What a difference a year makes. We’ve gone from zero coverage of the liquidity issues in the U.S. Treasury market to multiple articles a week. Our friends at CrossRate Technologies attribute this to Jamie Dimon raising an alarm about bond liquidity in JPMorgan’s letter to shareholders. I’m not sure I agree that it’s not just a coincidence, but David Light’s been writing about this for longer then anyone else I know, and he’s been consistently on point about these things.
I began worrying about liquidity in the U.S. Treasury market almost two years ago. As a market maker, I had to be attuned to the day-to-day ebb and flow of the market. Sitting in that seat for 10+ hours a day, I couldn’t ignore the tectonic shifts happening. I’d suddenly only be able to get a passive fill when the market went against me, I’d never get 100% done on my aggressive orders, and top-of-book liquidity was declining dramatically.
Data backed up my impressions. Month after month, my traditional measures for liquidity quality showed the market getting increasingly toxic. Fill rates were down dramatically, especially for larger orders. Last year, JPMorgan acknowledged that the IDBs had lost 70% of their top-of-book.
So what’s going on? My thesis is that three major forces are at work in the market, causing a secular change:
- Participants in the market have became more sophisticated and informed. The problem is not just the rise of the alpha-taking HFT firms that you read about in Flash Boys. The increased use and sophistication of internalization and single dealer platforms by larger dealers (and even some buy side shops) has resulted in the IDBs only seeing informed trades.
- Dealers have slashed balance sheet and risk tolerance. Line traders are trading less and holding fewer discretionary positions. Markets are made when you have a mismatch between long-term and short-term horizons. Most of the dealer trades in the market now are short term in nature (hedging customer risk), which means everyone in the market is going the exact same way.
- There has been a rise in bi-lateral trading venues like GETDirect (which I happened to have built) and CitiVelocity (for which our Head of Sales led the sales). These venues have taken a lot of natural order flow from dealers that traditionally would be going to the IDBs.
The heightened state of awareness brought on by all the media articles is a good sign. U.S. Treasuries are the benchmark of interest rates and reduced liquidity has ripple effects in bond markets across the globe. It’s better we start to hash out these problems now before it’s too late and a crisis forces our hands.
