Treasury market reforms must go further

The success of any market depends on confidence and trust, but nowhere more so than in the trading of US Treasuries. It’s the world’s biggest asset class – with over $15 trillion of outstanding securities and daily turnover in excess of $500 billion – but its inter-connectedness, widespread ownership and use as a global benchmark obscure some deep-rooted challenges for investors.

At the heart of these issues, undermining the future of the Treasury market, is the imbalance of liquidity available to institutional firms. This is especially the case in the “off-the-run” securities, where daily turnover has shriveled in comparison to the size of the market in the post-crisis years. This is largely due to the persistence of a bifurcated market structure that has no place in a modern, open marketplace.

Put simply, while significant changes have taken place in the balance of power in the industry, with principal trading firms (“PTFs”) taking up much of the slack for capital-constrained banks, essentially nothing has evolved for the buy-side investor. It is true that technology has enabled a number of electronic trading platforms to emerge, but vested interests have ensured that all the successful ones to date rely on a legacy, request-for-quote (“RFQ”) model, which dates back to the embryonic years of bond trading – many decades ago.

While there has been no major change in trading models – even with the vast power and opportunity that technology has presented to empower markets – it goes further. The Iron Curtain between the inter-dealer community and the dealer-to-client community persists, dented but with no material damage. Indeed, this two-tiered market structure is designed to ensure that there is as much liquidity and efficiency in the inter-dealer market as possible while looking to do almost the opposite for institutional clients.

It is easy to point fingers at the PTFs, infiltrators of the IDB market, out to trade aggressively to capture any and all intraday value with no regard or commitment to long-term institutional holders of US Treasury securities. But PTFs play an important role for dealers, injecting liquidity into the “on-the-run” marketplace, albeit only for the inner circle.

The challenge for participants and regulators alike is that market structure has outlasted its time, but no one until now has had the staying power to channel a broad-based change in behavior. The buy-side is too fragmented to coalesce around this pressing cause, and other participants have no vested interest in rocking the boat. It’s a little like the #MeToo movement, which only propelled change in the treatment of women once there was a critical mass of rightful indignation against what had been tacitly accepted business practices.

It’s time for a change, a big change. One way to encourage this will be to use a platform that not only creates liquidity by matching buyers and sellers but does so in a way that maintains anonymity and removes existing frictions between buy- and sell-side firms. For institutions with a genuine interest in holding and divesting Treasury securities, the RFQ remains problematic; it is not only inefficient but risks disclosing positions to traders who usually have the benefit of a ‘last look’ (a legacy, controlling tactic that stacks the odds in favor of liquidity providers).

An anonymous platform can enable participants to enjoy the benefits of greater efficiency and lower transaction costs, while also ensuring best execution from unique matching protocols. In the OpenDoor model, for example, it mirrors a series of rolling auctions that allow for outright bids and offers, with transparency focused on pricing rather than on the depth of the book.

Regulatory oversight is all about mitigating risk and, in particular, avoiding systemic risk. The target areas for this scrutiny are Operational Risk, Fair Dealing, Market Resilience and Oversight. All four of these aspects need to deliver sufficient visibility for regulators to be well informed to take action when required to maintain market integrity and protect investor confidence.

Concentration risk

The recent acquisition by CME of NEX will bring cash and futures markets closer together and enable players to do greater cross-market and combination trades, with even more margin efficiencies. It will also further centralize the points of transactions for most actively traded on-the-run Treasuries and derivatives, which will offer additional oversight benefits to the regulators and customers.

But it will also have principals looking for alternative trading venues due to concerns about possible concentration of risk in this new behemoth; and despite recent improvements, will still increase the need for light to be shone on other corners of the market.

There is no doubt that the supply and demand for liquidity are evolving and consequently regulation is also dynamic. Markets, therefore, have to continuously adapt to all these changes and pressures in order to meet customer, shareholder and regulator expectations.

The last word belongs to Antonio Weiss – now a senior gentleman at the Harvard Kennedy School’s Mossavar-Rahmani Center for Business and Government, who also served as counselor to the Secretary of the Treasury until January 2017. He wrote recently on Bloomberg, “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. But the first step is to ensure access to data and appropriate oversight of all entities that transact in Treasuries. 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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