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IN a flash, the bond market went wild.
What began on Oct 15 as another sleepy day in the US Treasury market suddenly turned into the biggest jump in volatility in a quarter century, leaving investors worrying there will be turbulence ahead.
The episode exposed a collision of powerful forces - the rise of high-frequency trading and the decline of Wall Street dealers - that are reshaping the world's biggest and most important bond market. Money managers say the US$12.4 trillion Treasury market is becoming less liquid, meaning securities can no longer be traded as quickly and easily as they used to be, thanks in part to the Federal Reserve's bond-buying programme.
"The way the market is set up right now, we'll see instances like we did on that day," said Michael Lorizio, senior trader at Boston-based Manulife Asset Management US LLC, which oversees US$281 billion. "There's going to be a learning curve as to how to handle that."
The development reflects unintended consequences of new financial regulation, as well as steps the Fed has taken to breathe life into the US economy. The implications, however, extend far beyond Wall Street, because the Treasury market determines borrowing costs for governments, companies and consumers around the world.
When the day began on Oct 15, an unprecedented number of investors were betting that interest rates would rise and US government debt would lose value. The news that morning seemed ominous. Ebola was spreading. So was war in the Middle East. At 8.30am in Washington, the Commerce Department announced a decline in retail sales.
The shift came all at once. The sentiment that the Fed would raise rates reversed. Traders who'd bet against, or shorted, Treasury bonds had to buy as many as they could as quickly as they could to limit their losses. By 9.38am, 10-year Treasury yields plunged 0.34 percentage point, the most in five years.
Analysts such as Jim Bianco, president of Bianco Research LLC in Chicago, blame the herd mentality of electronic traders. "A lot of these guys are focused on speed," Mr Bianco said. "They're all uncreative and write the same program. When the stimulus comes in a certain way, every one of them comes to the same conclusion at exactly the same moment."
The influence of high-frequency traders in the Treasury market is growing. About 60 per cent of Treasury securities trades are expected to be transacted on electronic platforms by the end of next year, an increase from 40 per cent in 2013, according to Tabb Group LLC, a New York-based research firm. Of those trades, 10 per cent were executed by robots in 2010, a share that will probably grow to 20 per cent next year, according to Tabb. "As the markets become more electronic, they become more volatile," said Larry Tabb, Tabb's chief executive officer. "It's the new normal."
At least one electronic trader, Charles Comiskey, the head Treasury dealer at Bank of Nova Scotia, said that he unplugged his computer for half an hour during the height of the frenzy. That may help explain why yields plummeted so fast without sellers to stem the fall. It may also explain why an unprecedented US$946 billion of US government debt ended up changing hands on ICAP's BrokerTec trading platform on Oct 15, breaking the record by 43 per cent. Once sellers stepped in and the plunge was arrested, there was plenty of liquidity.
Bloomberg LP, the parent company of Bloomberg News, competes with BrokerTec and other bond-trading platforms.
New rules adopted after the 2008 credit crunch are also part of the new normal. Global guidelines called Basel III, instituted by the Bank for International Settlements in Basel, Switzerland, require banks to hold more cash in reserve for assets such as bonds they keep on their balance sheets.
Partly in compliance with the regulations, the 22 primary dealers authorised to trade directly with the Fed reduced their US government debt holdings to US$46.3 billion at the end of October from a record high US$146 billion in October 2013, Fed data show. While they still hold inventory, they're allocating less to opportunistically buying big clumps of bonds and then slowly selling them, a process known as market-making.
Hedge funds have filled the vacuum created by the retreat of the big banks. On the morning of Oct 15, the turmoil in Treasuries echoed in the trading of junk bonds. As US$8 billion was being wiped out in that global market, Toronto hedge-fund manager Philip Mesman fielded e-mails from US bankers clamouring for him to buy their customers' holdings.
Investors were unloading the debt of the riskiest companies, forcing exchange-traded funds and mutual funds to sell. Before Basel III and the Volcker Rule, which limits the ability of US banks to trade on their own accounts, dealers would've bought the bonds themselves and held them until they found someone to take them. Instead, they were forwarding the "sell" messages to firms they knew had quick access to cash.
"In the old days, the dealers could carry inventory and it acted like a shock absorber," said David Breazzano, who manages US$8.2 billion in high-yield bonds and loans as Waltham, Massachusetts-based DDJ Capital Management LLC's chief investment officer. New regulations create "opportunities for other institutions to fill the gap", he said.
One result is a narrowing of the market. Average daily turnover in the US bond market shrank to US$809 billion last year from US$1.04 trillion in 2008, according to Securities Industry & Financial Markets Association data.
The Fed has bought so many bonds - US$3.5 trillion worth since 2008, including US$1.86 trillion of Treasuries - that big individual trades matter more now. The amount of US debt available to trade at one time without moving prices as at October has plunged 48 per cent to US$150 million since April, according to JPMorgan Chase & Co.
That phenomenon hasn't been confined to the US. The size of German bund futures that can go through the market at one time without moving the price has fallen 46 per cent to 784 contracts as at Oct 17, from this year's peak of 1,450 contracts in April, according to JPMorgan. The average over the past four years was 920 contracts.
Regulators are searching for an explanation. The Federal Reserve Bank of New York's Treasury Market Practices Group, a gathering of finance executives and New York Fed officials, met on Oct 16. It identified "possible drivers" of what happened as changes in the direction of trades by investors with a lot of borrowed money - "repositioning by leveraged investors" is how they put it - algorithm-driven robot traders and the regulatory restrictions that limit the participation of big banks, according to minutes of the meeting. "Members concluded that more time would be needed to fully understand the day's events," the minutes said.
Timothy Massad, chairman of the Commodity Futures Trading Commission, which oversees the Treasury futures market, told reporters in Chicago on Nov 5 that his agency "took a look at" the price fluctuations of Oct 15. "Basically we didn't see any break in liquidity," Mr Massad said. "I think it was just a high volume day. But let me just add that's based on our preliminary look. New evidence might come to our attention that suggests otherwise."
CME Group Inc, the Chicago-based derivatives exchange, saw record trading that day with 39.6 million contracts changing hands, including all-time highs for interest-rate futures and options at US25.1 million. Terrence Duffy, CME's executive chairman, said that one of the most active days in the history of futures trading went off without a hitch.
The US Securities and Exchange Commission is pushing mutual funds to test whether they could satisfy customer redemptions during periods of financial stress, said people with knowledge of the plans.
The Treasury Department heard concerns about high-frequency firms in fixed-income at a November 2013 meeting of the Treasury Borrowing Advisory Committee, a group of executives who represent banks and investment funds.
Members "suggested that the liquidity provided in the market through electronic trading was small on a relative basis and unlikely to persist during periods of market turbulence", according to the minutes of the meeting.
In certain markets, "there's a facade of liquidity", said Jon Duensing, a money manager at Amundi Smith Breeden, the US unit of the French asset-manager Amundi that oversees about US$1 trillion. "It's possible that the mechanisms that investors thought were in place to facilitate capital flow may break down." BLOOMBERG