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Saturday, March 14, 2020

Treasury Market Turmoil At Most A Symptom

There has been major disruptions in Treasury market liquidity, with it being very difficult to sell off-the-run bonds. My initial reaction to these stories is that this is the typical complaining you get from people in any overly-specialised field when something slightly atypical happens. My argument is the worst case interpretation is that this is a reaction to one or major entities' balance sheets blowing sky high. Alternatively, this is just what happens when too many people take finance academics too seriously, and build their entire business model around the premise of markets always being liquid and orderly 24/7. That was always a stupid assumption, and so this is just reality intruding on that fantasy.

As a disclaimer, I am basing my comments solely upon the chatter I see in media reports. My feeling is that we are seeing a repeat of similar trading patterns from the Financial Crisis, and I am extrapolating from that experience.

Dealers, Not Brokers

The key issue that most people are unaware of is the distinction between a dealer market and a broker market. Most people are aware of how stock markets works -- which are a broker market. Bond markets are almost entirely dealer markets.
  • In a broker market, an investor instructs their broker to do a trade, and the broker attempts to execute that trade at the best price possible. This is normally done in public markets, and quite often the trade is executed against an other investor at another broker.
  • In a dealer market, an investor trades directly against the dealer. In most cases, this is how buying bonds in a brokerage accounts works (although you might be able to find a bond that trades on an exchange, at least if you have access to a time machine).
This is a huge difference. In the first, the broker is trying to get you the best price (unless they have some sort of scam going on). Conversely, in a dealer transaction, every dollar you over-pay is one dollar more going into the dealer's pockets. (For this reason, I would recommend extreme caution when buying bonds directly, although automated platforms seem to have cut down on the worst mispricing.)

In order to buy or sell in a dealer market, you are buying or selling from/into the dealer's inventory of that bond. In the meantime, dealers are leveraged financial entities. They need to borrow to finance their inventories of bonds. As a result, if dealers are unwilling or unable to finance a position in a bond, there will be no bid.

What Happens Next?

 There are three scenarios.
  1. Markets will regroup over the weekend, and dealers will line up buyers and sellers of Treasurys. When trading reopens, it will be at a price where dealers fill they can unload positions quickly. Spreads and trading will return to something closer to "normal," although spreads will be wider than in recent years. The end result is that we can go back to ignoring the spreads on off-the-run Treasurys.
  2. The regulatory environment has created a structure where dealers have no economic incentive to tie up liquidity in Treasury trading, and will be deploying their risk and liquidity budgets elsewhere. Off-the-run Treasurys remain illiquid, but nothing else of interest happens.
  3. One or more entities have blown up, and there is no capacity to balance the market. The only way to contain this will be some form of direct intervention by the authorities to deal with the failing entities.
Unless one is deeply concerned with trading Treasury securities on a daily basis, only the last possibility is of concern. There was a similar inability to trade off-the-runs during the Financial Crisis (perhaps more in Canada than in the United States), but that was obviously the central concern of that era. 

Should Policymakers Care?

Needless to say, the authorities need to be concerned if liquidation is overwhelming the financial system, given the importance of non-bank finance ("shadow banking"). Beyond that, this should not be too deep a concern. Modifying regulations that had the unintended effect of killing Treasury market liquidity might be warranted, but that really would only be able to be determined once the dust has settled. Otherwise, we need to accept that market-making is a business, and they will allocate risk and liquidity budgets across asset classes in a way that maximises expected profit. Market dislocations will be worked out, and spreads will return to more sensible levels.

Should Investors Care?

If your business/trading strategy is predicated on continuously liquid markets, these events are shocking. For example, options based strategies are often predicated upon the ability to continuously make hedging trades. An inability to execute hedges means that you end up blowing through risk limits, forcing liquidation elsewhere. 

I do not have a lot of sympathy for this concern. Bulking up strategies of this sort is exactly the sort of thing Minsky warned us about; we need a periodic culling of the herd of investors who ignore Misnky's insights.

That said, there is a legitimate problem, the issue of valuation. Most funds are structured on a premise that we have a very good idea of what the net asset value (NAV) of the fund is. For example, funds need to assign a precise dollar value to inflows/outflows to the fund. They cannot just make up a NAV, as that could very easily lead to shenanigans. (E.g., drop the NAV of the fund on a day when managers invest a lot of their own money, and/or raise the NAV when they sell.)

From a philosophical standpoint, what is happening is that the true value of security is what someone else will pay for it; when markets get disrupted, there is no price. Nevertheless, this is only a temporary disruption, sooner or later, people will sniff profits and bids will appear. However, people in finance are not philosophers, and spend their days obsessing over the NAV of their funds (since that is what their bonuses are paid on). To a certain extent, the investors in private assets have a somewhat healthier attitude towards the question of fund valuation. Nevertheless, this is a concern for fund managers and investors in those funds, but not of wider import.

Concluding Remarks

One can look at the price action across markets and very easily conclude that they face disruptions on a level that is similar to 2008. Whether or not the stock market goes up or down in a day will not change the situation for a big fund that is being forcibly liquidated.

If we look at the disruptions in Treasury trading, we need to realise that it is not a question of just Treasury securities. The dealers in Treasury markets are part of big firms that are market-making across all markets. Liquidity constraints will hit everything, and Treasury trading is likely less lucrative than other markets, even taking into account the risk weighting advantages of Treasuries.

The big question is whether we face systemic risk from failing entities. I certainly do not know the answer, but I would point out that us outsiders would not likely find out until either the failures hit, or the authorities intervene to prop up the system. Until then, it is all guesswork.

(c) Brian Romanchuk 2020


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