Are Wall Street banks holding back advances in the structure of the $14 trillion U.S. Treasury market to preserve the status quo — and their trading profits?

Yes, say Employees Retirement System of Rhode Island, City of Atlanta Firefighters’ Pension Fund, American Federation of Teachers, Cleveland Bakers and Teamsters Pension Fund, Oklahoma Police Pension and Retirement System, and more than a dozen other institutional asset owners who manage the money of ‘mom-and-pop’ investors. Their allegations are detailed in a 186-page class-action lawsuit filed last month in Manhattan federal court.

The asset owners allege that some of the biggest Wall Street banks, including Barclays, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan, Morgan Stanley, and UBS colluded to rig prices in Treasury auctions, and/or conspired to unfairly wall off competition from rival trading platforms in the secondary market for Treasuries.

The end result, according to the suit (case number 1:15-md-02673), is that profit-seeking brokers have kept asset owners’ trading costs artificially high.

Regarding auctions, the complaint says “the primary dealers (the big banks) have a long and infamous history of building and exploiting inside-information advantages,” and the firms continue to use shared inside information to rig results.

In secondary markets, seven of the biggest banks “exploit the market power they have as the dominant sellers of Treasuries in the secondary market to block technological innovation at the expense of investors,” the suit alleges. The firms “have done so by boycotting any new or existing electronic trading venue that plans to launch an anonymous, ‘all-to-all’ platform—a platform on which all market participants could execute trades.”

The complainants note that while the liquidity and standardization of Treasuries are ideal for all-to-all trading, the market instead is bifurcated. The wholesale dealer-to-dealer segment offers state-of-the-art electronic trading, with best bids and offers displayed, but buy-side participants trade with dealers in a less efficient, voice-based system.

“Being compelled to use this archaic protocol deprives the buy-side firm of access to the best available quotes in the market,” the suit alleges. “Prices that are transparent in the D2D segment are opaque to buy-side investors in the D2C segment.”

Entities named in the lawsuit declined to comment to Markets Media, as did Sifma, the industry group that represents broker-dealers and banks. “It is SIFMA’s longstanding policy that we do not comment on litigation involving our members,” spokesperson Katrina Cavalli said.

“This is an important, and dangerous, case for the banks,” said Roy Smith, emeritus professor of management practice at NYU’s Stern School of Business and previously a Goldman Sachs general partner.

“It may be hard to prove that actual rigging took place, i.e. that market prices were changed because of it, but that’s not really the question,” Smith said. “Did supervised employees participate knowingly in a scheme that attempted to rig the Treasury bidding process? I don’t know what happened in the chat rooms, but if traders thought they were pulling something off — even if they thought it might not have been illegal — they will get slammed, and their employers will be stuck with failure to supervise.”

It’s notable that the largest buy-side institutions, such as BlackRock, State Street, and Vanguard, are not complainants in the lawsuit. That could be reflective of the longstanding ‘clubby’ nature of the Treasury market, in which the largest buyers get the best terms from the largest sellers, but smaller market participants need to work to get a fair deal.

Ensconced World

“Top-tier dealers offering favored pricing to top-tier, high-volume, real-money accounts is nothing new,” said Susan Estes, co-founder and CEO of OpenDoor Trading, which eight months ago launched a trading platform for off-the-run Treasuries. “That world is pretty well-ensconced.”

Off-the-runs, which are all Treasuries other than those most recently issued, are less liquid, less electronic, and costlier to trade, especially for smaller market participants. A recent Greenwich Associates report stated that “the largest players in this market continue to receive preferred pricing,” and only 37% of firms that trade low volumes believe the OFTR market is transparent.

In the Treasury market overall, “there is definitely a lack of incentive for banks to be trading electronically, as they can better protect price information over the phone,” said Kevin McPartland, head of market structure and technology research at Greenwich Associates.

However, McPartland noted that electronic trading in Treasuries has increased organically over the years to more than half of overall volume, an aggregate data point that potentially undercuts the lawsuit’s contention that banks control the market. He also said it’s not necessarily unfair for smaller buyers to not get the same pricing as larger buyers, just as it’s not unfair that Walmart’s price per cereal box purchased is much lower than an individual’s would be – high revenue clients often get the best deal.

“The argument has been that more electronic trading would level the playing field and prices would improve for everybody, but then when you talk to liquidity providers, they’ll say they’re not able to offer as good pricing when they don’t have an OTC counterparty and they don’t know who they’re trading with,” McPartland said. “There are markets where this is true, and there are markets where this matters less. Finding the in-between is the ultimate goal.”

Regarding the lawsuit, complainants face a long road, as the next steps are having the case stand up on appeal, and then moving to discovery. “As a class action, it starts slowly to build a case and get it admitted for a trial,” said NYU’s Smith. “Then the aim is to achieve a settlement, probably a big one,” he said, adding that the outlook for the banks worsens if federal prosecutors get interested.

The litigation “is certainly something to watch, and if nothing else it will reinvigorate the conversation about how electronic trading works,” McPartland said. “It’s positive that people are paying attention to how these markets operate. Ultimately these conversations can advance market structure and help us rethink the way markets work, rather than just having people continue to do things the way they’re doing them just because they’ve always done them that way.”