Remarks by Chairman J. Christopher Giancarlo at the Fourth Annual Conference the Evolving Structure of the U.S. Treasury Market, New York, New York

“The Complex and Dynamic Liquidity Hierarchy of the US Treasury Market”

December 3, 2018

Thank you.  Good afternoon.

I want to thank John Williams, Nate Wuerfel, and the New York Fed for inviting me to speak to you today.

It is good to be here in New York City.

It is good to be downtown Manhattan, in the financial district, the heart of this great city, the first capital of the United States.

It is good to be on Maiden Lane, where in 1790, at a house just down the block, Number 57, Thomas Jefferson, Alexander Hamilton and James Madison produced the compromise of 1790.  Under that agreement the national capital would move out of New York (satisfying the two Virginians, Jefferson and Madison) and the new Federal government would undertake and settle the Revolutionary War indebtedness of the thirteen states (satisfying Hamilton).  This compromise assured that the new District of Columbia would be America’s political capital and New York City would be its financial center.

Maiden Lane is also where I began my career thirty four years ago as a municipal securities lawyer.  As I walked up from the East River Ferry terminal this morning past my first office at 180 Maiden Lane, I thought about how much has changed in government debt markets in three and a half decades.

Then, the provision of trading liquidity was entirely a human activity, analog and personal, conducted by market specialists who crowded into the financial district and its trading pits and dealing floors each day from ferries, buses and subways.  Today, liquidity is increasingly machine conducted, digital and anonymous, from all parts of the country and all corners of the globe.

But what of that change?  What difference, if any, does it make?  That is part of what this New York Fed conference and the three that proceeded it are designed to explore – the evolving structure of the market for US Treasury securities.  That evolving structure has direct parallels, not only in markets for other government debt, but also in those for corporate debt and, for us at the CFTC, in the range of exchange traded and over-the-counter derivatives.

I followed closely Governor Brainard’s review this morning of the changing nature and roles of liquidity providers in US Treasury markets, including the growing liquidity provision by proprietary trading firms, trading their own account, and the greater use of electronic execution for more active market segments.  I am pleased to hear her estimation that the Treasury market has adapted well to the post-crisis regulatory regime, the normalization of monetary policy, and wide technological changes in trading processes that have emerged.

In fact, we observe quite similar developments in US and global derivatives markets, where both broker-dealers and proprietary trading firms play important, often complementary, roles in liquidity provision.  In swaps, we also see the growing use of electronic trading, including batch auction-based systems.  Yet, those more automated trading systems continue to operate alongside more traditional, “squawk box” voice execution, just as Governor Brainard confirmed remain active in less liquid segments of cash Treasuries.

What makes all of those methods of swaps execution continually viable is the complex and dynamic hierarchy of swaps liquidity.  It is the reason why the CFTC recently put forward a proposal to sanction within our swaps trading mandate a wider scope of trading methodologies similar to what is available in US cash treasuries.  Our new proposal is designed to encourage greater flexibility, competition and innovation in methods of swaps trade execution without impacting larger financial stability goals.  The dynamic and complex liquidity hierarchy of financial swaps requires the same diversity and flexibility in execution methods that are widely used in cash markets for US Treasury securities.

Today, I would like to tell you about a recent CFTC study on the relative liquidity of exchange traded futures contracts and cash securities in the US Treasury market.[1]  The study looks at the relatively new source of TRACE data on cash Treasury transactions with CBOT futures transaction data collected by the CFTC.  The study is the work of the CFTC’s Office of the Chief Economist and was authored by Lee Baker, LIhong McPhail and our Chief Economist, Professor Bruce Tuckman.

The study portrays a highly complex and dynamic “liquidity hierarchy” in the US Treasury Market.  It shows that, while overall risk volume is greater across all cash securities than across all futures contracts, the liquidity hierarchy is more complex, with certain futures contracts more liquid than certain cash securities, and vice versa.

The study also found that futures contracts play a special role in liquidity-challenged environments.  The relative amount of risk traded through futures contracts is higher on days with large price movements.  The amount of risk traded through futures is also larger at times after U.S. trading hours.

The study further found that average trade size, in risk terms, is much higher for cash securities that for future contracts.  This is likely due to the higher prevalence of automated trading in futures markets and execution on electronic exchanges.  This, in turn, results in futures trades being broken into smaller orders for execution.

There are, of course, many ways to measure trading liquidity in markets. To name some of the most common, there’s trading volume, turnover, bid/ask spreads, market depth, and the market impact of trades of various size.

The measure of trading liquidity used in this CFTC study is DV01 risk volume, which is a variant of trading volume.  To illustrate, using very round numbers, one could describe the trading liquidity of the 7-year on-the-run note by saying that its average daily trading volume is about $35 billion face amount.  Alternatively, however, one could express this trading volume in terms of how much interest risk changes hands.  Using the common risk metric of DV01, $35 billion of the 7-year note increases in value by about $22 million for a 1 basis point decline in rates.  Therefore, one can describe the trading liquidity of the 7-year by saying either that its trading volume is about $35 billion or that its DV01 risk volume is about $22 million.

One reason to use risk volumes is to account for the fact that trading $100 of the 7-year note represents a lot less risk transfer than trading $100 of the 30-year bond.  Again, using very round numbers to illustrate the point, say that the daily trading volumes of the 7-year and the 30-year on-the-runs are each $35 billion.  As we’ve just seen, this implies that the risk volume of the 7-year is $22 million.  The implication for the 30-year bond, however, is quite different. Using its DV01, its risk volume is $66 million, which is 3 times as large as that of the 7-year.

Another reason to use risk volumes is as a means of comparing trading liquidity in futures with liquidity in cash treasuries.  Futures volume is often measured as the number of contracts traded, while volume in cash treasuries, as we’ve been discussing, is often measured as the face amount traded.  Converting both to risk volumes is a straightforward and intuitive way to compare the liquidity of the two markets.

For further methodological details, please have a look at the paper, which is available on our website. For now, let’s look turn to the results.

Figure 1.

Average % DV01 Volume by Instrument.  The bars represent the average daily traded DV01 in each instrument bucket as a percent of the total DV01 traded.

Figure 1 shows the liquidity hierarchy of futures and cash instruments.  The volumes of futures contracts are depicted by red bars, of on-the-run bonds by blue bars with a black border, and of other cash securities by black bars.

The 10-year futures contract is the most liquid contract, at 19% of total DV01 volume.  The 10-and 5 year on-the-run bonds are next, with 15% and 10% respectively.  Then there are 30-year futures contract and the 30-year on-the-run bond with about 9.5 percent each.

In short, for reasons likely relating both to history and market factors, neither futures nor cash dominate the liquidity landscape.

We can also see that outside on-the-run bonds, cash securities are significantly less liquid.  We can see that futures contracts and on-the-run bonds comprise about 87% of total DV01 volume, with the rest of the 13% is divided across more than 300 remaining cash securities.

Let’s turn to Figure 2.

Figure 2.

Average % DV01 Volume by Instrument and Volatility Percentiles.  The bars represent the average daily traded DV01 as a percent of total DV01 traded in each instrument bucket and each volatility percentile. Daily volatility is measured as the intra-day price range of the 10-year futures contract.

Figure 2 shows the average percentage DV01 volume for various instruments buckets and groups of buckets for 4 sets of days.  The red bars show results for the high volatility days, with the dark red bars showing the 90^th percentile of volatility and the light red bars show the 75^th percentile of volatility.  The blue bars show results for low volatility days, with the light and dark blue bars showing the 25^th and 10 percentiles, respectively.

Four futures contract groups are depicted on the left side.  For each of these groups, futures comprise a higher percentage of DV01 volume on higher volatility days than on lower volatility days.  The effect is particularly pronounced for the most liquid bucket, the 10-year futures contract.  For that contract, average percentage DV01 volume is 21% and 20% on high volatility days, compared with 18% and 17% on low volatility days.

Take a look at the right side of Figure 2.  The two most liquid groups, the 10-and 5-year on-the-run bonds, have an average percentage DV01 volume that is relatively flat across the volatility categories.  For the 30-year on-the-run bond, the percentage DV01 is a bit higher on low volatility days.  Most noticeable, however, is the group “All Other Cash” securities, which includes all bonds other than the 10-year, 5-year, and 30-year on-the-runs.  On high volatility days the risk volume share of this other cash group is around 18% or 19%, but 23% or 24% on low volatility days.

So, as volatility increases, liquidity migrates from less liquid cash securities to more liquid futures contracts.  Isn’t that interesting.

Now, let’s turn to Figure 3.

Figure 3.

Average % DV01 Volume by Instrument and Trading Hours.  The bars represent the average daily traded DV01 as a percent of total DV01 traded in each instrument bucket and each of U.S., Asian, and European trading hours.

Figure 3 breaks down the trading hours results by instrument.  In almost all cases, futures are a bigger fraction of risk transfer outside of U.S. trading hours.  The reverse is true for cash securities.

The trading hour effects are particularly pronounced for the super-liquid 10-year futures contract and for all but the most liquid cash securities.  The 10-year futures contract comprises 16% of risk volume during U.S. trading hours, but over 30% of volume outside those hours.

By contrast, during U.S. trading hours, “All Other Cash Securities” comprise 24% of risk volume, but only 13% during Asian trading hours and 8% during European trading hours.

These trading hours results are subject to the caveat that TRACE includes only trades reported by FINRA members, which could underrepresent cash trades outside of U.S. trading hours.

Figure 4.

Average and Median Trade Size, quoted in Dollar DV01 by Instrument.

Our last figure shows a large difference between risk trading in cash and futures.  Trade size is much greater for on-the-run bonds than for futures contracts.  Across all on-the-run bonds, the median and average trade size is over $1,300 and almost $5,000 of DV01.  The corresponding numbers across all futures are much lower, with the median less than $200 and the average just under $500.  As the figure makes clear, the greater median and average trades sizes for on-the-runs relative to futures holds across all individual instruments.

So, what have learned from this study of new TRACE data on cash Treasury transactions with CFTC futures transaction data?

First, while overall risk volume is greater across all cash securities than across all futures contracts, the liquidity hierarchy is more complex, with certain futures contracts trading in greater risk volume than certain cash securities and vice versa.

Second, futures contracts play a dynamic role in liquidity-challenged environments.  The relative amount of risk traded through futures contracts is higher on days with large price movements and at times outside of U.S. trading hours.

Third, average trade size, in risk terms, is much higher for cash securities than for futures contracts.  This is likely due to the higher prevalence of automated trading in futures markets and execution on electronic exchanges, which in turn results in futures trades being broken down into smaller orders for execution.

With this study, we have a much clearer picture of the complex and dynamic nature of trading liquidity in markets for US Treasury cash bonds and exchange-traded Treasury futures contracts.

The sophisticated liquidity hierarchy of the US Treasury market is well served by the diversity of new and traditional market makers and liquidity providers.  Trading cash treasuries in this complex hierarchy is also appropriately conducted by the varied methods of trade execution that Governor Brainard reviewed for us this morning, from electronic trading and batch auction-based systems to traditional voice execution.

This dynamic and complex liquidity hierarchy is also present in financial and other swaps markets overseen by the CFTC.  Regulated swaps markets require the same diversity and flexibility in execution methods that continue to provide a robust and resilient foundation for cash markets for US Treasury securities.

This combination of complex and dynamic trading liquidity, diversity of liquidity provision and multiple modes of trade execution is a hallmark of the continued vitality of the US Treasury market, a cornerstone of the global financial system.

Much has indeed changed in the past decades here in the Financial District.  The US Treasury market certainly continues to evolve. Yet, its sophistication, depth and diversity persist.

The more we understand our markets, the better we are able to enhance their resilience and dynamism for decades to come.

Thanks for letting me share this data with you.

Thank you.