Treasury Market Liquidity: An Overview

Treasury Market Liquidity: An Overview Tobias Adrian

3rd U.S. Treasury Roundtable on Treasury Markets and Debt Management & 13th International Monetary Fund Public Debt Management Forum "Managing Liquidity of Government Debt" June 19-20, 2013

The views expressed in this presentation are those of the author and do not necessarily represent the views of the Federal Reserve Bank of New York of the Federal Reserve System

Outline

1. Treasury Market and Funding Liquidity Measures 2. Market Illiquidity Events 3. Pricing of Liquidity 4. Supply Effects 5. Trading Technology

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Treasury Market and Funding Liquidity

Market liquidity (see O'Hara 1997, Fleming EPR 2003) 1. Trading volume, trading frequency 2. Bid-ask spread, quote size, trade size 3. Depth, price impact

Funding liquidity (Brunnermeier Pedersen RFS 2009, Vayanos Vila 2009, Fleming Rosenberg 2008, Adrian Fleming 2005) 1. Balance sheet capacity of dealers 2. Balance sheet capacity of arbitrageurs

Market liquidity and funding liquidity are mutually reinforcing Supply shocks affect both

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Trading Volume

Daily Trading Volume

Dollars (billions) 70

Dollars (billions) 70

60

60

Two year

50

50

Five year

40

40

30

30

20

Ten year

20

10

10

0

0

2006

2007

2008

2009

2010

2011

Source: Engle, Fleming, Ghysels, and Nguyen (2013)

Note: 3-month moving average.

Trading volume of Treasury securities increased sharply at the beginning of the crisis (August 2007-March 2008), and then declined sharply for the rest of 2008.

While the five year and ten year bonds have seen an increase in volume since the beginning of 2009, the two year's trading volume has kept declining.

The decline of trading in the two year maturity likely reflects the sustained low level of short-term interest rates.

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Bid-Ask Spreads

Bid-Ask Spreads

32nds 1

0.9

0.8

Ten year

0.7

0.6

0.5

0.4

Five year

0.3

0.2

Two year

0.1

0

2006

2007

2008

2009

2010

Source: Engle, Fleming, Ghysels, and Nguyen (2013)

Note: 3-month moving average.

Bid-ask spreads are computed

from the trading book as the

difference between the best bid

32nds 1

and ask.

0.9

0.8 Bid-ask spreads increased

0.7

dramatically during the financial

0.6

crisis, despite the sharp

0.5

increase in volume.

0.4

0.3 The increase in bid-ask

0.2

spreads reflect uncertainty at

0.1

that time, as well as the

0

reduced balance sheet

2011

capacity of dealers.

Bid-ask spreads have reverted back to pre-crisis levels since then.

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Market Depth

Quoted Depth in the Book Across All Price Levels

Dollars (billions)

Dollars (billions)

4.5

4.5

4

4

3.5

3.5

3

3

2.5

2

Ten year

1.5

1

Two year

Five year

2.5 2

1.5

1

0.5

0.5

0

2006

2007

2008

2009

2010

Source: Engle, Fleming, Ghysels, and Nguyen (2013)

Note: 3-month moving average.

2011

0

Market depth measures the amount that can be traded at a given moment in time as indicated by the trading book.

The measure reported here aggregates the bid and the ask depth across the book and averages across the two.

Market depth declined dramatically during the financial crisis, and has not fully recovered since.

The decline of market depth might reflect dealers' diminished market making capacity since the crisis.

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Dealer Inventories

Primary Dealer Net Outright Positions: US Gov't Securities

Dollars (billions)

Dollars (billions)

125

June 3, 2009

125

75

Sept 17, 2008

75

Aug 8, 2007

25

25

-25

-25

-75

-75

-125

-125

-175

-175

-225 1994

1997

2000

Source: Federal Reserve

2003

2006

2009

-225 2012

Primary dealer net outright positions in U.S. government securities exhibit a sharp reversal since the beginning of the crisis.

Dealers used to be long corporates, agencies, MBS/ABS, and short Treasuries.

This spread trade got unwound with the crisis.

Since the end of the crisis, dealers have been long Treasuries.

Overall size of dealers has declined markedly.

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Fixed Income Hedge Fund AUM

Hedge Fund Assets Under Management

Dollars (billions) 700

600

Relative Value

500

400

Dollars (billions) 700

600

500 400

Fixed income arbitrage is a classic investment strategy that is a textbook case for the economics of "limits to arbitrage."

The most basic strategy is to bet that deviations from a Treasury valuation model are temporary, i.e. betting on convergence.

300

Fixed Income Value

200

100

0 2002

2004

2006

Source: Hedge Fund Research

2008

2010

300

200

100

0 2012

In times of market turbulence, as some arbitrageurs are forced to unwind, temporary losses can spread across desks and funds, as was arguably the case in 1998 and 2008.

Among relative value strategies, fixed income arbitrage has lost AUM recently.

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