"Turn Those Machines Back On" - The Day The Bond Market Died (If Only For A Few Minutes)

The first hint that Skynet was self-aware took place on May 6, 2010, when the DJIA crashed over 1000 points in minutes, a move we warned would take place in April of 2009 with "The Incredibly Shrinking Market Liquidity, Or The Upcoming Black Swan Of Black Swans" merely extrapolating the ubiquitous and pervasive presence of HFTs in all parts of the market, leading to terminal instability and illiquidity. Four years later, on October 15 2014, the HFT hammer struck again, only this time it wiped out liquidity in the world's supposedly biggest and most liquidi market: the US bond market.

We showed the unprecedented, multiple sigma moves at the time as follows:

However, while the algos would have been delighted to let October 15 slide into the collective memory made obsolete by a constantly rising market (because investors are only truly angry when the market plunges not when it surges) just as the regulators made a mockery of their fiduciary responsibilities in the aftermath of May 6, and now markets are more fragile than ever as HFTs comprise the vast majority of all trades, some appear to be complaining and even, gasp, asking questions how it is possible that the $12 trillion US Treasury market traded like an illiquid Pink Sheets pennystock, or worse, the Nikkei.

Here is the WSJ with some of the complaints: “It starts moving faster and faster, and you can’t point to anything,” recalled Mark Cernicky, managing director at Principal Global Investors , which oversees $78 billion.

The WSJ cites JPM which notes that "during the plunge in bond yields, trading volumes exploded in the futures market and in Treasury bonds. But, according to J.P. Morgan data, that morning the average amount of Treasury 10-year notes available to be bought or sold near current market prices was 54% below the average for the prior two weeks. For two-year notes, the available stock of notes was 75% below the two-week average."

Now, investors and regulators are burrowing into the causes of the plunge in yields to try to understand whether electronic trading and new regulations are fueling sudden price swings in a market that acts as a key benchmark for interest rates, investments and U.S. home loans.

 

Regulators and other experts are examining deep-seated shifts in trading since the financial crisis, which could help explain the unusual size of the move in a market many investors rely on for its relative stability.

 

“What happened on Oct. 15 is the result of things that had been building for a while,” said Alex Roever, a strategist at J.P. Morgan Chase & Co. who follows the government-bond market.

Well, yes. They have also been extensively previewed here, most recently in Phantom Markets: Why The TBAC Is Suddenly Very Worried About Market Liquidity. And sure enough, with the usual year and a half delay, the regulators are finally on the scene.

The Federal Reserve, Treasury and Commodity Futures Trading Commission are looking at that day’s trading activity, according to people familiar with the situation. One focus is the role of high-speed electronic trading in the bond market, although regulators haven’t yet drawn any conclusions, these people said.

 

Market supervisors at the Fed and Treasury have pored over the day’s trading data and reached out to big banks to better understand what caused the sudden drop in yields, said people familiar with the matter.

What caused it? Simple: first and foremost thank the Fed, whose relentless purchases up of Treasurys from the private market has led to a historic shortage of the most popular CUSIPs, and a daily update where Treasurys trade negative in repo land, meaning an constant inability to procure the underlying bonds.

Capital rules have also led to a shrinking of the “repo” market. Short for repurchase agreements, repos are short-term loans crucial to the smooth functioning of the market by enabling bondholders to lend out securities to investors who want to sell and bet on price declines. “The net effect of regulation has been to lower liquidity,” said Ashish Shah who heads credit at $473 billion asset manager AllianceBernstein LP. “So you get short-term dislocations that are larger than what we used to get—even in Treasurys.”

Odd, that, because we warned about precisely this in July: 'The Current Repo Fails Issue Rebukes Any Notion That The Fed Is In Control."

And then there are the algos. The WSJ's take is the following:

Potentially amplifying swings, banks have become wedded to risk measures that mandate traders pull back from the market when volatility spikes.While these models help manage risk, by forcing dealers out of the market when prices get volatile, “at times like mid-October they can in a way be self-fueling,” said William O’Donnell, head Treasury strategist at RBS Americas.

 

CME Group has said about 35% of its volume is attributable to high-frequency traders, and some bond-market participants say much of the electronic trading is concentrated in roughly a dozen speedy-trading firms.

 

Researcher Tabb Group estimates that electronic trading in Treasury securities will rise to 60% of overall market volume by 2015 from 37% in 2013.

 

A decade ago, a trader at a fund company would have to pick up a phone to call a salesperson at a bank for a quote on bonds they want to buy or sell. Today, dealers have computer programs that automatically spit out quotes to clients on a screen.

 

This change has meant firms can process information and trade much faster. But where dealers used to have a closed network of brokers through which to set prices, in the last few years fast-trading hedge funds and proprietary-trading firms have been allowed to trade in this network.

We have written so much about the takeover of the capital markets by various assorted algos and electronic trading modalities that we won't even link back to any of the thousands of Zero Hedge articlescovering this topic.

However, we will provide a glimpse of how all this relentless artificial zero volume levitation will finally end. One day, when everything is about to crash and exchange are flooded with sell orders, all the machines - the algos, the exchanges, the Mahwah and Chicago servers - will simply be shut off:

The presence of high-frequency traders has help offset some of the decline in trading by dealers. But in times of market tumult, those speedy traders often seek to avoid losses by pulling back from the market, while dealers tend to seek to help clients get trades completed.

 

What’s more, virtually all major dealers have shifted to using computers to automate Treasury prices quoted to clients. While that has generally helped make trading faster, on Oct. 15, several traders shut down these systems.

 

Among them was Guggenheim Securities. A spokesman for the firm said it does so “at time of great volatility...as it cannot keep up with the extreme volatility of the market.”

 

He said shutting such automated systems off “protects the firm from giving erroneous prices,” and allows it to continue quoting clients—albeit at a slower pace—over the telephone.

Which considering that virtually every time there is a sharp drop in stocks, some exchange - be it BATS, Nasdaq or NYSE - breaks, is all one needs to know of the coming capital market future: please join the rest of the cat herd, courtesy of the Fed's ZIRP policies, and deposit your money into the pyramid scheme stock "market", just don't hope to be able to withdraw any of it out when the music finally stops.