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Federal Reserve Board Chair Janet Yellen sounded at least open to the idea that new regulations have contributed to potential liquidity problems, but said more study is needed.
July 15 -
Those looking for easy answers from a government report about what caused recent volatility in the Treasury markets including whether regulation is to blame were likely disappointed.
July 13 -
Nearly five years after the passage of the Dodd-Frank Act, regulators are beginning to question whether the cumulative effect of the rules authorized by the law are hurting market liquidity and if that could pose a systemic risk.
June 12
WASHINGTON Treasury Department and Federal Reserve officials on Monday outlined several new challenges posed by the broad movement of financial markets toward high-frequency, algorithmic trading, including the risk that inexplicable "flash" events might occur.
Speaking before the Brookings Institution, Antonio Weiss, counselor to Treasury Secretary Jack Lew, said that the recent multiagency examination of the Oct. 15, 2014, spike in yields for Ten-Year Treasury bonds was largely precipitated though not necessarily caused by high-frequency, algorithmic trading. A report released last month pointed to several contributing factors to the event, but ruled out any single cause to the event.
During the 12 minutes between 9:33 and 9:45 a.m. that day, algorithmic traders employed by traditional market players, as well as newer private algorithmic trading companies, known as Principal Trading Firms reacted to relatively benign retail sales numbers, combined with a burgeoning sell-off of optimistic interest rate positions, by buying up safe Treasuries, Weiss said. That reaction rapidly grew into to a kind of feedback loop that drove up yields to extraordinary heights before human traders could react.
"A large part of the story of what happened between 9:33 and 9:45 a.m. appears to turn on the interaction at very high speeds of complex algorithms that generate massive amounts of trading activity at speeds far too fast for human beings to track," Weiss said. "High-speed trading algorithms, which are employed by many bank dealers and hedge funds, as well as by PTFs, appeared to respond to an extraordinarily one-sided trading environment, with far more willing buyers than sellers, by generating a rapid rally in treasuries."
Weiss went on to say that the market shift toward high-frequency automated trading has brought with it certain risks that may have been underappreciated by market participants and regulators to date. For one, the drive for a speed advantage over other traders might be hurting the competitive nature of markets, with traders preferring to outgun rather than outsmart their competition. While it would clearly be impossible to completely turn back the clock on electronic trading, "We need to consider whether the race for speed, at this already advanced stage, helps or hurts market functioning," Weiss said.
There also needs to be greater regulatory scrutiny of algorithms that trade with themselves a practice that is not necessarily illegal or even improper, Weiss said, but one that certainly could be a means for market manipulation, either by creating the appearance of liquidity where it may not exist or even by manipulating prices. Officials need to take events like this seriously and be diligent in making sure markets especially Treasury markets function appropriately, Weiss said.
"The truth is, this was a really an awakening for market participants," Weiss said. "We need to be vigilant about events like that. It did, of course, self-correct, but because it self-corrected the one time, you can't count on it self-correcting at some future date."
Federal Reserve Gov. Jerome Powell, while avoiding staking out specific preferred policies, echoed Weiss' concerns that the rise in algorithmic trading, at the very least, creates an environment where a large number of trades are being conducted based not on market fundamentals but on fairly small and unpredictable data inputs particularly other automated traders' positions.
"If trading is at nanoseconds, there won't be a lot of 'fundamental' news to trade on or much time to formulate views about the long-run value of an asset; instead, trading at these speeds can become a game played against order books and the market rules," Powell said. "We can complain about certain trading practices in this new environment, but if the market is structured to incentivize those practices, then why should we be surprised if they occur?"
Powell announced that a conference will be held at the New York Federal Reserve Bank this fall to further examine the interplay of algorithmic trading, regulation, and other shifts in the fixed-income markets are leading to possible liquidity shortages and other adverse effects.
Weiss' and Powell's remarks do not mark the first time that federal regulators have raised questions about the potential for automated trading to disrupt markets. Before the October 15 "flash rally", as Weiss called it, market observers would point to the May 6, 2010, "flash crash" in the stock market -- whose causes were similarly nebulous as an example of why to be skeptical of algorithmic trading. But when the July 13 report was released, officials had been hesitant to single out algorithmic trading as an area that required further scrutiny.
During her testimony before the House Financial Services Committee July 15, Fed chair Janet Yellen said it was not clear what exactly had caused the flash rally but rather maintained that there were a number of contributing causes, and it was not clear that there is an underlying liquidity problem in the bond markets.
"I think it's not clear what's happening in these markets and what is causing what," Yellen said. "We just don't have a conclusion about what happened in the Treasury market at this point."
