The premise is simple: trying to stuff too much of something into a conduit will create a bottleneck.
Is there a bottleneck ahead in the U.S. Treasury market?
Quite possibly, some say. The $14 trillion market is the world’s most liquid, but that designation applies mostly to the most recently issued benchmark securities. There’s a lot of less-wide-open road to the market outside of those ‘on-the-runs’.
Earlier this month, the U.S. government boosted its planned auctions for the August-October period by $30 billion. The increase comes amid a rising budget deficit that is expected to hit $1 trillion in the next two years, feeding a $21.3 trillion national debt that needs to be financed and refinanced.
As issuance churns higher and the amount of bills, notes and bonds on the secondary market climbs through uncharted levels, the trading infrastructure that enables the activity comes under the microscope. Is there a point at which the current system -- with decidedly less big-bank presence versus years ago but many more smaller liquidity providers -- falters in its ability to match institutional trades in less-liquid areas of the market?
Josh Holden, OpenDoor Securities
“We're entering an unprecedented expansion in debt at a very uncertain time,” said Josh Holden, Chief Information Officer at OpenDoor Securities, which operates a trading platform for off-the-run Treasuries and TIPS. “Fixed income markets' ability to digest this amount of issuance has never truly been tested."
Holden believes the volume of Treasury issuance has set the stage for a tipping point, which he described as “when a system enters a critical phase where otherwise small changes can align to create an often dramatically outsized result.”
"There have been significant changes to underlying market structure in the past few decades that have largely flown under the radar -- specifically, decreases in the value of primary dealership through the Treasury Direct program and in relative-value risk-taking,” Holden said. “Combine this with the dramatic increase in the cost of holding fixed income inventories by sell-side desks and high concentration of market share among Treasuries trading in the top five dealers and it appears a tipping point is inevitable."
The principal trading firms (PTFs) and other participants who provide the bulk of Treasury liquidity are less tethered to the market than the ‘bulge bracket’ banks whose role they have usurped. This doesn’t bode well for market quality in the next time of tumult, Holden noted.
“They will translate increased volatility directly into wider bid/ask spreads and into smaller quoted sizes,” he said. “As a result, the cost for moving block-sized positions could easily increase by an order of magnitude."
Ken Monahan, Greenwich Associates
It’s unclear whether there is a tipping point ahead in fixed income, as there are moving parts in the market that reduce visibility, noted Ken Monahan, Senior Analyst at consultancy Greenwich Associates. “There’s a lot going on in market structure, and though it’s difficult to discern the direction of the change, we know it’s going to be significant,” he said.
Smaller trading-platform operators, most of which have sprung up in recent years to try to fill the liquidity gap left by banks, are “giving people an alternative methodology to trade something that’s hard to trade like off-the-runs, or giving them access to liquidity that they did not previously have,” Monahan said. “They can head off the potential for breakage by creating more links within the market than existed before.”
