September 27, 2006
HP-118
Remarks of Deputy Assistant Secretary for Federal Finance
James Clouse
U.S. Department of the Treasury
Before the Bond Market Association,
Government Securities and Funding Division
New York City, NY - Thank you very much. It is a great pleasure for me to be here today to address this distinguished audience. Before turning to my prepared remarks, let me just take a moment first to thank the Bond Market Association for organizing this event and second to thank all of you for taking time out of your busy schedules to be here today.
I would like to take this opportunity to elaborate on one of the themes that Under Secretary Quarles raised in his speech before the annual meeting of the Bond Market Association in May--in particular, the recent developments in the secondary market for U.S. Treasury securities. Over the last two years, we have witnessed an increase in trading practices in the cash, repo, and futures markets for U.S. Treasury securities that have raised questions for the U.S. Treasury and the regulatory agencies that monitor these markets. Simply put, we have observed instances in which firms appeared to gain a significant degree of control over highly sought after Treasury issues and seemed to use that market power to their advantage. In the process, prices in the cash, repo and futures markets appear to have been distorted to varying degrees.
There are a number of factors that may account for the upturn in the number of observations of questionable trading activity in the Treasury market. Trading volumes in the Treasury market over recent years have risen sharply relative to the amounts of individual Treasury issues outstanding, perhaps allowing firms to acquire a controlling position in a particular issue more readily than in the past. In addition, the financial incentives to manipulate or "squeeze" an issue have risen markedly since mid-2004. The potential gain for any would-be manipulator in the Treasury market is often a function of the degree and the duration of the "specialness" that a firm can induce for a given security. Specialness is an inelegant term often used to refer to the spread between the general collateral repo rate and the rate for a particular security in the specials repo market. In 2003 and the first half of 2004, the general collateral repo rate stood at historically low levels close to 1 percent. With a lower bound for the specials rate of essentially zero, the potential gain from squeezing an issue over this period was a rather modest 1 percentage point. Of course, the general collateral repo rate is now much higher, implying that an effective squeeze in the Treasury market can be substantially more rewarding--a fact that has not gone unnoticed in some market circles.
In some quarters, these observations meet with a certain ambivalence. Strategic behavior in the Treasury market is viewed by some as an integral part of the "game" in the Treasury market, and the potential to gain control over an issue is simply part of the reward that dealers and others reap as a return for assuming risks and making markets. Moreover, this game and its consequences are often viewed as largely contained within the universe of dealers and other sophisticated professional investors, with few if any implications for smaller investors or the economy at large.
In contrast, the Treasury and other federal regulatory agencies regard market manipulation as a serious impediment to efficient and competitive financial markets. I'm sure that the compliance professionals in this audience have similar concerns about market manipulation, and we certainly would like to enlist your help in conveying the message that manipulative or otherwise questionable trading behavior undermines the integrity of the Treasury market and can also result in quite serious consequences for the persons and the firms engaged in that behavior.
Ensuring the integrity of the Treasury market is essential. The U.S. Treasury market is the deepest and most liquid market in the world. Average daily trading volumes currently fluctuate in the neighborhood of $600 billion--many times the average daily trading volumes in the U.S. equity and corporate bond markets--and dealers operate with very thin bid-ask spreads. The liquidity and depth of the Treasury market have made it a critical national asset: It affords the U.S. government unparalleled access to funding at the lowest possible cost over time; it is the primary market employed by the Federal Reserve in conducting open market operations and implementing monetary policy; and it conveys important so-called public good benefits to investors around the globe. Active and continuous trading in the Treasury market provides market participants with real-time readings on the "risk-free" rate that, in turn, is both a key benchmark in pricing a broad array of private instruments and a cornerstone for efficient financial portfolios. Finally, the liquidity of the Treasury market has made Treasury securities the instrument of choice for many market participants in managing interest rate risk.
Of course, no one in this audience really needs to be reminded of these special attributes of Treasury securities and the Treasury market, but these basic observations provide an important backdrop for regulators' concerns about recent questionable trading practices. Manipulative or otherwise questionable trading behavior in the Treasury market has the potential to affect virtually every individual and firm in the United States and around the world that interact with credit and other financial markets in some capacity. Moreover, the extraordinary liquidity that we observe in the Treasury market involves an element of so-called network externalities--investors trade and take positions in the Treasury market, in part, because many other investors are doing so as well. This is a self-reinforcing process in which increasing numbers of potential counterparties tend to reduce trading costs, which in turn tends to draw in more investors and lead to further reductions in trading costs. These sorts of network externalities can work in reverse as well. If the integrity of the secondary market were to be compromised by manipulative trading behavior, many investors could well migrate away from Treasuries in favor of other instruments. Left unchecked, that process could impair many of the special attributes of the Treasury market and raise the Treasury's cost of borrowing over time.
These and other adverse effects of market manipulation have long been recognized as a threat to the efficient functioning of our financial system. It is no surprise then that prohibitions against market manipulation are a core element of
Generally, there is a presumption that private markets are efficient until proven otherwise. That said, the recent incidents in the Treasury market have certainly raised questions. I would emphasize, however, that I am not expressing an official view on any specific matters or on any matters that may be enforced by other regulators. Indeed, I would remind you that the SEC, not the Treasury, is charged with enforcing the anti-manipulation prohibitions in federal securities laws. And the CFTC is the relevant enforcement agency on matters pertaining to futures markets.
There is though a strong sense of history repeating itself in the recent instances of questionable trading practices. Over the last twenty years, there have been occasions in which firms have employed various tactics to first gain control over a highly sought-after Treasury issue and then to intentionally constrain the availability of the sought-after issue in the market so as to benefit their overall trading positions. In the so-called "futures squeeze," for example, a firm acquires control in the repo market or cash market over a security that is cheapest-to-deliver into a Treasury futures contract. In addition, the firm establishes a position in the futures market in which it is due to receive securities at settlement. Ordinarily, firms close out their open positions in an expiring Treasury futures contract and roll into the subsequent contract. But a firm attempting a futures squeeze instead insists on taking delivery at settlement with the intent of using its control over the cheapest-to-deliver security to force other market participants to settle their futures obligations by delivering more expensive securities. The futures squeeze is a stratagem that has been observed in a number of countries over the years. [1] In the
Another common strategy is the "repo squeeze" in which firms reverse in very large positions in highly-sought after securities in the term repo market. At the same time, they limit the availability of the security to other market participants by financing only a portion of their term repo position in the specials market. The balance of their position is financed at higher rates in tri-party repo or similar arrangements. In tri-party repo, the custodian ensures that the collateral pledged by a firm borrowing cash is immobilized and thus not available to be recirculated in the market. This is a very effective arrangement for general collateral transactions, but one might wonder why a firm would intentionally finance a large portion of a position in a scarce security in a tri-party arrangement at the general collateral rate rather than obtaining low-cost funding in the specials market. While there may be legitimate reasons for this behavior, the firm may also be engaging in a well known artifice, choosing the portions of its total position to finance in the specials market and the tri-party market so as to minimize its blended cost of funds. Essentially, this strategy can be an exercise in monopoly pricing.[2]
The market implications of these various schemes are a serious matter. As Under Secretary Quarles noted in May, the Treasury along with colleagues at the SEC, CFTC, the Federal Reserve Bank of
At this point, a word about transparency in the surveillance program is in order. Often market participants would like to have some specific parameters to help guide their risk management and compliance programs. And in the past, officials have offered some general guidance by suggesting that firms keep a close watch on the size of their position in specific issues relative to the total amount outstanding, the size of their trading volume in a particular issue relative to the total market volume in the issue, and any tendency for the specials rate for a particular security to trade at persistently low levels.[3] Concerns on the last point might be amplified still further if there are significant volumes of fails to deliver the scarce security.
These are helpful suggestions, but they are not necessarily definitive. For that reason, it may be appropriate for the risk management and compliance functions of financial firms to also focus broadly on questions that may bear on potentially manipulative practices.
For example, is the trading area able to exercise significant control over the floating supply of a scarce security in the market? The size of a firm's position in a particular security is certainly an important element in this regard. Historically, cases of market manipulation have often involved firms that have amassed very large positions in specific issues. We recognize, of course, that large positions may be quite benign. Indeed, large matched book positions can enhance market liquidity and efficiency. Conversely, it may also be worth noting that even comparatively modest positions could, in principle, become a vehicle for market manipulation. If the demand for a security is particularly inelastic, for example, even a modest constraint on supply could substantially affect market pricing.
Another fundamental question concerns whether a trading desk is intentionally exercising significant control over the floating supply of a scarce security in an effort to influence pricing in the Treasury cash, repo or futures markets. An especially important issue here may involve the means by which scarce securities are financed. In particular, it seems prudent for compliance officers to pay close attention to situations in which the trading desk is financing a significant portion of its holdings of a scarce security in tri-party repo or other arrangements that limit the availability of the security to the market. Again, reliance on tri-party financing for scarce securities is not a perfect indicator of manipulative intent; there may be legitimate reasons for a trading desk to finance a portion of its holdings of a scarce security via tri-party or similar means. However, when a trading desk continuously finances a large portion of its holdings of a scarce security in the tri-party market at a rate well above that prevailing in the specials market, compliance officers might want to review the factors that are giving rise to this funding choice. In a similar vein, it seems appropriate for compliance programs to note when Treasury trading desks are generating abnormally high profits on a position in an issue in which it is exercising significant control over the floating supply. Once again, there are many factors that can potentially explain elevated profits apart from manipulation--skill and serendipity among them. But one also has to recognize that there generally are no free lunches in a highly competitive and efficient financial market--so profits booked by a Treasury desk that are well outside the norm ought to at least trigger some measure of additional scrutiny.
Let me just close by saying that I recognize the topic that I have discussed today is an uncomfortable one in some respects. And I don't want to leave anyone with a false impression that regulators in
The role of compliance functions at financial firms is absolutely crucial in stemming potential problems before they become serious enough to warrant the attention of federal regulators. In addition, the Treasury and other regulators would very much welcome a continuing dialogue with market participants on these issues. We look forward to working cooperatively on any steps that can help safeguard the integrity and efficiency of the Treasury market--an outcome that serves all of our interests. Thank you very much.
[1] For an excellent discussion of a futures market squeeze in the U.K., see the paper by John J. Merrick Jr., Narayan Y. Naik, Pradeep K. Yadap, "Strategic Trading Behavior and Price Distortion in a Manipulated Market: Anatomy of a Squeeze," Journal of Financial Economics, 2005.
[2] See the discussion on short squeezes in Appendix B of the Joint Report on the Government Securities Market, published by the Department of the Treasury, Securities and Exchange Commission, and Board of Governors of the Federal Reserve, January 1992. See also the lucid discussion in the paper by Mark Fisher, "Special Repo Rates: An Introduction," Federal Reserve Bank of Atlanta Economic Review, second quarter of 2002, pp. 27-43.
[3] See remarks by Peter R. Fisher,