For release on delivery
10:30 a.m. EST
December 3, 2018
The Structure of the Treasury Market: What Are We Learning?
Remarks by
Lael Brainard
Member
Board of Governors of the Federal Reserve System
at
"The Evolving Structure of the U.S. Treasury Market"
Fourth Annual Conference
Hosted by the Federal Reserve Bank of New York
New York, New York
December 3, 2018
I am pleased to join the fourth annual conference on the evolving structure of the
U.S. Treasury market. Four years ago, the Treasury "flash rally" served as a wake-up
call for regulators and market participants alike that the structure of the Treasury market
had changed radically from the conventional view. Since the surprising sharp spike in
Treasury prices on October 15, 2014, the public sector has devoted significant effort and
resources to monitoring the ongoing changes in the Treasury market. The interagency
working group's (IAWG) Joint Staff Report on the events of October 15, the Treasury
Department's request for information on the report's recommendations, and the
subsequent collection of transactions data by the Financial Industry Regulatory Authority
(FINRA) through its Trade Reporting and Compliance Engine (TRACE) system have
offered us a much better understanding of this market.1
But the market is not resting, and neither can we. Even in the past year, much has
changed in the Treasury market, and technology is continuing to drive rapid
transformation in the competitive landscape. I would like to talk about the changes we
are seeing, what we are learning from the TRACE data, and emerging developments that
are important to monitor. In particular, I want to highlight an initiative that the Federal
Reserve is considering to expand the public sector's access to transactions data in order to
help ensure the IAWG is able to keep up with the market.
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Still Changing
At the first Treasury conference in 2015, market participants were still processing
the results of the Joint Staff Report.2 It came as a surprise to many that the high-
frequency trading activity conducted by "proprietary trading firms," or PTFs, accounted
for a majority of trading in the interdealer platforms that are so central to the Treasury
market. Indeed, the names of the largest proprietary trading firms were new even to
some seasoned professionals. At that time, the discussion often drew a very bright line
between traditional dealers and proprietary trading firms and, in particular, the trading
activities associated with each.
The distinction between broker-dealers and proprietary trading firms remains
important today with regard to why they are trading, but less and less with regard to how
they are trading. Now, as then, broker-dealers intermediate financial transactions
primarily to serve their clients' needs, and, for this reason, they are required to register
with FINRA. Conversely, the hallmark of proprietary trading firm activity was and still
is high-frequency proprietary trading. Proprietary trading firms trade for their own
account rather than that of a client, which places them outside of FINRA's jurisdiction
and many other forms of oversight. This distinction remains important today.
how
But the distinction in broker-dealers and proprietary trading firms trade was
already starting to blur by the time of the first conference. For example, some of the
larger dealers had already invested heavily in electronic trading systems by 2015. Since
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that time, the distinctions have blurred considerably further. Almost all midsize and large
dealers now possess autoquoting capabilities and deploy them on Treasury trading
platforms. Several primary dealers have even entered direct partnerships with proprietary
trading firms, effectively outsourcing some parts of their market-making operations.
The evolution of the dealer business model to incorporate advanced technology is
not limited only to trading activity. A number of developers of emerging financial
technologies, or fintech, have arisen in recent years to provide dealers and other market
participants with back-office tools that reduce costs by automating routine processes,
streamlining regulatory reporting, and more efficiently allocating capital, collateral, and
margin among competing uses. On the front end, dealers are increasingly offering their
customers web-based research and analytic tools, trading and execution engines, and
even apps that allow clients access to internal software for pricing and structuring
transactions.
The landscape for proprietary trading firms has changed considerably in recent
years, too. Since 2015, we have witnessed the first initial public offering by a proprietary
trading firm, as well as a few high-profile mergers and acquisitions.3 The industry is
contending with declining revenue growth and diminished returns by expanding
operations into new asset classes and geographies. Proprietary trading firms are also
adapting in other ways. Some have begun to offer broker-dealer services themselves or
appear to be contemplating such a business model change. Still others have entered joint
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ventures with one another to finance new investment in faster microwave
communications and defray the high costs of that infrastructure.4 Third-party providers
are also offering high-speed links to firms that wish to engage in high-frequency trading
without investing directly in microwave tower infrastructure.
We have seen important recent changes among infrastructure providers as well.
CME Group's acquisition of NEX and the BrokerTec platform has recently been
finalized, with direct implications for the structure of the Treasury market.5 We have
also witnessed the conclusion of J.P. Morgan's exit from broker-dealer settlement
services in the triparty Treasury repo market and the transition to BNY Mellon
Government Securities Services Corp. as a subsidiary offering Treasury market
settlement services. Beyond these changes, some new trading platforms are
experimenting with the very structure of the market.6 These platforms are promoting
new trading models such as all-to-all trading, in which many buy-side and sell-side
participants transact directly, and direct streaming, in which live continuous, executable
prices are delivered electronically under bilaterally or multilaterally negotiated terms.
These services can potentially bridge all of the venues of the Treasury market, connecting
not just dealers and proprietary trading firms, but also those entities with buy-side clients.
And, finally, the macroeconomic landscape has undergone some significant
changes that have important implications for the Treasury market. At the time of the
flash rally in October 2014, the Federal Reserve was still actively purchasing Treasury
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securities, and the federal funds rate was still at the effective lower bound. With the
economy now at or beyond full employment and inflation around target, the Federal
Open Market Committee has since gradually increased its target for the federal funds rate
to between 2 and 2-1/4 percent, and normalization of the balance sheet is well under way.
Since October 2017, the portfolio of the System Open Market Account has decreased in
size from $4.2 trillion to about $3.9 trillion.
What Have We Learned So Far?
Against this changed backdrop and with more than a year's worth of information
from the TRACE data available, it is a good time to ask what we have learned since the
initial market event and what questions remain. First, the initiation of policy
normalization and the ongoing reduction of the Federal Reserve's balance sheet do not
appear to have sparked a deterioration in Treasury market liquidity. Standard metrics
such as bid-ask spreads have not materially changed for benchmark securities since 2014.
Market functioning has also been orderly during a number of recent events that were
characterized by high trading volume and elevated price volatility, such as in early
February of this year.
Second, some segments of the market seem much more active than observers may
have feared before the collection of TRACE data. In particular, according to the TRACE
data as shown in figure 1, off-the-run trading accounts for 27 percent of overall trading
volume, while deep off-the-run notes and bonds--seasoned securities older than the first
or second off-the-run--account for 14 percent of all coupon activity.7 Likewise, the data
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show that Treasury Inflation-Protected Securities (TIPS) trade in significant volumes as
well.
Due to the TRACE data, we are now able to measure with reasonable precision
the transaction volumes in these securities. Off-the-run and TIPS activity is largely
concentrated in the dealer-to-client (DTC) and voice venues of the market, segments into
which the public sector had only limited insight before the TRACE data. While
substantial analysis with respect to pricing and liquidity remains to be done in these
market segments, the early results allow us to conclude that these securities do trade in
meaningful amounts.
Third, although there was speculation that proprietary trading firms had already
eclipsed bank dealers in benchmark Treasury trading or would come to threaten the
dealer business model more broadly, neither has occurred.8 Based on the TRACE data,
as shown in figure 2, we can now state with a reasonable amount of confidence that
dealers generally--and primary dealers particularly--still intermediate the majority of
activity in all Treasury securities.9 In the market for Treasury bills in particular, primary
dealers play an important role in allocating issuance to investors. This can be seen where
most activity in bills occurs, as shown in figure 3, which depicts the share of trading
volume of bills in the DTC, interdealer broker (IDB), and interdealer segments of the
8
See Federal Reserve Bank of New York (2015), "Conference Summary: The Evolving Structure of the
U.S. Treasury Market (October 20-21, 2015),"
https://www.newyorkfed.org/medialibrary/media/newsevents/events/markets/2015/ConferenceSummary.pdf.
9
TRACE data do not currently identify PTF firms. We estimate the activity by assuming PTFs account for
92 percent of nondealer trading volume on the electronic and automated interdealer brokers, which is the
Joint Staff Report
share of nondealer activity accounted for by PTFs on electronic IDBs reported in the
from 2014. The Securities and Exchange Commission recently approved a rule change proposed by
FINRA to require some reporters in TRACE to identify non-FINRA member activity. Once in effect, this
change will enhance regulators' ability to identify trades with PTFs on IDBs and to more accurately
identify the share of overall trading activity attributable to PTFs.
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market. Federal Reserve staff analysis of the TRACE data reveals that nearly three-
fourths of total trading volume of bills is in the DTC market, where dealers are, of course,
the main intermediary. From this and other analysis, there is substantial evidence that the
dealer business model plays a central role in this market and will continue to do so into
the future.10
That said, proprietary trading firms do occupy an important space in the Treasury
market alongside dealers, and it is clear that they, too, are here to stay. When it comes to
areas where speed is paramount--for instance, in trading across and between asset classes
and trading venues--proprietary trading firms are deploying technology and infrastructure
in ways that are having lasting effects. This is evident in the Treasury market in the
intervals following economic data releases. Again turning to the TRACE data, we see in
figure 4 a depiction of average trading volumes of all Treasury securities across five-
minute intervals on days in which the Employment Situation report, gross domestic
product data, or consumer price index data are announced. The TRACE volume data
indicate that the immediate surge in trading activity following these announcements
occurs mainly in the electronic IDB venue, where proprietary trading firms dominate.
In short, the TRACE data are enabling us to put some old puzzles to rest. Our
analysis makes clear that the Treasury market has adapted well to the post-crisis
regulatory regime, the normalization of monetary policy, and technological changes in
trading processes, and that both broker-dealers and proprietary trading firms play
important, often complementary, roles in the market structure that has emerged.
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Looking Ahead
Of course, the structure of the Treasury market will continue to evolve, along with
changes in technology and the broader financial environment. Looking forward, we will
need to ask more of the data as we seek to understand what is next for the structure of the
Treasury market. As I mentioned earlier, experimentation with new protocols is
occurring now. Although all-to-all trading in the Treasury market was contemplated at
the first conference, direct streaming largely was not, which might prompt us to ask what
else is on the horizon.
In addition to direct streaming, another development that bears watching is the
batch auction platforms that have arisen in the voice IDB market, something that has not
received as much attention from market participants. Started after the financial crisis,
batch auctions are now conducted by a number of IDB firms at regular intervals
throughout the trading day. Like any closed auction, the IDB collects anonymous bids
and offers for a specific security in specific amounts during a relatively short window of
time, generally on the order of a few minutes. After the batch auction closes, the orders
are matched, and participants are notified of their awards.11 Figure 5, based on TRACE
data, depicts average trading volumes of TIPS securities in the IDB venue of the market
across five-minute intervals. As you can see, the level of activity rises significantly at
intervals, which correspond to the timing of the auctions. While it is not a large part of
the overall market, this activity appears to be an important innovation for segments often
deemed to be less liquid--in particular, for off-the-run and TIPS trading on voice IDBs.
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Before the collection of the TRACE data, there was limited insight into this area of the
market, which made it difficult to assess the significance of such innovations.
No doubt there are other innovations that have yet to be assessed. Recently, the
debate over liquidity has turned toward the participation of proprietary trading firms in
the off-the-run segment of the market, an area outside of their traditional domain. All-to-
all and direct-streaming platforms are also attempting to establish a foothold in the off-
the-run segment by offering new services. I look forward to further analysis as the
structure of the market continues to evolve.
Keeping Up
As the Treasury market has evolved, the public sector has had to evolve as well in
order to keep up. Many of the recommendations in the Joint Staff Report have now been
implemented. Our colleagues at Treasury, the Securities and Exchange Commission, and
FINRA deserve credit for the work to begin collecting Treasury transaction data on
FINRA's TRACE system. My hope is that you will take away from my remarks, along
with those of my colleagues from other agencies, a comprehensive picture of how all of
the IAWG agencies are using the data to work through the many issues that intersect with
our various policy missions and mandates.
As the market continues to innovate and the broader financial environment
continues to shift, we will maintain our focus on the resilience of the Treasury market
specifically and the financial system more broadly.12 In this regard, the staff at the
Federal Reserve continues to work on important issues raised by the events of October
15, 2014. Markets have been able to weather several episodes of short-lived market
turbulence well in the past few years. But the fact that sharp market movements--some
on the order of seven or eight standard deviations outside the norm--can occur even in the
absence of clear news drivers remains a concern and highlights the potential risks to
financial stability posed by the high-speed transmission of price and liquidity shocks
across multiple markets and trading venues.
The TRACE data now allow us to monitor events when equity and bond markets
move sharply. For instance, take the turbulence in equity and bond markets on February
5, 2018. While trading volumes in both the electronic IDB and DTC market segments
were markedly higher than average, some metrics of liquidity, such as market depth near
the top of the order book on major electronic IDB platforms, deteriorated and remained
low through the week. The pattern of a spike in trading volumes followed by a persistent
decline in market depth has been characteristic of three recent market turmoil episodes:
(1) the Treasury flash rally on October 15, 2014; (2) the flash crash in the British pound
on October 7, 2016; and (3) the spike in the VIX on February 5, 2018.13 Figure 6 shows
this pattern for February 5, 2018. These seemingly contradictory dynamics are easier to
reconcile if the prevalent role played by high-speed electronic trading in the Treasury
market is taken into account, particularly under stressed conditions. As previously noted
in the Joint Staff Report, high-speed market makers are able to manage perceived risks
from sudden adverse price moves by greatly reducing the sizes of orders placed on
electronic execution venues while, at the same time, increasing order placement rates as
much as needed to accommodate increased trading volumes without the need to widen
bid-ask spreads.
That said, the ability of high-speed market makers to nearly simultaneously adjust
liquidity provision across multiple closely linked markets can create potential challenges
for large institutional investors seeking to reliably aggregate posted liquidity among
otherwise distinct trading venues.14 The dynamic nature of liquidity provision by high-
speed market makers makes static measures of liquidity, such as posted bid-ask spreads
and market depth, less useful. For the purposes of improving our assessment of financial
stability, it is therefore necessary to look for alternative ways of gauging liquidity and
transaction costs in these markets. For example, measures such as implementation
shortfall aim to account directly for the difference between the original decision price and
the final execution price for a trade split into multiple smaller transactions.15 As IAWG
staff members continue to refine the TRACE data to assess market resilience more
accurately in light of changes in structure and speed, it will be important to incorporate
alternative measures of liquidity and transaction costs.
Separately, the increased role of managed funds is also having an effect on the
Treasury market. TRACE data can help us keep up with that development as well. As in
other asset classes, 3 p.m. has become an important liquidity point during the trading day
for Treasury securities. There is a regular spike in trading activity around 3 p.m., as can
be seen in figure 7, which depicts average trading volumes across five-minute intervals.
Federal Reserve staff analysis reveals that the 3 p.m. spike in trading volumes tends to be
fairly evenly divided between the DTC and IDB market segments, suggesting that both
dealers and proprietary trading firms play an important role during this narrow window of
activity. In the DTC market, the increase around 3 p.m. would be consistent with trading
related to mutual fund daily and end-of-month portfolio rebalancing. In the electronic
IDB market, the increase around 3 p.m. would be consistent with the increased role of
proprietary trading firms in intraday intermediation and the possible closeout of positions
toward the end of the main part of the trading day. From a market resilience perspective,
it would be valuable to analyze these systematic intraday spikes in trading volumes,
particularly as they may influence price formation and liquidity provision in the Treasury
market.
The large spike in flows toward the end of the trading day points to a financial
stability consideration that is worth flagging. The Treasury Market Practices Group
(TMPG) has done valuable work in mapping out clearing and settlement patterns in the
Treasury market. One issue that this analysis highlights is the currently limited potential
for same day, or T+0, settlement on transactions conducted near the end of the day. The
flash events we have seen in the Treasury market so far have occurred early enough in the
day to allow time for prices to recover before market close, and they have not been
accompanied by any participant's failure to perform, let alone a major participant,
platform, or exchange.
As the TMPG's work shows, most transactions in the Treasury market settle the
next day, or T+1. As can be seen in figure 8, Federal Reserve staff analysis based on the
transactions recorded in TRACE shows that same-day settlement volumes, on average,
represent only about 4 percent of total daily volume, with the rest concentrated primarily
on one-day settlement. Same-day settlement volumes since the inception of TRACE
have never exceeded roughly 10 percent of the daily total. Fortunately, we have not
recently observed a large liquidation of Treasury holdings for cash at the end of the same
day. But we cannot rule out that this will always be the case. It is not clear from the
TRACE data whether the market could accommodate a large sale of Treasury securities
later in the day, perhaps associated with a need to raise cash quickly to settle outstanding
positions, without causing a substantial move in prices. It will be important to follow
closely how the market evolves in light of the potential risks and resilience issues
identified in the recent TMPG white paper on clearing and settlement in the secondary
market for U.S. Treasury securities.16
Before I conclude, let me discuss one other step the Board is planning to take to
help us keep up with the changing nature of markets. The TRACE data are indispensable
in the IAWG's ability to track and understand this market. However, FINRA's
collections are limited only to its members. The Federal Reserve is close to finalizing an
agreement with FINRA to act as our agent in expanding the collection of Treasury
transactions to key banks that are also active in this market. In addition, in light of recent
changes in the market, the Board has decided to issue a notice of proposed rulemaking to
seek public comment on collecting agency mortgage-backed securities (MBS) and debt
transactions as well. This collection will help round out the IAWG's view of these
markets and ensure continuous coverage in circumstances where trading moves between
the bank and the broker-dealer within a firm. It is important that reporting thresholds be
appropriately tailored to avoid imposing undue burden on smaller firms, and we will be
particularly attentive to public comments on this matter.
I see important potential benefits of transparency under appropriate
circumstances. The Treasury Department is currently considering these issues, and we
would seek to harmonize our approach with any future decisions by the Treasury
Department and the IAWG in making Treasury transactions data available to the public.
Our expectation is also that Federal Reserve policy would be harmonized with FINRA's
practices in making anonymized agency MBS and debt transactions publicly available,
taking into account what we learn from the comment process.
Conclusion
In sum, we recognize it is vitally important for the Federal Reserve and other
agencies to keep up with the rapid changes we are seeing in the Treasury market. The
Treasury market is a cornerstone of the global financial system: Treasury securities are
used to finance the federal government, represent a store of value for investors and
households alike, and serve as the primary reserve asset for the global financial system.
The Treasury market is also vital to the Federal Reserve: It is central to the transmission
of our monetary policy, provides key signals on market expectations for inflation and
future interest rates, and is a key source of high-quality liquid assets for the banking
system. Given the centrality of the Treasury market, it is all the more notable that access
to data on Treasury market transactions on par with those available for futures, equity,
and corporate bond markets is a very recent development. The recent collection of these
data has provided crucial insights into the resilience and structure of the Treasury market.
Recognizing that the market will continue to evolve, we are committed to doing our part
to make sure the scope of our data and their availability evolve commensurately.
The Structure of the Treasury
Market: What Are We Learning?
Lael Brainard
Figure 1
Daily Volume for On-the-Run and Seasoned Securities by Security Type
On-the-Run / Coupons Bills TIPS FRNs
Off-theRun Split $ billion $ billion $ billion $ billion
On-the-Run 362 25 7.0 0.5
First Off-the-Run 31 8.3 1.2 0.1
Second Off-the-Run 7.7 7.6 0.0 0.0
Deep Off-the-Run 64 28 5.5 0.9
Note: TIPS is Treasury Inflation-Protected Securities; FRNs is Floating Rate Notes.
Source: Board staff calculations, based on Trade Reporting and Compliance Engine (TRACE) data from the Financial
Industry Regulatory Authority (FINRA). Sample is from August 1, 2017, to July 31, 2018.
Figure 2
Share of Trading Activity for All Securities by Participant Type
Buy-side
(estimated)
Primary
28%
and Other
Dealers
51%
Principal Trading
Firms (estimated)
21%
Source: Board staff calculations, based on Trade Reporting and Compliance Engine (TRACE) data from the
Financial Industry Regulatory Authority (FINRA). Sample is from August 1, 2017, to July 31, 2018.
Figure 3
Share of Volume for Bills by Venue
Interdealer
Broker
22%
Dealer-toDealer
Dealer-to-Client
6%
72%
Source: Board staff calculations, based on Trade Reporting and Compliance Engine (TRACE) data from the Financial
Industry Regulatory Authority (FINRA). Sample is from August 1, 2017, to July 31, 2018.
Figure 4
Average Intraday Volume on Economic Announcement Days (NFP, GDP, CPI)
14
12
8:30 to 8:35 AM
10
8
Dollars
of
6
4
Billions
2
0
Dealer-to-Client (DTC) Dealer-to-Dealer (DTD) Interdealer Broker (IDB)
Note: NFP is Non-Farms Payroll data release; GDP is gross domestic product data release; CPI is Consumer Price Index data release. Key identifies
regions in order from bottom to top.
Source: Board staff calculations, based on Trade Reporting and Compliance Engine (TRACE) data from the Financial Industry Regulatory Authority
5
(FINRA). Sample is from August 1, 2017, to July 31, 2018. Volumes are averaged over five-minute intervals.
Figure 5
Share of Total Average Intraday TIPS Volume in IDB Venue
blank)
(intentionally
Share
Percent
Note: TIPS is Treasury Inflation-Protected Securities; IDB is Interdealer Broker. Given the narrow scope of this sample of data, the y-axis is left
intentionally blank to ensure anonymity in the data.
Source: Board staff calculations, based on Trade Reporting and Compliance Engine (TRACE) data from the Financial Industry Regulatory Authority
6
(FINRA). Sample is from August 1, 2017, to July 31, 2018. Volumes are averaged over five-minute intervals.
Figure 6
February 2-7, 2018, Intraday Market Depth and Volume
35,000 350
30,000 300
25,000 250
Dollars
20,000 200
Feb 5, 2018 3:05 to 3:10 PM Millions
of
of
15,000 150
10,000 100
Millions Dollars
5,000 50
0 0
PM PM PM PM PM PM PM PM PM PM PM PM PM PM PM PM PM PM PM PM PM PM PM PM
AM AM AM AM AM AM AM AM AM AM AM AM AM AM AM AM
1:00 2:00 3:00 4:00 5:00 1:00 2:00 3:00 4:00 5:00 1:00 2:00 3:00 4:00 5:00 1:00 2:00 3:00 4:00 5:00
8:00 9:00 8:00 9:00 8:00 9:00 8:00 9:00
12:00 12:00 12:00 12:00
10:00 11:00 10:00 11:00 10:00 11:00 10:00 11:00
2/2/2018 2/5/2018 2/6/2018 2/7/2018
TRACE Volume (LHS) Market Depth (Top 3 Levels, RHS)
Figure 7
Average Intraday Volume per Five-Minute Interval
9
8
3:00 to 3:05 PM
7
6
Dollars
5
of
4
3
Billions
2
1
0
Dealer-to-Client (DTC) Dealer-to-Dealer (DTD) Interdealer Broker (IDB)
Note: Key identifies regions in order from bottom to top.
8
Source: Board staff calculations, based on Trade Reporting and Compliance Engine (TRACE) data from the Financial Industry Regulatory Authority
(FINRA). Sample is from August 1, 2017, to July 31, 2018. Volumes are averaged over five-minute intervals.
Figure 8
Average Daily Volume by Settlement
500
471
T+0: 4%
450
400
350
300
Dollars
of
250
200
T+1: 83%
Billions
150
100
34
50
23
21
9
5 4
0
T+0 T+1 T+2 T+3 T+4 T+5 >T+5
Source: Board staff calculations, based on Trade Reporting and Compliance Engine (TRACE) data from
9
the Financial Industry Regulatory Authority (FINRA). Sample is from August 1, 2017, to July 31, 2018.