market. For example, some of the most active participants in the Treasury cash market are not registered with the Commission. This hinders the Commission’s ability to monitor and regulate this market effectively. In the context of equity market reform, the Chair called last year for the staff to prepare a rule clarifying that high frequency traders are dealers, and must therefore register with the Commission. In preparing that rule, the staff should consider how it can be made applicable to Treasury market participants, as well.
  • Sixth, as the Report notes, there is currently no quote or price reporting mechanism in the Treasury market. Given that post-trade reporting systems have already been developed in the corporate and municipal bond markets, this means the Treasury market, the largest and most liquid government securities market in the world, is now arguably the least transparent fixed income market in the U.S. The events of October 15, 2014 demonstrate with absolute clarity that this state of affairs is no longer acceptable. The members of the Working Group should set as their most urgent priority how to foster a post-trade pricing mechanism in the Treasury market. The Working Group should further consider ways to enhance pre-trade price transparency in the Treasury market, as well. As I have noted in the context of the municipal securities market, one possibility to enhance pre-trade price transparency in fixed income markets is for the Commission to amend Regulation ATS to require trading systems with material transaction volume to publicly disseminate their best bid and offer prices, even if on a delayed and non-attributable basis.

Conclusion

The goal of this statement is to underscore the significance of the Report’s findings, to support its recommended next steps, and to urge the Commission and other regulators to take specific action where there is a clear path forward. The events of October 15, 2014 have revealed that the Treasury market has changed in myriad ways in recent years, and that we, as its regulators, may lack the tools and the information necessary to supervise it effectively.

The Commission and the Working Group cannot afford to wait for the next major market event before taking action. As Benjamin Franklin once said, “We may delay, but time will not.”

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