Nearly two years ago we wrote about a phenomenon that has become the most acute problem facing the modern, "QEverywhere" financial system: an unprecedented collateral shortage, as a result of central banks soaking up trillions in "high-quality collateral" in the form of government bonds. To wit from "Desperately Seeking $11.2 Trillion In Collateral":
Over a year ago, we first explained what one of the key terminal problems affecting the modern financial system is: namely the increasing scarcity and disappearance of money-good assets ("safe" or otherwise) which due to the way "modern" finance is structured, where a set universe of assets forms what is known as "high-quality collateral" backstopping trillions of rehypothecated shadow liabilities all of which have negligible margin requirements (and thus provide virtually unlimited leverage) until times turn rough and there is a scramble for collateral, has become perhaps the most critical, and missing, lynchpin of financial stability.
Not surprisingly, recent attempts to replenish assets (read collateral) backing shadow money, most recently via attempted Basel III regulations, failed miserably as it became clear it would be impossible to procure the just $1-$2.5 trillion in collateral needed according to regulatory requirements.
The reason why this is a big problem is that as the Matt Zames-headed Treasury Borrowing Advisory Committee (TBAC) showed today as part of the appendix to the quarterly refunding presentation, total demand for "High Qualty Collateral" (HQC) would and could be as high as $11.2 trillion under stressed market conditions.
In short, there is a unprecedented "quality" collateral shortage.
It took several years, but slowly and surely everyone caught on from the mainstream media, to Jamie Dimon and even the IMF, realizing also that the reason why liquidity in what was formerly the world's deepest and most liquid bond market, that of US Treasurys, has completely collapsed is due to not only central banks "soaking up" collateral from private holders but also algorithmic traders who - as it turns out - not only do not provide liquidity, but consume every last trace of it.
It has gotten so bad that even the New York Fed's Treaury Market Practices Group, or TMPG, issued its starkest warning yet. Who is the TMPG?
The TMPG is a group of market professionals committed to supporting the integrity and efficiency of the Treasury, agency debt, and agency mortgage-backed securities (MBS) markets. The TMPG is composed of senior business managers and legal and compliance professionals from a variety of institutions.
The Group meets regularly to discuss and promote best practices related to trading, settlement and risk management in the Treasury, agency debt and agency MBS markets. From time to time, the TMPG publishes guidance to market participants, including the Best Practices for Treasury, Agency Debt, and Agency Mortgage-Backed Securities Markets and Fails Charge Trading Practice recommendations for the Treasury, agency debt, and agency MBS markets.
It counts among its current members such organizations, banks and hedge funds as:
- JPMorgan Chase
- Morgan Stanley
- Goldman Sachs
- Graham Capital Management
- Barclays Capital
- Depository Trust & Clearing Corporation
- Bank of America Merrill Lynch
- American Capital Agency
- Citadel LLC
- Banque de France
- Citigroup Global Markets
- Wellington Management
- State Street Global Advisors
- ICAP North America
And if back in 2013 the TBAC politely warned about the risks to the Treasury market with its note which served as the basis for our then-article on over $11 trillion in collateral shortage, the TMPG is positively screaming about the imminent risks to the US bond market, a harbinger of which was seen last October 15 during the infamous Treasury flash crash, where as a result of record illiquidity and pervasive algo trading, the entire US bond curve flash crashed.
And not surprisingly, the biggest threat voiced by the TMPG is one Zero Hedge also warned about over 6 years ago, in the days following our inception: the rise of HFTs, and the collapse in true liquidity that follows the algorithmic scourge in every market.
This is what the TMPG's white paper titled "Automated Trading in Treasury Markets" said:
An element of operational risk is inherently present in all financial transactions regardless of the degree of automation, but this has been an area of particular concern in the case of fully automated trading systems where increased speed necessitates different controls. In fact, recent market events attributed to automated trading have been directly linked to operational risks ranging from malfunctioning and incorrectly deployed algorithms to algorithms reacting to inaccurate or unexpected data. In these cases, internal controls at the trading firm and credit controls at trading venues and/or counterparties seemed insufficient to prevent erroneous orders from reaching the market. In some instances, malfunctioning algorithms have interfered with market functioning, inundating trading venues with message traffic or creating sharp, short-lived spikes in prices as a result of other algorithms responding to the initial erroneous order flow.
Which summarizes perfectly what the New Paranormal world has come down to: as a result of regulatory capture by these same HFTs and "malfunctioning algorithms" noted above, absolutely nothing has been done and will be done to temper the rise of the robots (at least until after the next mega market crash, which will be blamed exclusively on HFTs while central banks are just as culpable of blowing the world's biggest asset bubble in history), the world's biggest and formerly most liquid bond market, is now held hostage by algorithms!
Only this time it is not some fringe blog warning about it, but the most respected firms on Wall Street, among them none other than Citadel, the hedge fund which the NY Fed itself uses to "fairly price" stocks during moments of extreme selling.
The rest as they say is negative rates history, and a whole lot of prominent soundbites by those whose job is now impossible thanks to the actions of the Fed and the high frequency trading industry. For those we go to Bloomberg which in an overnight report writes that "six months after an unexplained flash rally in Treasuries sent markets reeling, bond investors are bracing for it to happen again."
This is how traders trade in a market that is not only no longer a "market", but is held hostage by the (malfunctioning) algos:
“There’s potential for extreme conditions in the marketplace when volatility really goes up,” said Steven Meier, head of cash, currency and fixed-income at Boston-based State Street’s money-management unit. “There’s still a lot of unanswered questions about what happened,” and no “clear explanation of what the drivers were.”
There is, but nobody wants to hear it as fixing it would gut and expose just how corrupt and broken not just the bond market, but every market has become.
Calvert Investments money manager Matthew Duch said the mystery of the flash rally leaves him in a tough spot. He wants to buy more high-yield bonds, but said he’s worried about the possibility that a Treasury-market swing could spark broader volatility, making it tough to trade the speculative-grade debt.
There truly is no alternative to those whose skill set is limited to buying (if not selling) securities: “Are you getting compensated for the risk? Uh, maybe not,” Duch, whose firm manages $13 billion, said in a telephone interview from his Bethesda, Maryland, office. “But in this yield-starved environment, it’s difficult to find other places to put your money.”
Some hope to avoid the collapse in underlying liquidity by trading synthetics, derivatives and futures, where for some reason, there is an Urban Legend that liquidity is greater:
Erik Schiller, a money manager for Prudential’s $533 billion fixed-income unit, said he’s been using futures more because they offer fast and anonymous trade execution during big market swings. “There’s the potential for these types of moves to happen,” he said. “The liquidity providers in the bond market are less now than they’ve ever been.”
Prudential Investment Management is trading more futures because they’re both liquid and anonymous. State Street Corp. is making smaller bets. And Pioneer Investments is looking for returns in higher-quality securities that are easier to sell.
Others trade ETFs which they, foolishly, believe offer more liquidity than the bonds they reference. The problem is that any assumption that a derivative is more liquidity than its underlying is absolutely wrong. Oaktree's Howard Marks explained as much last month:
[W]e’re back to wondering about whether there will be a buyer for the bonds the bank wants to short, and at what price. Thus we can’t get away from depending on the liquidity of the underlying high yield bonds. The ETF can’t be more liquid than the underlying, and we know the underlying can become highly illiquid.
Financial innovations created in good times often fool people into thinking a silver bullet has been invented that offers a better deal than traditional investments. (By “traditional” I mean investments that are acknowledged to entail increased risk as the price for targeting increased return . . . not the “miracles” where increased return comes gratis.) Many recent innovations have promised high liquidity from low-liquidity assets. As I said on page three, however, no investment vehicle should promise more liquidity than is afforded by its underlying assets. Do these recent promises represent real improvements, or merely the seeds for subsequent disappointment?
Over the course of my career I’ve seen many instances when market participants failed to do what they were supposed to do. The related financial innovations often remind me of my father’s story about the habitual gambler who finally found a sure thing: a race with only one horse. He bet all his money, but halfway around the track the horse jumped over the fence and ran away. Will ETFs prove liquid in the next crisis? And what impact will mass sales of ETFs have on the prices of underlying assets? We’ll find out.
Find out we will, and soon. Bloomberg adds that "one measure of Treasury dealers’ trading activity has fallen closer to its financial-crisis levels. Deutsche Bank AG’s index that gauges liquidity by comparing the three-month average size of dealer trades against moves in the 10-year note’s yield fell to about 25 in February. It was above 500 in 2005, and reached as low as 19 in 2009 during the depths of the financial crisis."
"If liquidity is as bad as it is now, what’s going to happen when things really get adverse?” said Richard Schlanger, who co-manages about $30 billion in bonds as vice president at Pioneer Investments in Boston.
That concern, shared very clearly by the Fed and its central bank peers, which are all now paralyzed over fears of unleashing the most terrifying "Frankenstein monster" market ever created and are perpetually unable to "renormalize" a market in which terrible economic news is great news for stocks, is why these same central bankers, huddling secretly in their bimonthly meeting in the Tower of Basel, have absolutely no ideas what to do next. Besides, perhaps, pray and act confident.