While there is broad agreement about the liquidity challenges of the US Treasury market, there is still much debate on how best to address them.
I had the opportunity to participate in the lead panel discussion at the TabbForum Fixed Income Conference: Panel Discussion Video . I spent a reasonable amount of time addressing the multiple layers of bifurcation in the Treasury market, and why it was necessary to include the entire curve (and not just the six most recently auctioned securities) in any discussion about the changing market structure.
I suggested that the new ecosystem should cater to all market participants, inclusive of the dealers who could sponsor end investors into a neutral platform, a Switzerland if you will, where liquidity intermediation in off-the-runs(OFTRs) would be able to take place in an anonymous all-to-all marketplace, while preserving and enhancing the relationships between dealers and investors.
In a recent post, Edith Mandel, a Principal at Greenwich Street Advisors, posted her thoughts on the subject, which can be summarized in her words as:
“Liquidity provision and execution is a profitable business in standardized rates products. Market-making spreads are wide, and high and stable correlations create a favorable environment for a liquidity provider. Dealers must automate and reduce their cost basis to remain profitable, and this effort has been ongoing for a number of years now. Hedge funds and proprietary trading firms are well positioned to claim the space. Returns on investment in rates market-making capabilities will be very significant for early movers.”
With deference to Edith, her conclusion sounds much like today’s ecosystem, with a transfer of risk and profits from the dealers (who, if they haven’t already, can no longer afford to automate given their sharply contracting ROEs on standardized rate products) to principal trading firms (PTFs) and hedge funds. Investors just go through a different classification of intermediary, and one that that has no obligation to help underwrite the U.S. Treasury debt.
In a world where investors are looking to access a greater pool of liquidity, this scenario leaves investors still dependent upon a closed subset of liquidity providers who have no incentive to compress spreads and no mandate to stand in and stabilize the markets in times of stress. I don’t see the solution in this for the broader market.
In the report released last month by the Committee on the Global Financial System, “Electronic Trading in Fixed Income Markets,” the Committee speaks to the comparative advantage PTFs have over bank dealers, “in trading electronically and, in many cases, by capital levels substantially lower than those of the bank dealers.” They go on to say, “PTFs are typically more nimble given their smaller size and fewer regulatory requirements compared with bank dealers.” Is this the new ecosystem the regulators envisioned when they were acting to make our market safer?
In the pre-crisis world of May 2007, when market fissures were becoming apparent, new sources of capital (sensing opportunity) were moving into mortgage originations. Like now, a number of hedge funds were stepping in to provide capital into a market in which they had previously not participated. Examples include Citadel purchasing ResMae; Cerberus, the fund parent for Ageeis, was injecting capital into Ageis to help them maintain adequate liquidity; Cerberus also purchased Option One Mortgage; Ellington purchased $2.9 billion worth of loans from Freemont General, and Arlie, a small hedge fund was providing capital to Alliance Bancorp (at the time a troubled Alt-A lender).
I have nothing against PTFs, and I strongly believe that hedge funds provide a significant value and a necessary balancing mechanism to the market when they actively pursue statistical arbitrage, but if you ask me whether they are the answer to the new ecosystem, whether new sources of capital alone will be sufficient to provide stability to the markets (if the primary dealer system is not preserved in some capacity) I would refer you to recent history.
Structural change in any marketplace takes time. Structural change in the largest debt market in the world, we should proceed with caution. OpenDoor intends to provide a platform where liquidity intermediation in OFTRs and TIPs can take place inside a much larger pool that does not discriminate among end-users, or disintermediate dealers, while still providing the anonymity desired by the buy-side. It is our intent to exist alongside existing platforms and within dealer banks that provide a necessary and severely undervalued service to the marketplace.
Susan Estes is CEO of OpenDoor Trading, LLC, 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.