No Smoking Gun on Cause of Liquidity Disruption

WASHINGTON — Observers hoping for a quick answer from a government report on what is behind recent volatility in the Treasury markets — including whether new financial regulation is to blame — were likely sorely disappointed on Monday.

The report focused on what caused sharp fluctuations in Treasury bonds on Oct. 15, one of the most volatile trading days ever. The sudden drop in yields — followed by a rebound of equal magnitude — has stoked concerns that regulatory changes could drive such volatility, among other potential causes.

But the report — issued by the Treasury Department and four regulatory agencies — did not pinpoint a single or proximate factor behind the October event. While they said the regulatory environment resulting from the Dodd-Frank Act was a possible contributor, they called for additional study and analysis to determine if there is a link and pointed to other potential causes as well.

"Evidence to date is limited on whether regulatory changes have affected dealer market-making behavior," said the joint report from Treasury, the Federal Reserve Board, Federal Reserve Bank of New York, Securities and Exchange Commission and Commodity Futures Trading Commission.

Questions over what precipitated the trading anomaly last fall and fears about future volatility have opened up a broader debate about the effects of heightened regulation. Critics of the Volcker Rule, for example, say the trading ban in Dodd-Frank — named for former Fed Chairman Paul Volcker — prohibits the very type of activities needed to promote liquidity. Meanwhile, some requirements issued by the international Basel Committee could drive institutions to purchase abundant amounts of low-risk Treasury bonds. Others could motivate firms to reach for yield.

On Monday, Rep. Randy Neugebauer, R-Texas, chairman of the House Financial Services subcommittee on financial institutions, hosted a roundtable event on the liquidity concerns where there were similarly not easy answers.

Sharon Bowen, a member of the CFTC who participated in the roundtable, said it may be premature to conclude definitively that there is a liquidity shortage because that term means different things to different people.

"We need to make sure that market participants can define what they mean by liquidity before we talk about whether it is growing or shrinking," Bowen said, adding that so far the alleged insufficient liquidity has been "in the eye of the beholder."

But Sandie O'Connor, chief regulatory affairs officer at JPMorgan Chase, said not enough attention has been paid to effects from the new regulatory requirements in the aggregate.

"It's absolutely important that minimum standards were created, but  … more work probably needs to be done on what is the cumulative impact of all those regulations added up," she said at the roundtable. "Each rule is written as if you weren't compliant with the rule before it."

Other regulators and market participants have been somewhat divided on whether there is a definitive link between regulations and market liquidity.

Fed Gov. Lael Brainard said last week that she "would guess that [regulation] is" playing a role in reducing market liquidity, while Treasury Secretary Jack Lew said last month that he does "not see a major impact in terms of broad liquidity" from regulatory changes. Fed Gov. Daniel Tarullo, meanwhile, has suggested that perhaps markets were never that liquid in the heyday before the crisis, and so the comparison is misleading.

The report issued by Treasury and the other agencies sought to summarize market conditions surrounding the fluctuations on Oct. 15.

Between 9:33 and 9:45 that morning, the 10-Year Treasury yield dropped by 16 basis points — signaling higher demand — and later rebounded to end the day slightly under where it had begun. Related securities, futures and options markets experienced similar volatility. The event is one of the four most volatile events in the history of those markets, the report said, but the only one not based on major monetary policy decisions.

The report said many market participants had taken short positions on interest rates in the days leading up to the trading day based on a previous expectation that interest rates would rise. But concerns about Europe and downbeat reports from the Fed and International Monetary Fund caused firms to unwind their positions by making bets that interest rates would be low in the long term.

The morning of October 15 also saw the release of a report that said retail sales were lower than expected. That could have also had an effect.

The report said so-called "Principal Trading Firms" — defined as proprietary, predominantly electronic and high-frequency traders — accounted for roughly 80% of market depth during the spike in Treasury prices at the beginning of the event window, while bank dealers had few if any orders. Conversely, as prices fell, PTFs accounted for 65% of market depth and banks rose to around 30%.

Meanwhile, the study also sought to dispel certain rumors and speculation about the cause. Specifically, the report said there was no evidence that firms had "unplugged" their trading operations, thereby exacerbating volatility. And even though there were a handful of large trades preceding the event, there was no evidence of a single large order or "fat-finger" error that spurred the event, the report said.

"In sum, record trade volumes, a decline in order book depth, changes in order flow and liquidity provision, and notable and unusual market activity together provide important insight into the factors that may have contributed to the heightened volatility, decreased liquidity, and round-trip in prices on October 15," the report said.

Yet certain other long-term changes in market structure deserve further examination as potential causes, the report said. Those include the rise of electronic trading. But the report stopped short of blaming High Frequency Trading outright since regulators have "difficulty in drawing an effective dividing line" between firms that met the definition of HFT and those that did not.