The Treasuries market's harrowing swing on Oct. 15, 2014, resulted in part from banks and high-frequency traders, U.S. authorities said in a report released Monday.
In a six-minute window that morning, banks essentially pulled out of the market, providing no, or very few, offers, the U.S. Treasury and other agencies said. At the same time, high-frequency trading firms exacerbated the situation by often being on both sides of the same trade, according to the report.
The rapid buying and selling caused Treasury yields to plunge and then rise, covering a 37-basis-point range during a 12-minute period starting at 9:33 a.m. Intraday changes of greater magnitude have only happened on three occasions since 1998, and unlike October's movement, were driven by significant policy announcements.
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While the government concluded that there was no single cause of the turbulence on Oct. 15, the report raised concerns that changes in market structure could lead to "rare but severe bouts of volatility." Those shifts include a big increase in electronic trading of Treasuries and banks pulling back from their traditional role as market makers.
The findings will probably spark debate on Wall Street, as financial firms have complained that a series of rules implemented under the 2010 Dodd-Frank Act have reduced liquidity in the bond market and exacerbated price swings. JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon has said what happened in October should serve as a "warning shot" to investors. Blackstone Group LP CEO Stephen Schwarzman added that new regulations may fuel the next financial crisis.
After the report's release, a group representing high-frequency trading firms emphasized that the industry kept providing liquidity on Oct. 15 and maintained tight spreads between offers to buy and sell Treasuries.
"We look forward to reviewing the report in more detail and discussing the findings and policy recommendations with the regulators," the FIA Principal Traders Group said in a statement.
Treasury and the financial regulators will keep studying the evolution of the U.S. Treasuries market and continue assessing trading practices and whether new rules are needed, the report said.
Robust Liquidity in Treasuries
The document calls for studying the implications of a registration requirement for firms engaged in automated trading. Registration would typically subject them to routine inspections by regulators and force them to provide more details on their trading strategies.
The report said liquidity and trading efficiency are as robust as they've ever been in the Treasury market. However, the changing nature of liquidity also suggests that the way it's measured may need to be improved.
A higher-than-normal share of transactions during the Oct. 15 price swing was conducted by speed traders using computer algorithms that resulted in individual firms being on both sides of the same deal. Such "self-trading" at the beginning of the swing accounted for 14.9 percent of cash transactions and 11.5 percent of futures in 10-year Treasury products, the report found.
While that type of trading can be illegal because it harms price competition by disguising market interest, the regulators stopped short of alleging any violations.
The report was conducted by the Treasury, the Federal Reserve, the New York Fed, the Securities and Exchange Commission (SEC), and the Commodity Futures Trading Commission (CFTC).
Treasury Secretary Jacob J. Lew said last week that Dodd-Frank rules shouldn't be blamed for reduced liquidity and increased volatility. Monday's report also deflects blame from recent regulations, a conclusion that drew a rebuttal from financial executives.
Liquidity Rules or Speed Trading to Blame?
Sandie O'Connor, JPMorgan's chief regulatory officer, said rules have had far-reaching effects on liquidity, including giving banks an incentive to hoard safe assets and deterring lenders from executing big trades for clients.
"Liquidity rules have required banks to hold high-quality liquid assets for their own purposes and not for market making," she said during a Washington panel discussion on the bond market Monday. "Post-trade disclosure requirements are reducing banks' appetite for underwriting large trades."
High-frequency trading firms are among the factors "driving markets toward smaller trade sizes," according to Treasury official Antonio Weiss, a counselor to Lew. These firms are playing a much bigger role as market intermediaries, replacing banks and brokers that pulled back after suffering losses during the crisis, Weiss wrote Monday in a Wall Street Journal opinion piece.
The report details potential hazards from an increase in automated trading, such as risks to operations, liquidity, transmission, and clearing activities. It said speed trading accounted for much of the imbalance in aggressive flows on Oct. 15. Automation can also give traders new tools to engage in unlawful conduct such as spoofing, the practice of placing and then canceling orders to give a misleading impression of the market.
The spike in trading volume and volatility coincided with bank-dealers exiting from the offer side of the cash market for brief periods, according to the report.
–With assistance from Jesse Hamilton in Washington and Alexandra Scaggs in New York.
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