Is The US Treasury Market Rigged? Some Say Yes by Gary D. Halbert
FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
January 13, 2015
IN THIS ISSUE:
1. The Largest Market in the World is Unregulated
At this year's SALT New York conference, Jean Hynes, the CEO of Wellington Management, took to the stage to discuss the role of active management in today's investment environment. Hynes succeeded Brendan Swords as the CEO of Wellington at the end of June after nearly 30 years at the firm. Wellington is one of the Read More
2. “Why the Treasury Market Needs a Lifeguard”
3. World’s Largest Bond Market Needs a Single Regulator
4. How the Treasury Department Sells US Debt
5. Primary Dealers Are Main Players in Treasury Market
6. How Individuals Can Buy Treasury Securities Directly
The Largest Market in the World is Unregulated
The last time federal regulators took a hard look at how Wall Street banks and brokers trade US Treasury securities – the largest bond market on the planet by a longshot – a little company called Google was just starting out.
That was 1998, and the technological leaps since then – including ones that are now transforming bond markets – have left government regulators in the dust. In particular, executives from three of the biggest market-making firms in Treasuries say an electronic bait-and-switch tactic known as “spoofing,” – which is already the focus of a manipulation allegation at a major futures exchange – needs to be investigated in cash Treasuries (OTC, etc.) and related futures.
Rules first enacted in 1986 that have gone virtually untouched since then are allowing certain high-tech firms to outmaneuver less-savvy rivals and are manipulating bond prices. They say a lack of cohesive regulation and technology to monitor “high-frequency traders” is making the world’s biggest government bond market more dangerous for everyone.
The following article appeared in Bloomberg/Businessweek on December 11. Since then, I’ve seen no one else touch it. I’ve googled this subject dozens of ways… and very little on this topic comes up. As such, I have reprinted the article below, which I think you will find very interesting and troubling.
Why the Treasury Market Needs a Lifeguard
By Matthew Leising
If you have a complaint about trading in the $12.3 trillion Treasury market, who are you going to call? That question is surprisingly hard to answer. While the U.S. Department of the Treasury and the Federal Reserve Bank of New York exercise some degree of oversight, there’s no one central authority charged with policing the market to prevent illegal trading activity in what is the world’s largest, most active bond market.
The rules governing Treasury trading were enacted in 1986—before high-frequency trading was common—and haven’t been updated in more than a decade. Taking advantage of those outdated regulations, speed-trading firms outmaneuver less savvy rivals and, some executives at trading firms assert, manipulate prices.
A lack of cohesive regulation or adequate technology to monitor high-frequency traders is making the market more dangerous for everyone, they argue. “Understanding the daily movements in the market isn’t that relevant for the Treasury,” says Tony Fratto, who was the department’s chief spokesman during the George W. Bush administration. While officials understand automated trading strategies, “they’re not regulators of that market,” he says. “No one is.”
Safe and efficient trading of U.S. debt is “essential for the Department of the Treasury to borrow at the lowest possible cost and for the Federal Reserve System to effectively execute monetary policy,” regulators said in a 1998 study of how the market is regulated. Treasury bonds are also a major component of many pension plans and 401(k) investments.
One issue that remains unaddressed, according to executives from three of the largest Treasury trading firms, is an electronic bait-and-switch tactic known as spoofing. Spoofers try to make money by feigning interest in buying or selling at a certain price. That creates the illusion of demand and gets other traders to move the market. A spoofer cancels his original trade before it’s executed and profits by buying or selling at the new price. Spoofing has cost traders in Treasury bonds and related futures contracts $500,000 to $1 million a day, according to one of the people. The three executives, who asked not to be named because they aren’t authorized to speak publicly, say they have no idea where to take their allegations of spoofing.
The 1986 Government Securities Act gives bank regulators the authority to prevent fraud and manipulation in the Treasury market. It gave the Treasury Department the authority to write rules, but not to enforce them. For that, Treasury must turn to the Securities and Exchange Commission, which oversees broker-dealers that buy and sell Treasury bonds, or to other groups such as the Financial Industry Regulatory Authority (Finra), the industry’s self-regulatory group.
A review by Bloomberg of dozens of SEC enforcement cases over the past 10 years shows instances of the agency taking action against illegal Ponzi schemes, insider trading, and theft of investor money in the Treasury market, but no case alleging trading manipulation. An SEC spokesman declined to comment [other than to say]:
“The market continues to function smoothly, and the three agencies do not believe it is flawed in any fundamental way”
Finra spokesman George Smaragdis says the group has a rule for Treasury securities that says no broker or broker-dealer is allowed to “effect any transaction in, or induce the purchase or sale of, any security by means of any manipulative, deceptive, or other fraudulent device or contrivance.” Finra’s enforcement record includes actions related to excessive fees and failures to execute trades at the best prices for clients. No case that alleged trading manipulation was found.
Eric Pajonk, a spokesman for the Federal Reserve Bank of New York, declined to comment on the bank’s role in supervising the Treasury market. He referred to the 1998 study, conducted by Treasury, the SEC, and the Fed, which says the Markets Group of the New York Fed has “primary responsibility for day-to-day surveillance of the Treasury securities markets.” No mention is made of this role for the Markets Group on the New York Fed website. The monitoring and analyzing it does is to “inform the formulation and implementation of monetary and financial stability policy,” the site says.
When the Government Securities Act became law, Treasury trading was conducted manually. Now about half of Treasury trading by institutions is done by high-frequency traders, according to David Light, co-founder of CrossRate Technologies, which is trying to create a new electronic Treasury trading platform. In other markets, regulators have taken steps to keep pace with technological changes. The SEC spends about $2.5 million a year on a surveillance system called Midas to help root out bad behavior in the $24 trillion U.S. stock market. The Commodity Futures Trading Commission, the main derivatives regulator in the U.S., requested $115.8 million from Congress this year to fund its market surveillance and enforcement programs.
There’s no such system in Treasuries, nor any plans to create one. “The Treasury, Fed, whoever, have always taken a hands-off role with the government securities market,” says Craig Pirrong, a finance professor at the University of Houston. “It is rather remarkable that the Fed and Treasury have taken little interest in the dramatic change in market microstructure and trading technology.”
The Treasury Department “regularly monitors day-to-day movements of financial markets,” Adam Hodge, a spokesman, said in an e-mailed statement. “We take any concern about market manipulation seriously and routinely monitor developments with our regulatory partners.”
The 1998 study conducted by regulators concluded that the system was working as intended. “The market continues to function smoothly, and the three agencies do not believe it is flawed in any fundamental sense,” the report said. “As a result, we believe no additional rulemaking authority under the GSA, as amended, is required at this time.” The 16-year-old study is the most recent assessment of the market undertaken by the U.S. government.
The Treasury Department doesn’t have the tools or computer systems—or the inclination—to police modern markets, according to Fratto, the former Bush official, now a partner in Washington at banking lobbyist Hamilton Place Strategies. “They don’t monitor trade activity,” he says. “They monitor prices to inform their view of the macro economy. They may be afraid to tell you it’s not something they’re very interested in.”
That lack of concern could be a problem next year. Market volatility will rise in 2015 when the Fed finally seeks to raise interest rates for the first time in years, says Pirrong. “The volatility and trading activity will probably be greatest at the time of the Fed’s initial move.”
World’s Largest Bond Market Needs a Single Regulator
The US Treasury securities market, at an estimated $12.3 trillion, is by far the largest government securities market in the world. Yet it has no one single regulator to police it. The Treasury’s Debt Management Office has some responsibility for trading, yet Treasury has no authority to take enforcement actions against violators. The department can write rules, and it engages with market users and regulators such as the SEC, but is powerless to go after anyone breaking its own rules.
The SEC has regulatory oversight of broker-dealers that buy and sell Treasury bonds, but US Treasuries are exempt from being defined as a “security” under the Securities Exchange Act, the US law that gives the SEC its main authority.
A review of dozens of enforcement cases by the SEC over the past 10 years shows instances of the agency taking action against illegal Ponzi schemes, insider trading and theft of investor money in the cash Treasuries market – but no case alleging market manipulation by high-frequency traders or spoofers.
As noted in the article above, it is widely known that high frequency trading, and spoofing in particular, costs investors and traders in Treasuries $500,000 to $1 million a day, but no regulators seems to care enough to tackle this problem. This needs to change!
How the Treasury Department Sells US Debt
The United States has more outstanding debt than any other country in history at $18.1 trillion, and well above the outstanding debt of the next two largest countries, the UK and Germany. It would stand to reason that the US would have a regulator with legal authority over this enormous market.
To finance the public debt, the Treasury sells bills, notes, bonds, Floating Rate Notes (FRNs) and Treasury Inflation-Protected Securities (TIPS) to institutional and individual investors through public auctions. Treasury auctions occur regularly each year and have a set schedule. There are three steps to an auction: 1) the announcement of the auction date and amount to be offered; 2) the bidding process; and 3) the issuance of the purchased Treasury securities.
When participating in an auction, there are two bidding options – “competitive” and “non-competitive:”
- Competitive bidding allows would-be purchasers to specify the rate, yield, or discount margin that they are willing to accept. By doing so, they have no guarantee that they will receive the Treasury securities they are bidding on.
- Non-competitive bidding means that the purchaser agrees to accept whatever rate, yield, or discount margin that is determined at the auction. Non-competitive bidders are much more likely to receive the securities they bid on.
At the close of an auction, the Treasury awards all non-competitive bids that comply with the auction rules and then accepts competitive bids in ascending order of their rate, yield, or discount margin (lowest to highest) until the quantity of awarded bids reaches the offering amount. All bidders receive the same rate, yield, or discount margin at the highest accepted bid.
Primary Dealers Are Main Players in Treasury Market
So-called “primary dealers” in US Treasuries are multinational banks and large securities broker-dealers that are permitted to trade directly with the Federal Reserve Bank of New York, which is in charge of Treasury debt auctions. Such firms are required to make bids or offers at Treasury auctions. They also are involved when the Fed conducts “open market operations” and provide market information to the Fed’s open market trading desk.
Primary dealers purchase the large majority of Treasury securities issued by the government, and then distribute them widely in what is known as the “secondary market.” The primary dealers form a worldwide network that distributes new US government debt.
The number of primary dealers changes occasionally but is currently at 22. The cast of primary dealers also changes from time to time, but here is the current list of players:
- Bank of Nova Scotia, New York Agency
- BMO Capital Markets Corp.
- BNP Paribas Securities Corp.
- Barclays Capital Inc.
- Cantor Fitzgerald & Co.
- Citigroup Global Markets Inc.
- Credit Suisse Securities (USA) LLC
- Daiwa Capital Markets America Inc.
- Deutsche Bank Securities Inc.
- Goldman, Sachs & Co.
- HSBC Securities (USA) Inc.
- Jefferies LLC
- J.P. Morgan Securities LLC
- Bank of America/Merrill Lynch
- Mizuho Securities USA Inc.
- Morgan Stanley & Co. LLC
- Nomura Securities International, Inc.
- RBC Capital Markets, LLC
- RBS Securities Inc.
- SG Americas Securities, LLC
- TD Securities (USA) LLC
- UBS Securities LLC.
The vast majority of institutional and individual investors purchase US Treasury securities via one of these primary dealers or their affiliates around the world in the secondary market. However, as I will point out below, there is a way for institutions and individual investors to purchase Treasury securities direct from the government and bypass the primary dealers.
How Individuals Can Buy Treasury Securities Directly
You can purchase US Treasury securities on the secondary market or directly from the Federal Reserve. Buying direct from the Fed allows you to avoid commissions and markups and any price manipulation. When you purchase Treasuries directly from the Federal Reserve, you must buy new issues. The minimum purchase is only $100, so most anyone can participate.
The Treasury holds regularly scheduled government auctions four times a year: the first weeks of February, May, August, and November. You can enter bids for Treasury securities at www.treasurydirect.gov. This is the official website of the US government.
I have included a couple of links below that explain how you can do this and bypass banks, brokers, etc. in the secondary market. There is also a link to an article that explains how Treasury debt auctions work.
As always remember that when bonds are first issued, their prices (or face values) are fixed. But once issued, their prices can fluctuate in the secondary market due to changing interest rates and other factors. Thus, while Treasury securities are considered “safe” investments – in that they are secured by the “full faith and credit” of the US government – their prices on the open market can fluctuate widely. Thus, investing in bonds includes risk.
I hope today’s discussion on manipulation of the Treasury markets was helpful. I’m surprised this story isn’t receiving a lot more attention, but at least my clients and readers now know about this problem and how to avoid it.
Best football playoffs regards,
Gary D. Halbert