Part 1 of a 2-part series

The Fed and the Treasury describe the U.S. Treasury market as, “the deepest and most liquid government securities market in the world.” While arguably true for the six on-the-run (OTR) benchmark securities, those six securities make up less than 2% of the total $13.4 trillion of total outstanding supply. It is the other 98%, known as off-the-runs (OFTRs) that should be of greater concern to market participants and policy-makers alike.

The Treasury market has undergone a significant structural change post-crisis. As a result, the market is severely bifurcated between OTR and OFTR securities. They trade differently (fully automated vs. over-the-counter voice or RFQ). They also have different visibility in the market (live continuous OTRs vs. opaque non-live and not-held markets in OFTRs). But the most overlooked difference may be the market participants themselves. OTR and OFTR securities have different market constituencies: principal trading firms (PTFs) and high volume prop shops in the benchmark issues versus “real money” end-investors, such as foreign central banks, pension funds, mutual funds, insurance companies and banking institutions, in the OFTRs.

As a result, OTRs are now make up 68.5% of total daily volume while OFTR volumes have declined by over 21% just in the past 20 months. This change in market structure has major implications for the U.S. Treasury, the Fed, investors who are long-term holders of its debt, and more importantly, for the array of financial instruments globally that rely on the market as the key risk-free benchmark reference rate against which these securities are traded.

Data Problem

In recent blog posts, the Fed and the Treasury note the marked difference in data available for OTRs and OFTRs. OTRs have an overload of TIC data available through the inter-dealer broker market, and it is this data that is largely used by Fed and Treasury officials to conclude that overall market liquidity is not suffering.  But for liquidity comparison, the Treasury relies on a measure called the g-spread for OFTRs.

As the Treasury states in its most recent blog, “Examining Liquidity in On-the-Run and Off-the-Run Treasury Securities,” the g-spread is, “the measure of the discount in the price of an (OFTR) Treasury security versus a hypothetical (OTR) Treasury security of the same remaining maturity and coupon.” This is great for textbook learning, but is this measure appropriate for 98% of the marketplace when the data set from which it is derived is flawed?

In another blog post, A Deeper Look at Liquidity Conditions in the Treasury Market, the Treasury concludes – as does the Fed – that there is little compelling evidence of a broad-based deterioration of liquidity using traditional metrics. But its findings were based on “trading in on-the-run securities in the inter-dealer market —and thus does not account for trading conditions in off-the-runs, which are traditionally less liquid.” This disclaimer means that the Treasury came to its conclusions without considering the 98% of total outstanding supply that resides in the hands of real money investors.

Real money investors are often the long-term holders of OFTRs, but there is no guarantee their holding period will be indefinite. This matters because when there is a shift in monetary policy, an uptick in inflation, a macroeconomic development, a large bankruptcy or other systemic event, these investors will look to sell OFTRs into an illiquid market that barely trades. That is a recipe for dysfunction, for which the consequences would be severe across many markets.

To complicate matters, PTFs – which dominate the trading of OTRs yet play no official role in underwriting or distributing government debt – can (according to Liberty Street Economics, a blog published by the New York Federal Reserve) create a “liquidity mirage”, which makes it challenging for large investors to accurately assess available liquidity.

High Stakes

The changing ecosystem in the U.S. Treasury market is a big deal. The recent history of collateralized debt obligations (CDOs) serves as a case in point. In the movie of Michael Lewis’ book The Big Short, Selena Gomez’s original $10 million-dollar wager on her blackjack hand was the proxy for the original CDO. The bet then made on her hand by someone not sitting at the table, illustrated the creation of the first synthetic CDO.  A subsequent bet on that bet created the second synthetic CDO and so on. In this way, a single $10 million CDO placed in 2006 could be leveraged into billion dollar bets on the fate of the U.S. housing market.

We all know what happened next. Despite the plethora of information available, the majority of market participants and policy makers were unwilling to accept that it could all go terribly wrong.

This is especially concerning given that the $75 billion CDO cash market was a fraction of the size of the government bond market and was not the reference rate for anything. As a result, the stakes for protecting this market are far greater.

The Loudest Voices

PTFs do not operate totally under the radar. Last fall, a collective gasp was heard outside of Chicago when Risk.net leaked a confidential list of BrokerTec’s top 10 firms in U.S. Treasuries; it only included two traditional dealers.

On the other hand, according to SIFMA, pension funds that manage the retirement accounts for many government workers hold over $2.2 trillion in Treasury debt, mutual funds hold another $1.2 trillion and foreign central banks hold in excess of $6 trillion. These are the investors who have collectively underwritten the majority of the U.S. Treasury’s debt over the last three decades. Shouldn’t their desire for a fully functioning yield curve (which includes a liquid market for OFTRs) be given more consideration that a hypothetical depth of market brush off like the g-spread?

So why is the voice that actively trades the 2% is being so loudly trumpeted over the voice of those invested in the forgotten 98%?

The PTF community, while small by comparison, is well organized, well capitalized and has so far remained largely immune to the regulatory changes impacting the rest of the fixed income community. Not surprisingly, due to the compliance crackdown, primary dealers are nowhere to be heard, certainly not on record. Real money accounts have been more willing to speak, but they too lack a collective voice. Even prior to the economic crisis, these holders acted independently due to their competitive nature. Lastly, foreign central banks act in their own interest to manage their foreign currency reserve flows and prefer direct conversations with the U.S. Treasury over quotes in the press.

Without a collective voice, the real life examples of illiquidity in the OFTR market are more easily swept under the rug. I was recently invited into visit a large bank’s asset management group. Various portfolio managers felt very comfortable telling me (in the privacy of their conference room) that the liquidity drought in OFTRs was so severe that it was difficult to execute a duration neutral trade in triple-old OFTR 5’s to OTR 5’s of greater than $150 million for less than 2/32nds (pre-crisis, that same trade could be executed in the billions for less than 1/32). Yet, if the press reached out to them, they were prohibited from speaking on this (or most related topics) by their firm.

Unfortunately, both policy makers and academics tend to dismiss real-life examples as anecdotal, but it may be time to push that bias aside. Last month I was told by one very large central bank that “trading OFTRs in the U.S. market is like trading third world debt.” He was uniquely qualified to know since his country was once considered third world. He had also just tried and failed to sell $500 million of bills to one of the world’s largest dealers. Why? The dealer was unwilling to bid any price for the securities. This was a straightforward trade a few years ago. Anecdotal? I would like to believe that if I was standing in sub-zero temperatures and saw my fingers turning black, I would not need a physician to tell me that I have frostbite.

It is time to take a fresh look at the forgotten 98%.

Susan Estes is CEO of OpenDoor Trading LLC, a Jersey City, N.J.-based provider of an all-to-all electronic marketplace for off-the-run U.S. Treasury securities and TIPS. Over her 25+ year career in U.S. fixed income markets, she previously ran several top-tier trading operations and served as a member of the Treasury Borrowing Advisory Committee (TBAC) under both Greenspan and Bernanke.