America's Most Important Slidedeck

Every quarter as part of its refunding announcement, the Office of Debt Management together with the all important Treasury Borrowing Advisory Committee, which as noted previously is basically Wall Street's conduit telling the Treasury what to do, releases its Fiscal Quarterly Report which is for all intents and purposes the most important presentation of any 3 month period, containing not only 70 slides worth of critical charts about the fiscal status of the country, America's debt issuance, its funding needs, the structure of the Treasury portfolio, but more importantly what future debt supply and demand needs look like, as well as various sundry topics which will shape the debate between Wall Street and Treasury execs for the next 3 months: some of the fascinating topics touched upon are fixed income ETFs, algo trading in Treasurys, and finally the implications of High Frequency trading - a topic which has finally made it to the highest levels of executive discussion. It is presented in its entirety below (in a non-click bait fashion as we respect readers' intelligence), although we find the following statement absolutely priceless: "Anticipation of central bank behavior has become a significant driver of market sentiment." This is coming from the banks and Treasury. Q.E.D.

Some highlights specifically from the TBAC component of the presentation.

First, the TBAC discusses key changes to the Fixed Income markets over the past few years:

  1. Reduced liquidity of spread product
    • Likely a consequence of investor risk aversion and regulatory reform. Treasuries remain liquid
  2. Prevalence of “risk on / risk off” mentality
    • Extreme valuations, correlations rising, excess returns becoming more volatile
  3. Role of government
    • Extraordinary monetary policy (ZIRP, balance sheet growth, communication/transparency)
    • Regulatory reform
  4. Changes in market participant behavior
    • Cyclical (risk tolerance) and secular (demographics / LDI strategies), customized solutions
  5. Growing role of electronic trading
    • Driven by increased efficiency and regulatory reform

Supporting visual data:

And what matters for bond traders everywhere: Implications of Reduced Corporate Bond Liquidity, which are mostly the lobby group's efforts to neutralize the Volcker Rule:

  • A reduction in liquidity / wider bid-offer spreads has both an upfront cost to existing investors (who have to mark their existing holdings at wider levels) as well as an ongoing cost for issuers and investors
    • Per a recent study, a strict implementation of the Volcker Rule for the corporate bond market may cost $90-315bn upfront plus $12-43bn/yr for issuers and $1-4bn/yr for investors in future transactions
    • Analysis by Barclays** indicates that the liquidity premium has risen from ~20bps in Jan ’07 to ~40bps in Mar ’12
  • Policy makers should carefully consider the impact on market liquidity when introducing new financial regulations, such as the Volcker Rule
    • SIFMA, the Credit Roundtable (a group of large fixed income money managers), and other market participants have submitted comments on this topic
    • Given the size of the bond markets, it would be difficult, if not impossible, for the banking sector to reintermediate the capital markets (replacing bonds with loans) in response to a prolonged market dislocation

The TBAC then goes on to point out what we have been demonstrating for, oh, about 3 years: the surging role of governments in the setting of monetary policy, with the kicker statement as follows: "Anticipation of central bank behavior has become a significant driver of market sentiment" - BINGO.

  • Global central banks have taken extraordinary actions in response to the financial crisis
    • Monetar polic rates cut to near zero
    • Balance sheet expansion and composition
    • Federal Reserve’s communication strategy / level of transparency
  • Interest on Excess Reserves
  • Anticipation of central bank behavior has become a significant driver of market sentiment
  • Exit strategy uncertain

The bolded bullet point and the above chart are probably the most important data points in the entire slidedeck: it appears that everyone is now finally realizing just how critical central planning is in maintaining price stability.

There is much more on regulatory reform, on OTC market reform,  where we read the hilarious gross is not net argument once again: "Gross notional outstanding exceeds $700trn, but is a poor measure of risk posed to the financial system"... "Gross credit exposure, a more accurate assessment of risk, is ~$3trn"... right, until the dominos start falling and gross IS net.

Then the TBAC pulls some really great humor out of its sleeve, when discussing CDS clearinghouses - keep in mind the source are the same banks whose only real source of revenue is trading CDS in house, and not on a clearinghouse. Does anyone actually believe Goldman and JPM would agree to a clearinghouse idea? We didn't think so. Yet that JPM accusses clearinghouses of being TBTF and increasing moral hazard is just... priceless.

  • Implications of central clearing
    • Clearinghouses are likely too-big-to-fail
    • Moral hazard could be substantial, depending on structure
      • Profits accrue to shareholders, while losses are borne by clearing members
      • Competition among clearinghouses could lead to degradation of standards
      • Regulators should consider setting minimum margin and shareholder equity requirements to ensure incentives are aligned
    • Collateral posting requirements could trigger a liquidity squeeze during a market panic
      • A recent BIS study found that although major derivatives dealers likely have sufficient unencumbered assets to meet initial margin requirements, dealers could face large variation margin calls (a 1-in-200 day event could require ~$60bn in collateral posting by the 14 largest dealers)

Continuing, the TBAC presents visually how it sees debt supply and demand mechanics:


  • Supply
    • Positive net new issuance (new issuance > redemptions) from US govt. and corporations
    • Negative net new issuance of securitized products (especially non-agency MBS)

  • Demand
    • Mutual Funds and ETFs – Significant inflows into fixed income funds
    • Money Market Funds – Assets stabilizing, prime funds continue to move up in quality
    • Corporate Defined Benefit Plans – Shifting into fixed income, particularly long-duration assets
    • Rest of World – Buying treasuries, GSE holdings declining
    • Federal Reserve – Acquired treasuries, agency bonds, and agency MBS via QE
    • Growth of customized and non-traditional solutions – Global, credit-focused, unconstrained
    • Movement from active to passive equity strategies

Then the TBAC take a detour into threetopics it has hardly discussed previously.

First: ETFs

  • While still small relative to fixed income mutual funds, fixed income ETFs have grown quickly over the past few years
    • ~$4bn AUM as of 12/31/2002, ~$21bn as of 12/31/2005, and ~$184bn as of 12/31/2011
  • High Yield ETFs have grown especially fast and now hold over 3% of outstanding HY bonds, while High Grade ETFs hold ~1% of outstanding bonds
  • High Yield ETF fund flows have begun to exert technical forces on the bond market, with benchmark-eligible bonds outperforming non-benchmark bonds during periods of HY ETF inflows (and vice versa)

Then, electronic trading in the Treasury Market, where we learn that "~45% of ICAP's 2009 trading volume in Treasuries was executed via algorithms"

  • The treasury market is characterized by high turnover and strong liquidity
    • $140 trillion of trading volume reported by primary dealers in
    • This equates to turnover of over 14x the outstanding volume
  • Dealer-Dealer Trades
    • Interdealer trades are the largest segment of the market
    • The vast majority of interdealer trades of on-the-run treasuries occur electronically, while off-the-run treasuries generally trade via voice
    • any interdealer trades are executed with the assistance of computer algorithms, which break large orders into smaller pieces or automatically execute trades to hedge trading-book risks
      • ICAP Plc, the largest interdealer broker and whose electronic platform accounts for ~25% of all Treasury trading volume, reported that ~45% of their 2009 trading volume in Treasuries was executed via algorithms
  • Customer-Dealer Trades
    • Electronic trading continues to increase in prevalence
    • Customers can trade electronically with a variety of banks via Tradeweb and Bloomberg
    • Prices for smaller-sized electronic trades can be automatically quoted via dealer algorithms
    • Voice trading remains the only option for large trades

Then the TBAC goes on to discuss the implications of Electronic Trading in Derivatives, as well as for the first time formally bashing High Frequency Trading:

  • The mandated shift of derivatives from the OTC market to exchanges or Swap Execution Facilities represents a significant change to market structure
  • It is possible that trading dynamics of derivatives in the future will begin to resemble the equity or FX markets of today
    • Higher volumes and lower bid-offer spreads
    • Significant shift toward electronic trading
    • Increased use of computer algorithms by (1) banks and high-frequency traders to automatically quote prices and (2) investors to source liquidity / seek best execution
  • This change is not without risks
    • Shifting from voice to electronic trading introduces “fat finger” risk
      • For instance, in 2002, the Dow dropped 100 points when a Bear Stearns trader accidentally entered a sell order for $4bn, rather than $4mm.
    • The use of algorithms to implement trades can have adverse consequences
      • The CFTC-SEC study of the 2010 “Flash Crash” concluded that a mutual fund who tried to sell ~$4bn of E-Mini S&P 500 futures contracts via an algorithm was a contributor to the crash. The sell algorithm was set to target 9% of trading volume over the previous minute (without regard to price or time).
    • High frequency trading may become more prevalent
      • Analyses of the impact of high frequency traders (HFTs) reach mixed conclusions
      • HFTs generally enhance market liquidity. However, it has been observed that some (but not all) HFTs withdraw liquidity from the market during periods of stress, possibly leading to price volatility

Finally, here is what the TBAC and the Treasury will be focusing on in the future. We bring your attention specifically to bullet 4 and last- the treasury is now focusing on what happens to systemic threats if banks keep on losing money...

There are several market structure developments that we believe warrant further analysis.

  1. Impact of pending regulations on credit availability / liquidity
    • Is secondary market liquidity (outside of the treasury sector) permanently impaired?
    • Will the securitization market (particularly non-agency MBS , CMBS, and ABS) be a viable source of term funding going forward?
    • Will the flow of credit to “Main Street” be adversely affected?
  2. Clearinghouses
    • Are we putting all of our eggs in too few baskets?
    • Are incentive structures aligned to promote market stability?
  3. Movement of derivatives trading from OTC to exchanges / Swap Execution Facilities
    • What will the new derivatives market look like? How will the mix of investors change?
    • Will appropriate safeguards (i.e. pre, during, and post trade controls) be in place?
    • Will the likely rise in cost / decrease in liquidity of non-standardized derivatives adversely affect end users with legitimate hedging needs?
  4. Systemic threats posed by reduced banking sector profitability
    • If regulatory reform reduces the ability of banks to cover their cost of capital, what new activities will they undertake? What will be the consequences?

All in all fascinating stuff.

Full presentation: