The Periodic Treasury Exchange: A Proposal to Increase the Depth and Liquidity of the U.S. Treasury Market

17 Aug 2016


In recent years, the liquidity of many fixed income markets has declined as banks have stepped away from their traditional role as market makers, triggering sharp market movements, as, for example, happened on October 15, 2014 when the yield of the 10 year Treasury experienced a 37 basis point trading range. Even though market making in the Treasury market is increasingly electronic, the balance sheets of many electronic market makers are not large enough to support significant positions, particularly in off-the-run securities. In this article, we propose a mechanism by which off-the-run treasury securities can be exchanged periodically for on-the-run treasury securities, allowing market participants to better hedge their books, and therefore to transact in significantly larger sizes without fear of disrupting the market or experiencing significant losses from a widening of the basis between near-offsetting long and short positions.

Introduction and Overview

At the present time, there are over 600 different U.S. Treasury securities outstanding, ranging in initial maturity from 1 week to 30 years. Most market participants, though, trade only the most liquid nominal on-the-run bonds, of which there are but 6, and liquidity rapidly declines as one moves away from on- and near-on-the-run issues to further off-the-run issues.

Market participants who are active in the on-the-run market can implement a wide range of yield curve trades at different tenors – outright bets on duration, as well as steepeners, flatteners and butterflies – and can hedge their exposures using Treasury futures. They typically do not need access to off-the-run bonds. Likewise, market participants who are active in the market for off-the-run bonds can implement many of these strategies, but at higher cost and with lower liquidity, and, in addition, can implement relative value trades between bonds of similar maturity and duration. Market participants can also create long term static hedges for known future liabilities, and typically need access to both on-the-run and off-the-run bonds.

Market makers intermediate between buyers and sellers of Treasury bonds and provide tight markets (typically ½ bp – 1 in yield for on-the-run bonds, 1 bp – 4 bp for off-the-run bonds), but the sizes at which they are willing to transact at these bid-ask spreads has declined significantly since the 2008 financial crisis, in large part because market making capacity has declined at banks, the traditional providers of this function. We believe this decline is structural, not cyclical, and is driven by the growth of electronic market making as well as by regulatory changes which have substantially increased the amount of capital that must be held against a trading book.

The Department of the Treasury raises capital in the capital markets to finance the operations of the United States Government. The Treasury, rightly, wants to be seen by market participants as a predictable, transparent price taker that is strongly supportive of well-functioning capital markets as well as of market making; and which sets its level of borrowing independent of movements in yields (at least in the short term).

Following the very high level of volatility in the Treasury Market on October 15, 2014, when the yield of the 10 year benchmark Treasury note experienced a 37 basis point trading range, the joint staffs of the Department of the Treasury, the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, the Securities and Exchange Commission, and the Commodity Futures Trading Commission wrote a report reviewing market activity on that day. In their report, they show that Principal Trading Firms (PTFs), many of whom are electronic market makers, and bank-dealers reacted in different ways on October 15. Broadly speaking, PTFs reduced their limit order quantities, but continued to offer a tight spread between bid and ask prices throughout the day. Bank-dealers, in contrast, significantly widened their bid-ask spreads, and removed their offers to sell securities. Both actions caused a decline in market depth and liquidity.

More recently, in January 2016, the Department of the Treasury published a Request for Information (RFI) in the Federal Register asking stakeholders for their views on structural changes in the U.S. Treasury market and the implications of such changes for market functioning, including trading and risk management policies and practices across the U.S. Treasury market. The RFI also sought views on the most effective means of providing additional information about Treasury market activity to the official sector on an ongoing basis, and was intended to inform the ongoing work related to the next steps in the Joint Staff Report on the U.S. Treasury Market on October 15, 2014

In this note, we propose a simple mechanism by which both the liquidity and the depth of the market for Treasury securities can be enhanced, thus increasing its resilience, particularly on days such as October 15, 2014. In light of the above discussion, we believe that any such mechanism must, at a minimum, satisfy the following conditions:

    1. It must be neutral on the financial borrowing requirements of the Treasury,
    2. It must be cost neutral in the long term, and preferably in the short term as well,
    3. It must not distort the maturity profile of the outstanding stock of Treasury debt to any significant degree,
    4. It must be demand driven once the program’s parameters have been announced,
    5. It must be supportive of well-functioning capital markets,
    6. It must enhance secondary market liquidity in the securities or maturity sectors that are most crucial to the market participants.
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