Lack of liquidity in a key sector of the government bond market is now costing institutional investors billions of dollars annually in sharply widening bid/offer spreads. This post-financial crisis inefficiency is straining market structure to the point that the traditional principal-based dealer model is not working for either the dealers or the buy-side community. It’s time for a new way of doing business.
The principal area of concern is the off-the-run sector of the U.S. Treasury market, which accounts for more than 35% of all trading activity, according to the Federal Reserve Bank of New York. This sector includes all but a half-dozen of the approximately 296 total outstanding U.S. Treasury issues. The six securities are the most recently issued, or “on-the-run” securities, and are almost 100% traded electronically in a highly transparent market. But off-the-run securities are still largely traded by phone, and that’s where the trouble lurks.
Off-the-run Treasury securities are sought after by many investment managers. The broader choice of those securities allows managers to more precisely meet the needs of asset owners and match investment strategies. The challenge is that these are the very securities that dealers tend not to keep as inventory, and have therefore become very expensive to buy or sell.
The root of the problem lies in the unintended consequences of regulatory reform. While Treasuries were exempted from the Volcker rule (a part of the Dodd-Frank Wall Street Reform and Consumer Protection Act) in an attempt to preserve the liquidity of a marketplace on which the government depends for funding its deficits, Basel III’s enhanced supplementary liquidity ratio, requiring greater capital reserves, neutralizes this benefit.
Capital concerns remain a priority for banks. When I ran Deutsche Bank’s bond trading desk in the early 2000s, we were the overall market leader with a 10% share of all U.S. Treasury trading; the top quintile of dealers commanded an estimated 40% share of the overall trading pie before the crisis. That’s now climbed to around 60%, with the top trading desk commanding 25% of trading activity. This degree of market concentration and associated reduction in dealer inventory is also evident in the interdealer marketplace, in which dealers trade directly with each other to manage their risk.
The spillover impact on investment managers and their asset owner clients is without precedent. Around $10 billion in off-the-run Treasury execution costs — as measured by the bid/offer spread across all securities traded — were absorbed by the buy side in 2015, under my estimates. That’s an increase of more than $7 billion since the pre-crisis levels, or the equivalent of $14 million in excess fees being paid on average by each of the top 500 asset management firms. If you assume an average $100 billion in fixed-income assets, the loss of yield for investors could be as much as 17 basis points, highly significant in a low-return environment.
The buy side is not alone in suffering the consequences of this liquidity vacuum. Obama administration officials will be wary of the potential for rates to edge up because of a lack of adequate numbers of market makers (down to 22 now from a high of 51), as each basis-point increase in interest rates approximates to almost $1 billion in additional annual interest payments for the Treasury Department.
TREASURY MARKET 2.0
As a result of this dynamic, investment banks now hold only 5% of outstanding U.S. Treasury securities, according to Federal Reserve data. This imbalance of power is unsustainable for much longer without fundamental change. With limited inventory, the traditional principal-only model does not work for investment managers. It doesn’t work for dealers, either. In fact, investment banks are now generating less than 10% of their operating income from interest rate-related products, down from an estimated 22% in 2012, according to consultancy Oliver Wyman, a unit of Marsh & McLennan Cos. It’s clearly in everyone’s interest to uncover new ways to access liquidity in the Treasury market.
The solution is to find ways to open up the marketplace and create a level playing field for all participants. Having an electronic marketplace for the off-the-run Treasury securities, as there is for the on-the-run Treasury securities, is the only sure way to bring reform. Historically, one of the biggest challenges to this approach has been information leakage, but there are precedents for market reinvention.
While investment banks have not always, or all, been evangelists for electronic trading, their financial situation now compels them to take action. Asset owners and investment managers ought to get behind reform because it is in their financial interest to do so. As the door is now open, let’s seize the opportunity. If it can simultaneously narrow the bid/offer spread for institutional investors, while reinforcing the value that the dealers still provide, so much the better.
Regardless of the ultimate solution, the liquidity situation is not going away. Without a viable response to the challenge, it is inevitable that the frequency of liquidity-driven crises will increase, triggered not just by financial dislocations but by systemic weaknesses as well. The uncomfortable truth is that when liquidity is most needed by the buy side, it is least available. If the market is to evolve, it needs to move fast. There is little choice; a dysfunctional Treasury bond market would have implications for asset owners and investment managers far beyond the confines of the major financial centers.
*This article originally appeared in Pensions&Investments
Susan Estes is CEO of OpenDoor Trading, LLC, a provider of an all-to-all marketplace for off-the-run US Treasuries. During her career, she has managed fixed income trading at several major financial institutions including Deutsche Bank, Morgan Stanley and Countrywide Securities. She was also a member of the Treasury Borrowing Advisory Committee under Federal Reserve Chairmen Greenspan and Bernanke.