U.S. Treasury Market

The United States Treasury market is generally considered the world’s second most efficient financial market (after foreign exchange). As the chairman of the SEC put it, “Treasury markets today exhibit an extraordinary combination of high liquidity and low transaction costs.” While the current system does handle many simple Treasury trades very efficiently, many large ones arising from transactions in other markets are subjected to significant costs because of dealer front-running, market manipulation, and gouging. These practices are well known to most experienced market participants, but as I have not seen them publicly discussed or acted upon by regulators I would like to try to describe both their general characteristics and some market data I recorded to illustrate their application in specific transactions. I will conclude with a few thoughts on how these practices could be reduced in the Treasury market and an extrapolation to other financial markets.

By all appearances, the Treasury market approaches the requirements of economists’ perfect competition in perfect markets: price-takers (the market has hundreds of participants contributing to liquidity) executing costless transactions (the bid-offer spread averages about one-quarter of a basis point, customers pay no commissions to trade with dealers, and dealers pay less than $10 per million to trade with interdealer brokers [IDBs]) in perfect communication (live bid, offer, and traded prices are available through Telerate, Reuters, and Bloomberg), thus achieving instantaneous equilibrium (screens go blank for only a few seconds after major news releases). An experienced money manager seeking to buy or sell a small to moderate amount of a benchmark Treasury (the most recently auctioned bill, note, or bond for a given maturity) can pick up one of his direct wires to primary dealers and, within a few seconds, usually execute a trade off of the same offers or bids he observes on the live pages of Cantor Fitzgerald (the largest Treasury broker) or GovPX (a display-only composite of the best prices at the other IDBs). If he does not like the prices he gets by calling one dealer, he can put several in competition on each trade.

Large trades carry the potential for front-running, though it should more accurately be called “simul-running,” because of the speed of benchmark trades (some traders increase their lead-time by hitting bids [selling] or lifting offers [buying] in the brokers’ screens as soon as a customer’s direct wire flashes based on an educated guess—frequently obvious—as to which way he is going). Competition on large trades may bring more than razor-fine markets. Traders usually do not like to miss on these inquiries because large market shares require hitting on them. So every time a customer buys a block by putting four dealers in competition, three traders have an interest in the market quickly moving against the winning dealer in order to caution other dealers against aggressive pricing on future trades and show their own firms’ trading managers and salespeople that it was a good miss (knowing when and how to miss, preferably gracefully, is an essential skill for a market maker). If the purchase is large enough and the market is well bid, one or more of the losing traders may attempt to push it up, pressuring the winning dealer to cover his sale at a loss. Some customers try to police such “back-running” since it leads to inferior pricing, but it is even harder to detect and deter than front-running.
If he decides that policing his dealers is more trouble than the information and liquidity (and entertainment) they provide is worth, he can open an account with Cantor (the other IDBs restrict who may trade with them) and bypass dealers whenever he chooses. There is a problem with this tactic: at any given moment other IDBs may have a better or collectively deeper (good for more size) bid or offer than Cantor.

The market for non-benchmark (off-the-run or OTR) Treasuries is only slightly more difficult for customers to navigate. OTRs trade on yield spreads to adjacent benchmark Treasuries. Most IDBs display active, and frequently very tight (approximately two-tenths of a basis point) dealer markets in swap boxes. However, these spread markets are displayed in price terms versus a fixed price for the appropriate benchmark (updated when the outright market moves significantly) and therefore do not appear in GovPX, preventing customers from seeing live markets in OTRs. Cantor, whose screens are directly visible by non-dealers, has periodically attempted posting outright OTR prices derived from swap spreads but has had limited success because dealers (still Cantor’s dominant customers) are reluctant to give Cantor the necessary spread markets and quick to protest outright OTR markets based on others’ spread markets.

While GovPX does display continuously updated estimates of OTR bids and offers corresponding to current market levels of the appropriate benchmarks, this is a poor substitute for the live price-action seen by dealers on the individual IDB screens. (The same complaint applies, to a lesser extent, for benchmark Treasuries: GovPX shows that a 100-19 bid for the ten-year was hit; it does not show whether all the 100-19 bids were hit. This can be a meaningful distinction.) Consider the customer trying to determine if his request for a bid on a block of an OTR is being front-run. Since GovPX does not display swap-box trades, the customer has no way of seeing if the trader at the first dealer he calls immediately hits the best swap-box bid for that security, yet the bids he receives from each dealer he subsequently calls (whose traders will know exactly what happened) will suffer as a result. Whether the trader at the first dealer bids the customer off of the swap-box spread he sold or off of a wider spread depends on several factors: how many of the OTR he was able to sell through the IDB at the original spread, whether he likes owning the OTR at that spread, how good a shopper he judges the customer, and whether he is under pressure from his boss to execute that customer’s inquiries or achieve broad market-share targets. If he does choose to bid off the original spread, hitting the swap-box bid may have at least reduced the probability that another dealer will match his bid. Note that the first dealer’s front-running may help non-front-running dealers by reducing the price required to win the trade. For most customers, awareness of OTR front-running depends on another dealer reporting swap-box activity to them. However, since customers have no way to prove which dealer (or dealers, for more than one may trade ahead of a customer on a given inquiry) is guilty, attempts at disciplining dealers are necessarily imprecise.

Despite these problems, the experienced money manager who follows OTR spreads continually, not just when he needs to trade them, does not telegraph his intentions, and uses dealers intelligently can buy or sell OTR Treasuries on very tight markets. Indeed, many traders grumble that they are required to provide favored customers with more liquidity than they themselves receive from other dealers through the IDBs. (They also point out that dealers are not the only ones to employ questionable tactics: some customers simultaneously execute identical large trades with several dealers, virtually guaranteeing that the market quickly moves against them.)



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