Wall Street bond dealers are moving rapidly to the sidelines of US Treasury auctions — the very activity that defines their status at the heart of the world’s biggest bond market.
Until 2008, the roughly two dozen “primary dealers” designated by the Federal Reserve Bank of New York had a virtual stranglehold on the distribution of new US government debt, capturing at least 60% of every 10-year note auction and usually more than 80%.
But by last year their role was starkly smaller: The average was under 17% and, in one auction, was as low as 7.4%. The trend is the same for the Treasury’s other notes, bonds, and inflation-protected securities. Two auctions last week produced record low awards to those primary dealers.
The diminished sway of the once-dominant players stems in part from institutional investors that have seized on the ability to buy directly from the Treasury, bypassing the firms that snap them up and resell them to customers. It’s also a side effect of the US government’s burgeoning debt, which swelled faster than the dealers’ capacity to absorb it all and left others picking up the slack.
“The US Treasury market has evolved to include a more diverse set of market participants that is increasingly driven by investor, rather than dealer, trading,” said Kevin McPartland, head of research for market structure and technology at Coalition Greenwich.
The trend has contributed to the deep reduction in the Treasury market’s liquidity, or the ability to buy or sell big blocks of bonds without moving prices. While other factors have also played a role in the liquidity drop — including a surge in volatility — the auction figures show how the Wall Street giants have scaled-back their role in a market where they have been counted on to step in to soften the impact of selloffs.
The US Treasury sells seven varieties of notes and bonds — maturing in two, three, five, seven, 10, 20 and 30 years — with one auction a month of each. In 2022, only the three-year note, a relative newcomer, had auctions in which dealers were awarded more than 25%. Last week, auctions of three-year notes and 30-year bonds produced record low primary dealer awards. (Auctions of Treasury bills, which mature in a year or less, continue to be dealer-dominated, however.)
The size of such Treasury auctions has risen steeply over the past decade as the government borrowed to cover its budget deficit. It sold $5.14 trillion of notes and bonds in 2022, up from $1.03 trillion in 2008, according to the Securities Industry and Financial Markets Association. Meanwhile, there are 25 primary dealers, compared as many as 46 in 1988, according to New York Fed records.
At the same time, regulations enacted after the 2008 financial crisis have made it more costly for dealers to allocate additional capital to lower-return businesses like Treasuries, said Jay Barry, head of US interest-rate strategy at JPMorgan Chase & Co. They include the Fed’s supplementary leverage ratio and the Financial Stability Board’s capital buffer surcharges for global systemically important banks.
“Intermediation of the market has not kept up with the growth of the Treasury market,” Barry said.
Barry’s favorite broad measure of liquidity, which is based on the quantity of bonds being quoted at the top three best prices in the inter-dealer market, declined about 60% last year, nearly matching the worst levels reached during the 2008-2009 financial crisis and in March 2020.
The primary dealers’ loss of market share in auctions has coincided with the rise in direct bidding, in which institutional investors can bypass dealers to acquire Treasuries at auction. Such buying has taken off since the Treasury moved to an internet-based platform in 2008. Through 2008, six auctions produced direct bidder awards exceeding 10%. In 2022, just one auction had a direct bidder award less than 10%, and most were between 15% and 25%.
Concentration in the asset management business is likely also a driver of growth in auction awards to end users, said Priya Misra, global head of rates strategy at TD Securities. The top 20 US asset managers in 2021 were responsible for $49.7 trillion, more than double the $18.2 trillion they controlled in 2012, according to research by Willis Towers Watson.
Officials at securities dealers have long argued that direct bidding by investment firms would increase volatility by making auction outcomes more difficult for them to predict, encouraging them to bid cautiously. That’s at odds with their role as primary dealers obligated to participate meaningfully in Treasury auctions in exchange for being designated as trading counterparties in the New York Fed’s daily money-market operations.
Historically, primary dealers’ auction access has been viewed as the counterpart of their commitment to provide liquidity for Treasury debt subsequent to the auctions, in the so-called secondary market, said Robert Almgren, co-founder of Quantitative Brokers LLC.
“If more of the issuance goes directly to other players than primary dealers, one would expect liquidity to be worse,” Almgren said.
It’s also unclear how many firms are responsible for the direct buying. The Treasury hasn’t provided any detailed information about the number of investors using the direct bidding system since 2004, when then-undersecretary for domestic finance Brian Roseboro said there were 825. The department won’t say how many there are today.
Institutional investors, who still rely on dealers when they need to buy or sell debt securities, are likewise closemouthed about using the channel. Representatives for Vanguard Group, BlackRock Inc., Fidelity Investments and Pacific Investment Management Co. declined to say whether they submit direct bids in Treasury auctions.
While there’s nothing to prevent primary dealers from being shut out of a Treasury auction, that outcome may be forestalled by the expected growth in auction sizes in the coming years, JPMorgan’s Barry said.
Still, dealers’ shrinking footprint in the market only makes investors more likely to bid directly for auctions, rather than waiting for a potentially better opportunity to get the securities they need.
“There’s been a fundamental market-structure shift to liquidity, which I think just lends itself towards using the auctions as more of a liquidity point for end users,” he said.
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