Treasury Market Liquidity From Lehman To The October 15 Crash In A 1 Minute Video

It is now just over a month since the infamous Treasury flash crash of October 15, which has by now surpassed the May 2010 stock market crash in terms of causative mystery as well as again exposing the SEC's inability do its job and police such future market calamities simply because the culprit - the SEC's most lucrative lobby comprised of high frequency and other algorithmic traders - is by now far too embedded in the market structure that its withdrawal would cause a crash as pervasive as a halt of liquidity injection by the central banks. Which is why as Michael Lorizio, senior trader at Boston-based Manulife told Bloomberg, "The way the market is set up right now, we’ll see instances like we did on that day. There’s going to be a learning curve as to how to handle that." Also, a whole lot of praying.

We covered the epic October 15 collapse in rates in the past but for those who missed it, here it is again:

What began on Oct. 15 as another day in the U.S. Treasury market suddenly turned into the biggest yield fluctuations in a quarter century, leaving investors worrying there will be turbulence ahead.

 

The episode exposed a collision of forces -- the rise of high-frequency trading and the decline of Wall Street dealers -- that are reshaping the world’s biggest and most important bond market. Money managers say the $12.4 trillion Treasury market is becoming less liquid, meaning securities can no longer be traded as quickly and easily as they used to be, thanks in part to the Federal Reserve’s bond-buying program.

 

The shift came all at once. The sentiment that the Fed would raise rates reversed. Traders who’d bet against, or shorted, Treasury bonds had to buy as many as they could as quickly as they could to limit their losses. By 9:38 a.m., 10-year Treasury yields plunged 0.34 percentage point, the most in five years

We warned about precisely this over a year ago. What happens next will be even worse, but here is Bloomberg with the more politically correct, PG-17 version:

The influence of high-frequency traders in the Treasury market is growing. About 60 percent of Treasury securities trades are expected to be transacted on electronic platforms by the end of next year, an increase from 40 percent in 2013, according to Tabb Group LLC, a New York-based research firm. Of those trades, 10 percent were executed by robots in 2010, a share that will probably grow to 20 percent next year, according to Tabb.

 

At least one electronic trader, Charles Comiskey, the head Treasury dealer at Bank of Nova Scotia, said he unplugged his computer for half an hour during the height of the frenzy. That may help explain why yields plummeted so fast without sellers to stem the fall.

 

It may also explain why an unprecedented $946 billion of U.S. government debt ended up changing hands on ICAP’s BrokerTec trading platform on Oct. 15, breaking the record by 43 percent. Once sellers stepped in and the plunge was arrested, there was plenty of liquidity.

Of course, when it comes to stocks, it's the other way round: every flash crash needs buyers, which is where the Citadel-NY Fed Joint Venture "memontum reversion and ignition" team comes into play.

As for the reasons why the 10Y will increasingly pennystock, there are two culprits. First and foremost, the Fed:

“In the old days, the dealers could carry inventory and it acted like a shock absorber,” said David Breazzano, who manages $8.2 billion in high-yield bonds and loans as Waltham, Massachusetts-based DDJ Capital Management LLC’s chief investment officer. New regulations create “opportunities for other institutions to fill the gap,” he said. One result is a narrowing of the market. Average daily turnover in the U.S. bond market shrank to $809 billion last year from $1.04 trillion in 2008, according to Securities Industry & Financial Markets Association data.

 

The Fed has bought so many bonds -- $3.5 trillion worth since 2008, including $1.86 trillion of Treasuries -- that big individual trades matter more now. The amount of U.S. debt available to trade at one time without moving prices as of October has plunged 48 percent to $150 million since April, according to JPMorgan Chase & Co.

And then old faithful: algos, or rather their idiot programmers. Jim Bianco said it best when describing the herd mentality of electronic traders. “A lot of these guys are focused on speed,” Bianco said. “They’re all uncreative and write the same program. When the stimulus comes in a certain way, every one of them comes to the same conclusion at exactly the same moment.

Who'd a thunk it that a math Ph.D. would be insufficient to analyze and trade the largest market in the world?

Naturally, the CFTC - the same CFTC that found no sign of precious metals rigging until first Barclays and then UBS were charged for precisely that - has found nothing wrong.

Timothy Massad, chairman of the Commodity Futures Trading Commission, which oversees the Treasury futures market, told reporters in Chicago Nov. 5 that his agency “took a look at” the price fluctuations of Oct. 15. “Basically we didn’t see any break in liquidity,” Massad said. “I think it was just a high volume day. But let me just add that’s based on our preliminary look. New evidence might come to our attention that suggests otherwise.”

And they will keep repeating until the next crash, when as Icahn warned, there may be no rebound to "normal" levels:

In certain markets, “there’s a facade of liquidity,” said Jon Duensing, a money manager at Amundi Smith Breeden, the U.S. unit of the French asset-manager Amundi that oversees about $1 trillion. “It’s possible that the mechanisms that investors thought were in place to facilitate capital flow may break down.”

Not possible. Certain.

And just to put the events of October 15 in context, here is a 1-minute clip courtesy of Nanex showing the daily history of bond market liquidity starting just before Lehman and going through November 2014, with an emphasis of what happened during both the stock flash crash in May 2010 and the bond crash in October 2014.

As Nanex explains, each line represents the sum of top 3 depth levels in the active 10 Year CME T-Note futures contract (ZN) for each second between 3:00 and 16:00 Eastern time. Each frame is one trading day. The level of the line indicates approximately how many contracts could be immediately bought or sold without moving the price more than 3 ticks or price levels. Basically, the higher the line, the more liquidity in the market at that time.

The downward spikes occurring at regular times are from scheduled news releases, the most common being at 8:30 and 10:00 AM. Some 3.3 billion records from 1,708 trading days covering January 3, 2008 through November 5, 2014 were processed in creating this animation. The final frame is composed from about 1.3 million individual line segments.

The animation pauses on two dates, May 6, 2010 (the flash crash) and October 15, 2014 (the Treasury flash crash).