November 17, 2014 7:34 pm
Bonds: Anatomy of a market meltdown
Tracy Alloway and Michael Mackenzie
Fall in Treasury bond yields left investors asking if world’s safe haven needs shoring up
For decades, the US Treasury market has been a bedrock of global finance. While stock markets are prone to sudden price swings, such episodes in the vast and easily-transacted world of Treasuries have been far rarer – giving the market an exceptional reputation for orderly trading.
That reputation took a big hit last month.
Electronic pricing machines, which now play a bigger role than ever in the trading of Treasuries, were halted and orders cancelled by nervous dealers as prices see-sawed.
James Angel, associate professor at Georgetown University, says the US Treasury market should be regulated in a different way now that it has embraced electronic trading.
“When people use computers to provide prices across markets it [liquidity] can be withdrawn in a heartbeat,” he says. “How much market liquidity really exists under this type of market structure and what changes should be made are the questions for regulators.”
Unlike other bond markets, US Treasuries are viewed as being open for business for the entire global trading day. They also enjoy safe-haven status during times of tension. The immense size of the market means investors can easily express opposing views about the direction of interest rates by buying or selling the government debt.
Any indication that the market can suddenly shut down with little warning raises troubling questions about how the nature of trading has changed in recent years. Electronic systems are more visible to the whole market, so trades tend to be smaller than those that take place in private telephone conversations between dealers and investors.
A number of US regulatory agencies are looking at last month’s Treasury market mayhem. An official at the Federal Reserve Bank of New York told the Financial Times: “In the course of our normal market monitoring we regularly explore and assess market developments.”
Timothy Massad, chairman of the US Commodity Futures Trading Commission, which regulates interest rate futures trading at the Chicago Mercantile Exchange, said that the agency’s initial view was that the market had functioned reasonably well given the high number of trades.
“Let me just add, that’s based on our preliminary look. New evidence might come to our attention that suggests otherwise.”
When dawn broke on a grey October 15 in New York, traders and investors had plenty of reasons to be nervous. Concerns over the spread of Ebola and weakening economic activity in Europe and China were weighing heavily – helping to push bond yields lower as investors sought the refuge of US Treasuries.
The scuppering of AbbVie’s £32bn deal to acquire Shire left many big hedge funds nursing heavy equity losses and may have contributed to the rapid repositioning that would eventually engulf markets.
One hedge fund manager recalls being bewildered by subsequent events: “What on earth was charging through the market to want volume at such a price and why, in response to that catalyst, did the electronic marketplace just take any and all liquidity away?”
By 8:45am, liquidity began noticeably deteriorating, and the process accelerated after 9:30am, according to data from Nanex, a market research firm. By 9:33am, the yield on the 10-year Treasury had sliced through the critical 2 per cent level, causing many who had bet on rising yields finally to capitulate and close out their negative bets by buying back US government debt and various interest rate futures contracts.
In September, hedge funds had established a record net “short” position in interest rate futures according to CFTC weekly data. Between the end of September and the week ending October 21, this big bet shrunk from 1.27m contracts to just 217,000, reflecting more than $1tn of notional exposure being cut.
“The elephant tried to squeeze through the keyhole,” says John Brady, managing director at RJ O’Brien, a futures broker in Chicago.
Eric Hunsader, Nanex chief executive, says the scale of the shift in US Treasury prices may have prompted the “market-makers” who usually support trading of the debt to retreat: “The speed of the move was abnormal and trading systems lack historical data for such episodes that can provide them with some guidance.”
When the day drew to a close nearly $1tn worth of cash Treasuries had changed hands, illustrating the intensity of the rush for the exit. Such huge volumes also show liquidity was available, but was possibly difficult to obtain at prices deemed reasonable by investors on the day and amid rapidly fluctuating markets.
The head of trading at a major dealer-bank says: “Once volatility shows up, you don’t want to make a mistake in a fast market and so you always see dealers pull back from providing prices.”
Compounding such pressures are changes that have transformed Wall Street since the financial crisis, with the big banks who once dominated Treasury trading now under tougher balance sheet constraints thanks to regulation and a newfound aversion to risk.
This trend has encouraged greater electronic trading and a migration of experienced traders from dealers to hedge funds and asset managers, leaving a younger generation of traders manning Treasury desks at big banks. Many of these have never experienced the gung-ho pre-crisis days when banks were more willing to make bets on the market.
“The appetite to take on a position is lower than it was pre-new regulation,” says Greg Gurevich, managing partner at Maritime Capital Partners, adding that compensation structures “do not reward the trader to take risk that may ultimately cost the trader his or her job”.
The two main electronic trading venues for US Treasuries are run by Nasdaq’s eSpeed and Icap’s BrokerTec. In recent years these platforms have opened up to a range of broker-dealers and high-frequency traders. These firms do not underwrite US Treasury debt sales and are often viewed as opportunistic – providing prices when they spot a quick profit and then retreating when trading turns tricky.
Customer orders are now transacted and almost instantaneously hedged, or offset, by computer systems – a type of automation that works well when trading is orderly but rapidly breaks down when the situation changes. At such moments, turning off the machines becomes a necessity. This contributed to the downdraft in liquidity on October 15.
“Dealer-banks don’t really position in bonds,” said one head trader at a large US bank. “They basically act as a pass-through to places like BrokerTec and eSpeed or match off their client flow.
The market-makers in this new market are not obligated to be there when everyone’s selling.”
The worry is that even the highly dependable US Treasury market may suffer from sudden droughts in liquidity because big banks have been barred from “proprietary” trading. The “prop traders” could take the other side of huge customer demand to buy or sell bonds.
“If the Street – for balance sheet, risk appetite and regulatory reasons – can’t provide a speed bump between buyers and sellers such as hedge funds and asset managers, then the Treasury market will experience a lot more jumps in trading,” says one trader.
A broader consequence of last month’s turmoil may be that Fed rate rises will be more likely to take the form of a series of slow steps, rather than big moves that run the risk of sparking turmoil in the bond markets, according to analysts.
For the US Treasury, which is responsible for making sure budget deficits and maturing debt are refinanced smoothly, further episodes of turmoil could well impair the market’s ability to underwrite government debt efficiently, says Michael Cloherty, analyst at RBC Capital Markets.
Mr Cloherty says the US Treasury market has altered structurally and lacks the depth to absorb easily surprises in Fed policy and changes in market sentiment. This trend has gathered pace as the central bank has become a major owner of Treasury debt through its emergency bond-buying programme, further limiting liquidity.
He adds that any sign that the Treasury market’s liquidity has declined would cast a shadow over investor confidence – and may ultimately raise the cost of selling government debt.
Says Mr Cloherty: “Investors know they can trade large amounts of Treasuries and any erosion of confidence in the market’s liquidity has long-term consequences.”
Additional reporting by Gregory Meyer
Investors fear fresh ‘value at risk shock’
The models attempt to forecast how much money firms could lose from trading – within a certain timeframe and probability – by overlaying historic market movements with statistical analysis. Firms typically place internal trading limits based on their VaR estimates, meaning that if they breach the figure they may have to curb trading and, in extreme cases, sell off positions.
With the shockwaves of late 2008 now gradually receding, and a period of low market volatility taking its place, these VaR models have been indicating that the risk of investors sustaining large losses is very low.
That means investors may be subject to a so-called “VaR shock” in the event that volatility returns to markets.
Lower risk appetites at the biggest banks have “created the effect of reducing liquidity in trading securities . . . particularly during periods of stress,” Fitch Ratings said in a report on the day’s events. “This was demonstrated by the inability to trade fixed-income.”
The rating agency estimates that the trading VaR of the major US banks had fallen about 66 per cent between the end of 2010 and mid-2014.
While post-crisis reform efforts have encouraged banks to factor in “stressed VaR” models that incorporate more turbulent events into their capital requirements, concerns remain that the risk management tools could end up having the perverse effect of sparking market mayhem rather than helping to prevent it.
“VaR-based analysis leads to self-reinforcing loops,” a group of banks warned in a presentation to the US Treasury weeks before October 15. “An unexpected increase in volatility might come from broad-based selling of assets wanting to de-risk in front of a turn of policy.”