Hedge Funds Bigger Players Than Investment Banks in Treasuries

The Financial Times reported today, in a page one story, “Funds take firm grip on US Treasuries,”

Big hedge funds have recently grabbed such a large share of trading in US Treasury bonds that their activity is eclipsing many of the investment banks which have traditionally dominated the market.

This falls in the category, “I know this isn’t good, but I can’t tell you why.”

Or more accurately, I can give some reasons, but since I don’t trade Treasuries, I am certain to be missing some important nuances, enough that a participant can pick at details. Nevertheless, I believe the theory is valid.

Investment banks and big commercial banks have Treasury trading desks. That means they have taken upon themselves an obligation (of sorts, it isn’t a contractual obligation), to make a market, that is, stand willing to buy and sell Treasuries. They will post prices on an interdealer trading system. Many transactions can be executed electronically; larger trades (and the size varies by the particular issue, since some bonds are more liquid than others) need to be confirmed with a trader. Big trades are likely to be done at a price slightly off the screen price. Note these are terribly crude generalizations.

Access to the interdealer screens has been considered to be an advantage; it gives better insight into where the market is than the Bloomberg screens. And the advantage has increased now that these systems are now trading platforms.

Now hedge funds have obtained the same informational footing as the market makers, they have no obligation to make a market, and according to the Financial Times story below, they trade in bigger volumes than the market makers. Seems that they have the upper hand. If I were a market maker, I think I would be less likely to risk capital in a market like this, since it has become a less attractive business proposition now that the hedge funds run the show.

This may not matter most of the time. The Treasury market is so liquid that market makers being more chary likely won’t have any discernible impact. But in the bad old days, when bond firms were macho and could make real money, some firms prided themselves in making a market even in adverse circumstances: very big trades, very volatile markets. One can imagine we’ll see less of that sort of thing.

The FT story continues:

Citadel, the Chicago-based fund, is now estimated to account for more than 10 per cent of trading in the most liquid Treasuries, according to market participants with knowledge of the fund’s activity.

The surge in the significance of hedge funds has arisen partly because Citadel and others are increasingly using computer-driven trading models that make trades very frequently to exploit tiny differences in prices, generating high volume.

The shift indicates the degree to which the arrival of such electronic trading is now reshaping financial markets.

Benn Steil, an academic who works at the Council for Foreign Relations, said: “Once hedge funds start accounting for this much of the market, it is hard to know what to call them – they are not really bank customers any more.”

It is difficult to calculate accurately the proportion of the market represented by hedge funds since they do not release figures on their trading flows. Meanwhile, the two platforms that dominate electronic trading in liquid Treasuries – BrokerTec and eSpeed – are reluctant to discuss individual clients’ activity.

However, in recent months Citadel and other funds have offered some data to financiers in Europe, because they are seeking to join MTS, the dominant platform for trading eurozone government bonds, whose membership is currently limited to banks.

In the Treasury market, hedge funds and other big users are already connected directly to “inter-dealer” trading systems managed by eSpeed and BrokerTec, a unit of Icap.

The data suggest that Citadel accounts for at least 10 per cent of trading flows on eSpeed and BrokerTec, which in turn are believed to account for about two-thirds of trading flows in the most frequently traded Treasury instruments .

Citadel declined to comment.

Two decades ago, the banks designated as “primary dealers” in Treasuries accounted for around 80 per cent of all trading in the inter-dealer market.

However, one trader now estimates that this proportion has roughly reversed.

The shifts in the Treasury market is now fuelling debate in Europe, since hedge funds such as Citadel are now seeking to gain direct access to MTS, so that they can execute computer-driven trading strategies in European bond markets too.

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