Jerome H Powell: Structure and liquidity in treasury markets
Speech by Mr Jerome H Powell, Member of the Board of Governors of the Federal Reserve
System, at the The Brookings Institution, Washington DC, 3 August 2015.
* * *
I'm very pleased to be here to discuss the current structure of the Treasury markets.1 My
involvement with these markets dates back to the early 1990s, when I served as Under
Secretary of the Treasury for Finance. Some of you will recall the Salomon Brothers auction
bidding scandal that broke in the summer of 1991. 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.2 As part of that process, we put
together a public conference to consider further reforms to Treasury auction procedures, with
the participation of regulators, academics, and the financial sector. Some of the ideas that
came out of that conference eventually led to 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.3 It is also possible that liquidity may be more prone to disappearing at times of
stress. 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 2013 "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: rapidly
diminishing liquidity, and large price moves for a given quantum of news.4 But the causes
and implications of these events are unclear. Is this the new normal? We don't know. Current
macroeconomic and market conditions are unprecedented in many respects. For now, what
we have is a small number of broadly similar events that bear careful consideration.
Most of these considerations apply across markets, but they are particularly important here
because of the crucial role that Treasury securities play within the global financial system. In
1
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.
2
See Department of the Treasury, Securities and Exchange Commission, and Board of Governors of the
Federal Reserve System (1992), Joint Report on the Government Securities Market (PDF) (Washington:
Government Printing Office, January). The formation of an interagency working group, which in July 2015
published a joint staff report (PDF) on the events of October 15, 2014, was among the reforms noted in the
1992 report.
3
The joint staff report on the U.S. Treasury market on October 15, 2014 (see note 2), includes measures of
benchmark order book depth in the cash market that have declined since 2013 although they are comparable
to levels in the early 2000s. Measured trade sizes in both cash and futures markets are lower than levels in
the early 2000s.
4
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." On March 18, 2015,
shortly after 4 p.m. EDT and two hours after the release of the March FOMC 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.
addition to serving the financing needs of the U.S. government, Treasury markets are
important for the conduct of monetary policy. 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 2004). Banks have also increased their holdings of
Treasuries to meet HQLA requirements. These holdings are less likely to turn over in
secondary market trading, as the owners largely follow buy and hold strategies.5 Another
change is the increased presence of asset managers, which now hold a bigger share of
Treasuries as well. 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 overstate 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 New
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.6 Thanks to advances in
telecommunications and computing, the speed of trading has increased at least a
millionfold.7 Advances in computing and faster access to trading platforms have also allowed new
types of firms and trading strategies to enter the market. Algorithmic and high-frequency
trading firms deploy a wide and diverse range of strategies. In particular, the technologies
and 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 did 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 the bid-ask spread, but it may also reduce liquidity in the public market. At
the same time 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."8 Trading algorithms are, after all, simply a
set of rules, and they will necessarily interact with and optimize against the rules of the
trading platforms they operate on. 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 auctions as an alternative to the central limit order
book, and argue that this would lead to greater market liquidity.9 Others have argued that
current market structures may lead to greater volatility, and suggested possible alterations
designed to improve the situation.10 To be clear, I am not embracing any particular one of
these ideas. 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.11 Post crisis reforms
have made the repo market safer but also raised the costs of repo transactions. 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 clarity 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. The conference will take place this fall at the
Federal Reserve Bank of New York, in cooperation with the Treasury Department, the Board
of Governors, the Securities and Exchange Commission and the Commodity Futures Trading
Commission. My hope and expectation is that it will bring market participants and regulators
closer to an understanding of whether there are changes in trading and risk management
practices, regulation and market structure that could make our Treasury markets even more
liquid and more resilient.