Brookings Institution on Structural Issues in Bond Markets

Brookings Institution

“Are There Structural Issues in U.S. Bond Markets?”

Monday, August 3, 2015 

Key Topics & Takeaways

  • Technology in Bond Markets: Morgan Stanley’s Zamsky said other markets have high homogeneity and greater depth of markets that make electronic trading easier to adopt, but that those characteristics do not exist in bond markets.
  • Fed Conference on the Treasury Market: Governor Powell announced an October 20-21, 2015 conference to take place at the Federal Reserve Bank of New York to generate understanding between market participants and regulators as to whether changes in “trading and risk management practices, regulation and market structure” could increase resiliency and liquidity in the Treasury markets.
  • HFT Pilot Program: Weiss called upon regulators to take advantage of opportunities for pilot programs on different policy ideas regarding high-frequency traders to determine the impact changes might have on the broader financial system. 


Panel on the Corporate Bond Markets

Steve Zamsky, Managing Director, Morgan Stanley

Steve Zamsky opened by expressing that he believes that changes to liquidity in corporate bond markets has been a result of an overall evolution in the structure of credit markets more generally. He noted that in the wake of the financial crisis there has been a change in the mix of market participants as well as the total amount outstanding, making the identification of any specific catalysts for changes in the liquidity environment challenging. Further, he highlighted that elements of illiquidity have always existed in the corporate bond market. 

Zamsky added that the he felt recent commentary surrounding the effects of financial regulation on liquidity might have been somewhat overemphasized, yet he reiterated that certainly the aggregate effect of regulation has had some impact. He said the combination of regulatory action has impacted the traditional dealer community, increasing their costs of transacting and pushing some dealers out of the market. As a result, he said it was likely that we could expect more volatility given the overall structural evolution with more moderate-sized participants well-positioned to gain share in the market. 

Zamsky asserted that the biggest question in his mind was the outlook for markets when rates normalize. In the medium term, he opined that the buy-side could look more balanced and the dealer community could grow over time as the market adjusts for regulatory costs. He further commented that he believed that in the near term liquidity could be improved through the use of better hedging tools for both the buy-side and sell-side as well as tweaking the trade reporting process to allow market-makers to more easily intermediate large risk transactions. 

Annette Nazareth, Davis Polk Wardwell LLP

Annette Nazareth opened by saying debt markets have seen a tremendous evolution over the last ten years with the increased adoption of electronic trading. She expressed surprise that given the size of fixed income markets, they have been relatively immune to technological changes seen in other asset classes. She continued by saying fixed income markets have been much slower to evolve, even as its size continues to increase, in part because the corporate bond market is relatively illiquid and heterogeneous with around 40,000 unique securities. She added that only 20% of corporate bonds trade on a daily basis and 18% barely trade at all with trades occurring mostly bilaterally and over-the-counter (OTC) with dealers acting as principal. Nazareth summarized by saying that as a result of the characteristics of corporate bonds, the market remains mostly manual and dealer-centric with a relatively large number of bespoke securities and little movement toward more electronic platforms that would allow for a larger number of participants. 

Nazareth touched on the recent concerns regarding liquidity issues by highlighting the reduction of dealer inventories since the financial crisis and the possible impact on their ability to make markets during periods of market stress. She added that many have speculated that on the causes of the reduction in dealer inventories including: decreased risk appetites, regulatory changes such as the Volcker Rule and increased capital requirements, and reductions to inventories to increase balance sheet liquidity for the resolution planning process. Overall, Nazareth stated that regardless of the causes, vulnerability of fixed income market structure is a growing concern. 

Dennis Kelleher, President and CEO, Better Markets

Dennis Kelleher highlighted that there has been hysteria over the current liquidity environment but countered that the data shows no evidence that regulation has hurt liquidity, and that evidence in fact shows the opposite. He argued that the decrease in Wall Street dealer corporate bond inventory has been grossly exaggerated, claiming they never held much inventory before the crisis and calling much of what they did hold “illusory.” He pointed out that measures showing declining dealer inventories often included reductions in holdings of mortgage-backed. 

Kelleher further argued that Wall Street dealers are not shock absorbers but rather “opportunistic predatory buyers” and “shock creators.” He added that trading always dries up during periods of market stress regardless of regulation and that if anything, dealers would contribute to the selloff. Kelleher asserted that when the Federal Reserve eventually raises interest rates, volatility will increase and some investors will lose money; but that this should not be mistaken with a liquidity problem. He summarized by advocating that there is no basis to change financial regulation targeted at illusory dealer inventory and emphasis should rather be placed on risk management. 

Kashif Riaz, Managing Director, BlackRock

Kashif Riaz recapped that industry participants agree that a number of factors have contributed to the overall change in the liquidity environment of credit markets including: 1) the growth of credit markets over the past several years, driven by supply and demand side pressures; 2) changes in the OTC market-maker’s risk appetites (Riaz commented that he believes changes are not simply a reaction to new regulation but also a result of dealers learning more about their business models and appropriate leverage levels post-crisis); 3) regulatory Changes; and 4) recognition that the pre-crisis liquidity conditions were neither healthy nor sustainable. He added that while liquidity has gotten a lot of attention over the past year, he believes that the debate is somewhat overheated since liquidity risk is nothing new and managers have successfully dealt with such risks for years.

Riaz said that given the size of global credit markets, he believes that the traditional OTC model is outdated and that the adoption of technology has been too slow in the market. He advocated that given the limitations on growth of dealer balance sheets, the use of more all-to-all platforms should be encouraged to allow a greater range of participants to connect and transact. Riaz further stated that market participants should be willing to adapt their historical behaviors and expectations given changes to market structure. He added that generally he believes TRACE reporting has worked well to increase transparency but countered that due to the illiquid nature of parts of the credit market that it was worth revisiting some reporting thresholds. 

Question and Answer

Martin Neal Baily of the Brookings Institution moderated a question and answer session with the four speakers. 

Changes to the Market

Baily stated that new technology has revolutionized other parts of the market, but such changes have not impacted the fixed income markets. He asked the panelists why this is the case. Nazereth answered that she assumed that there is no dealer interest in having open trading platforms, and she added that it seems that much of the technology changes seek to replicate the existing dealer model. Zamsky said other markets have high homogeneity and greater depth of markets that make electronic trading easier to adopt, but that those characteristics do not exist in credit markets. Kashif commented that the status quo has met the needs of participants to date. 

Baily asked if Nazareth would recommend any changes in fixed income markets. Nazareth responded that the heterogeneity of credit products makes adaptation to automated trading difficult. She advocated for greater standardization of credit products to encourage automated trading but stopped short of calling for a regulatory mandate. She thought that industry initiatives would more likely spur progress. 

Riaz added that he supported the use of industry initiatives to promote change. Riaz highlighted that any steps made in isolation can be easily dismissed, and that to be effective a number of changes would need to be made together over the course of time. 

International Competitiveness

Baily asked Zamsky if he thought that from a global perspective the U.S. was becoming less competitive for companies seeking to raise capital in the wake of changes in regulation. Zamsky responded that U.S. markets have always been important for companies overseas and that he does not see that changing. 

Riaz stated that issuers abroad are coming to the US or attempting to replicate the depth and breadth of U.S. markets. He added that foreign countries are also trying to replicate out markets in order to become more competitive with the U.S. 

Price-Makers vs. Market-Makers

An audience member asked the panelists to comment on a proposed initiative of buy-side firms acting as price-makers, saying that it seems many investors do not want to post prices and prefer immediate executions at dealer prices. Zamsky said that he had lost track of how many initiatives there have been, adding that the market has not wanted or needed such a platform. Riaz responded there are a number of attempts to jumpstart electronic trading that use different trade protocols. He added that he believed that there is a group of hybrid protocols suited for different asset types based on their underlying characteristics. Nazareth agreed that there is no one-size-fit all approach, but she thought there were areas where technology could be helpful. 

Keynote Addresses on U.S. Treasury Markets

Antonio Weiss, Counselor to the Secretary of the Treasury

In his remarks, Antonio Weiss discussed the joint report released by financial regulators on the volatility episode of October 15, 2014. He said the event remains an “anomaly,” but that the analysis in the report underscores “profound changes” occurring in the structure of the Treasury market, especially regarding the effects of technology. He noted that the 37 basis point swing for 10-year yields was “highly unusual,” explaining that only three other days since 1998 have seen such a wide range in trading and each of those was associated with a significant monetary policy announcement, but this was not the case on October 15th

Weiss called the report compiled by the regulators the “most comprehensive study of trading” in U.S. Treasury markets since 1992. The report, he said, found that a confluence of events effectively laid the groundwork for the volatility of that day, such as bets about an increase in interest rates, the pessimistic tone of the annual IMF/World Bank meetings, and the Ebola outbreak. Investors turned to the Treasury market amid these developments, driving up prices and lowering yields. Ultimately, trading exploded while market depth collapsed over a twelve minute period, with algorithmic trading accounting for 70 to 75 percent of total trading while bank dealers widened their bid-ask spreads or withdrew altogether from the offer side of the order book. Weiss said both the algorithmic traders and bank dealers responded rationally in an economic sense, but the result of their individual decisions was a “dramatic reduction in overall market depth.” 

Weiss said there was no direct causal link to any single player, and that “a large part of the story” was linked to the interaction of high-speed trading activities coupled with the slower reactions of human traders. While some were disappointed that the report did not uncover a “smoking gun,” he said the broader findings of the report were possibly more significant in casting “a brighter light” on the evolution of Treasury markets, particularly with advances in technology. He said high frequency trading, a subset of algorithmic trading, is “a disruptive technological innovation which has reshaped an entire industry structure” by tightening pricing parameters and creating informational advantages. As with any technology, Weiss continued, there are “potential benefits and risks,” and he stressed that the key for policymakers is to recognize that the technology is “here to stay” and that regulators should be forward thinking about its effects on market functioning. 

The Treasury Department has been engaging with market participants, academics and other policymakers to understand the new market structure, Weiss explained, and that any policy proposals should be “carefully tailored to address the risks they are designed to address.” He said four risks would guide Treasury’s inquiry: 1) operational risks related to the speed of algorithmic trading and its effect on the “plumbing” of the system; 2) oversight and risk management regarding how minimum standards are set for testing and implementing new algorithms; 3) fair dealing and understanding the practice of self-trading to determine its benefits; and 4) market resiliency. 

Weiss also stressed the need for greater access to data and coordination across markets and agencies, commenting that regulatory authority over Treasury cash and futures markets is fragmented, which makes cooperation essential but slows response times. He added that the Treasury Department will be deliberate in its analysis going forward, diligently gathering “the best ideas” and crafting fact-based policy prescriptions that should be tailored to specific risks. 

Jerome Powell, Governor, Federal Reserve Board

Jerome Powell stated in his remarks that the Treasury market remains “deep and resilient,” but reasonable questions arise about whether market functioning can be improved. While “hard evidence” about the levels of liquidity in the secondary Treasury markets is mixed, he expressed, liquidity may be more likely to disappear at times of stress, such as the events of October 15, the 2013 “taper tantrum,” and the spring 2014 “bund tantrum.” None of these events, however, he said, have definitive causes and effects. 

Powell highlighted changes to the Treasury markets such as the diminished “footprints” of major dealers due to reduction in “risk appetite” and post-crisis regulations, increased market presence of asset managers and mutual fund investors, and an increase in ownership by the Federal Reserve and foreign owners of outstanding Treasuries to 67 percent, up from 61 percent in 2004. Electronic trading, Powell said, has been the “most fundamental” change in these markets. He described the transition over the past fifteen years from a completely paper system to one that is almost fully electronic with a speed that has increased “a million-fold.” 

Powell indicated that while post-crisis regulation had little to do with the events of October 15, it could be one factor driving declines in liquidity since banks are now required to hold higher capital, which has ultimately raised costs. Powell noted though that these changes have “materially lowered” the probability of bank default and the likelihood of another financial crisis. 

Other factors have contributed to the evolution in market making, Powell said, including massive technological changes that allow “new types of trading firms to act as market makers” in not just equity and foreign exchange markets, but also Treasury markets. He said the advent of trading algorithms, which are reliant not on “fundamental” news but instead on technical market changes, reflect a shift to greater market competition and lower costs across the board. Slower traders in this new environment, Powell noted, are placed at a disadvantage which could lead to withdrawal from the markets and fractured liquidity.

Powell, considering whether now is the time for market participants and regulators to decide whether to alter current market structure for general benefit, outlined several recommendations made by observers, including: 1) frequent batch auctions as an alternative to the central limit order book; and 2) alterations to market structure to dampen bouts of greater volatility. 

Emphasizing the interplay between the Treasury market and the repurchase agreement (repo) markets, Powell noted that repo markets are now safer but repo transactions are more expensive. He highlighted the potential to use central clearing more broadly in these markets to lower costs. 

Powell closed by highlighting the need to bring clarity to implementation of structural changes for liquidity and broader market functions. He announced an October 20-21, 2015 conference to take place at the Federal Reserve Bank of New York in cooperation with the Treasury Department, Federal Reserve Board of Governors, Securities and Exchange Commission, and Commodity Futures Trading Commission to generate understanding between market participants and regulators as to whether changes in “trading and risk management practices, regulation and market structure” could increase resiliency and liquidity in the Treasury markets. 

Question and Answer

Douglas J. Elliot, Fellow, Economic Studies, Initiative on Business and Public Policy moderated the question and answer portion between Weiss and Powell. 

Implications of the October 15 Treasury Flash Crash

Elliot asked the panel whether the October 15 “flash crash” has far-reaching implications. Weiss highlighted that this event served as an “awakening” for market participants and thus needs to be taken seriously, especially considering that Treasuries are an integral part of the markets. He cautioned that just because the market self-corrected once does not mean it will continue to do so in the future, but added that market participants should remain confident in the markets broadly. 

Powell added that within the context of continual evolution of technology, risk appetite, liquidity supply and demand, and regulation, it is unclear that the October 15 events matter broadly; however, as interest rates and volatility normalize, market participants and regulators will “learn over time.” 

Weiss indicated that the focus should be on price overshoots that do not self-correct and price movements that create a lack of confidence in the markets. Treasuries, he noted, are the foundation for future work in this area. 

Data Availability

In response to Elliot’s question on what interactions between dealers and customers were observable in the study, Weiss responded that nothing was available “other than anecdotal evidence.” He highlighted that evidence was present of greater withdrawal on the offer side of the first six minutes of the October 15   spike and that ultimately bank dealers expressed that this event represented the most stress in the environment since the 2008 crisis. 

In response to an audience question about whether regulators were surprised about the lack of available data during the event and in the aftermath, Powell responded that he was “very surprised” and that data needs to be more readily available to authorities overall. 

Market Making

Elliot, noting that the study of the events on October 15 demonstrated a shift in market making away from traditional entities to algorithmic trading firms, asked about the pros and cons of the shift. Powell responded that the question lies in whether the incentives, nature, and character of the liquidity created by algorithmic traders are different than that of traditional market makers who have a physical balance sheet. He highlighted that liquidity is a “public good” and regulators must look ahead to see if there is room for both PTFs and traditional market makers. 

Weiss added that when addressing this shift, it is important that regulators do not use “blunt instruments” that do not address specific risks, but instead called upon regulators to take advantage of opportunities for pilot programs on different policy ideas regarding high-frequency traders, to determine the impact changes might have on the broader financial system. 

High-Frequency Trading

In response to a question about whether high-frequency trading generated by algorithmic systems is reasonably based on technical information, Powell expressed that many different strategies are used, and generalizing about high-frequency and algorithmic traders is difficult. He added that while some are engaged in price discovery, others facilitate market making and market participants should be careful about drawing conclusions. 

An audience member, pointing to the success of Michael Lewis’s book Flash Boys which painted HFT as “institutionalized front-running,” asked panelists whether they are worried about growing cynicism among the public about the way major financial markets work. Powell highlighted that the markets have to be honest and participants must get a reasonable deal in their transactions. Ultimately, he said, Flash Boys downplays the complexity of the issue, and the benefits of the technology in the form of more efficiency and lower bid/ask spreads cannot be ignored. 

Weiss added that intermediaries, whether they be investors or high-frequency trading firms, are businesses and regulators should avoid “paint[ing] with a broad brush” when discussing them. To preserve confidence, he said, open discussion should occur on these issues. 

For more information on this event and to view an archived webcast, please click here