DePaul University The Microstructure of the US Treasury Market Q&A Discussion Question :
a report titled “The Microstructure of the U.S. Treasury Market”
Read the first ten pages of this paper (Sections 1 to 7) and create a one-page summary report.
In this report, address the following questions:
1. What are the three stages of secondary market trading?
2. In which of these secondary market trading stages do you think U.S. Treasury market bid-ask spreads are the narrowest? Why?
3.Unlike corporate bond and municipal bond markets, trade reporting in U.S. Treasury markets is not required. All else equal, how do you think a lack of trade reporting would affect secondary market liquidity?
4. Discuss the prevalence of high-frequency trading in contemporary U.S. Treasury markets and cite at least three relevant sources from the past six years. Do not copy and paste sentences from the U.S. Treasury market report or your cited sources. You may attribute quotes to your sources.
(Note: The length of this report should be no longer than one page, excluding any tables or graphs that you might decide to include.) Research Division
Federal Reserve Bank of St. Louis
Working Paper Series
The Microstructure of the U.S. Treasury Market
Bruce Mizrach
and
Christopher J. Neely
Working Paper 2007-052B
http://research.stlouisfed.org/wp/2007/2007-052.pdf
December 2007
Revised April 2008
FEDERAL RESERVE BANK OF ST. LOUIS
Research Division
P.O. Box 442
St. Louis, MO 63166
______________________________________________________________________________________
The views expressed are those of the individual authors and do not necessarily reflect official positions of
the Federal Reserve Bank of St. Louis, the Federal Reserve System, or the Board of Governors.
Federal Reserve Bank of St. Louis Working Papers are preliminary materials circulated to stimulate
discussion and critical comment. References in publications to Federal Reserve Bank of St. Louis Working
Papers (other than an acknowledgment that the writer has had access to unpublished material) should be
cleared with the author or authors.
Prepared for the Encyclopedia of Complexity, New York: Springer-Verlag
The Microstructure of the U.S. Treasury Market
Bruce Mizrach ∗
Department of Economics
Rutgers University
Christopher J. Neely
Research Department
Federal Reserve Bank of St. Louis
April 14, 2008
Abstract: This article discusses the microstructure of the U.S. Treasury securities market.
Treasury securities are nominally riskless debt instruments issued by the U.S. government.
Microstructural analysis is a field of economics/finance that examines the roles played by
heterogenous agents, institutional detail, and asymmetric information in the trading process. The
article describes types of Treasury issues; stages of the Treasury market; the major players,
including the role of the Federal Reserve Bank of New York and the interdealer brokers; the
structure of both the spot and futures markets; the findings of the seasonality/announcement and
order book literature; and research on price discovery. We conclude by discussing possible
future avenues of research.
JEL Codes: D53, E43, E44, G12,
Keywords: Treasury, microstructure, spreads, order book, announcement
∗
We would like to thank Dick Anderson, Frank Fabozzi, Michael Fleming, Robert Rasche and
an anonymous referee for detailed comments which greatly improved this manuscript. The views
expressed are those of the authors and do not necessarily reflect views of the Federal Reserve
Bank of St. Louis or the Federal Reserve System.
1. Glossary
Algorithmic trading Algorithmic trading is the practice of automatically transacting based on
a quantitative model.
Broker A broker is a firm that matches buyers and sellers in financial transactions. An interdealer broker (IDB) is an intermediary providing trading services to hedge funds, institutions,
and other dealers. IDB’s handle the majority of Treasury securities transactions in the secondary
market.
Coupons Owners of Treasury notes and bonds receive periodic payments called coupons. They
are fixed by the Treasury at auction and are typically paid semi-annually.
Depth Depth is the quantity the dealer is willing to sell at the bid or offer.
Electronic communications networks (ECN) The Securities and Exchange Commission
defines electronic communications networks (ECNs) as “electronic trading systems that automatically match buy and sell orders at specified prices.”
Market microstructure Market microstructure is a field of economics that studies the price
formation process and trading procedures in security markets.
On-the-run On-the-run refers to the most recently auctioned Treasury security of a particular
maturity. After the next auction, the security goes off-the-run.
Price discovery The process by which prices adapt to new information.
Primary dealers Primary dealers are large brokerage firms and investment banks that are
permitted to trade directly with the Federal Reserve in exchange for making markets in Treasuries.
They provide the majority of liquidity in the Treasury market, participate in Treasury auctions,
and provide information to assist the Fed in implementing open market operations.
Secondary market After the initial auction of Treasury instruments, trading in on-the-run
and off-the-run securities makes up the secondary Treasury market.
When issued When-issued bonds are those Treasuries whose auctions have been announced
but have not yet settled.
2. Definition of the Subject and Its Importance
This article discusses the microstructure of the U.S. Treasury securities market.
U.S. Treasury securities are default risk free debt instruments issued by the U.S. government.
These securities play an important, even unique, role in international financial markets because
of their safety, liquidity, and low transactions costs. Treasury instruments are often the preferred
safe haven during financial crises, a process often referred to as a “flight to quality.”
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According to the U.S. Treasury, there was more than $9 trillion in U.S. government debt
outstanding as of August 31, 2007. Of this quantity, the public holds more than $5 trillion and
$4.5 trillion is tradable on financial markets. Foreigners hold approximately $2.4 trillion of the
marketable supply, with Japan and China together holding more than $1 trillion. According to
the Securities Industry and Financial Markets Association (SIFMA), average daily trading volume
in the U.S. Treasury market in 2007 was $524.7 billion.
Microstructure is the study of the institutional details of markets and trading behavior. Microstructural analysis takes three ideas seriously that are often overlooked: the institutional features
of the trading process influence how private information is impounded into prices; agents are heterogeneous; and information is asymmetric. Empirical microstructure research studies topics such
as the causes and effects of market structure, how market structure influences price discovery, how
trading and order flow reveal private information, how quickly public information is impounded
into prices, the volatility-volume relation, and the determinants of transactions costs (i.e., the
components of bid-ask spreads). The relatively recent availability of tick-by-tick financial data and
limit order book data, as well as the computer resources to manipulate them, have been a great
boon to financial market microstructure research.
3. Introduction
We begin by describing the types of Treasury issues and the major Treasury market participants,
including the Federal Reserve, primary dealers and the major electronic brokers. We then outline
the stages of the Treasury market, from auction announcements to the secondary market. Next,
we examine several closely related areas of the literature: Seasonality in the Treasury market and
the reactions of the Treasury market to macro and monetary announcements; discontinuities in
Treasury prices; and the effect of order flow in Treasury markets. We then discuss modeling and
other academic questions about the Treasury market.
4. Types of Treasury Issues
As of October 2007, the U.S. Treasury issued four types of debt instruments. The shortest-maturity
instruments are known as Treasury bills. 22.6% of the marketable U.S. debt is in bills, securities
with maturities of 1 year or less. Bills are sold at a discount and redeemed at their face value at
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maturity. They do not pay any coupons prior to maturity and currently have maturities up to 26
weeks. Treasury bill prices are usually quoted in “discount rate” terms, which are calculated with
an actual/360 day count convention,
T-bill discount rate = [face value — bill price] × (360/number of days until maturity).
Thus, a bill with a face value of $100, 000, a cash price of $97, 500 and 90 days to maturity will
have a discount rate of 10% = [100 − 97.5] × (360/90) in a newspaper. Treasury bill yields are often
quoted as “bond equivalent yields,” which are defined as,
face value − bill price
] × (365/number of days until maturity).
T-bill yield = [
bill price
Treasury instruments with intermediate maturities (2-, 5- and 10-year) are known as Treasury
notes. Notes pay semi-annual coupons, and make up 54.7% of the debt.
In February 2006, the
U.S. Treasury also resumed issuing 30-year instruments, known as Treasury bonds. Bonds also pay
semi-annual coupons, and make up 12.5% of the U.S. debt.
The price of both notes and bonds are quoted as a percentage of their face value in thirtyseconds of a point. A quoted price of 98-08 means that the quoted price of the note (or bond) is
(98+8/32=) $98.25 for each $100 of face value. The cash price of bonds and notes is equal to the
quoted price plus accrued interest since the last coupon payment, calculated with an actual/actual
day count convention. Quoted prices are sometimes called “clean” prices, while cash prices are
said to be “dirty.”
The U.S. Treasury also issues 5-, 10-, and 20-year Treasury Inflation-Protected Securities
(“TIPS”), whose payoff is linked to changes in the U.S. Consumer Price Index (CPI). These
make up about 10.2% of the total value of Treasuries outstanding. The principal value of TIPS is
adjusted daily and the semi-annual coupon payments and principal payment are then based on the
adjusted principal amount. Economists extract inflation forecasts by comparing the TIPS yields to
those on similar nominal instruments. The Federal Reserve Bank of Saint Louis provides “TIPS
spreads” through its publication, Monetary Trends.
There is also an active market in STRIPS (Separate Trading of Registered Interest and Principal
of Securities) which are popularly known as “zero coupon” bonds. These instruments are created
by the Treasury through an accounting system which separates coupon interest payments and
principal. Finally, the U.S. Treasury also issues savings bonds, low denomination securities for
retail investors.
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5. Treasury Market Participants
5.1
The Federal Reserve in the Treasury Market
The Federal Reserve Bank of New York, under the guidance of the Federal Open Market Committee
(FOMC), is a uniquely important player in the Treasury market. The FOMC meets approximately
every six weeks to review economic conditions and determine a target for the federal funds rate,
the rate at which U.S. banks borrow/lend reserve balances from/to each other. The manager of
the Open Market Desk (a.k.a., “the Desk”) at the Federal Reserve Bank of New York is responsible
for ensuring that the average federal funds transaction is close to the target by buying and selling
Treasury instruments (primarily short-term). In practice, the Desk accomplishes this in two ways.
First the Desk buys sufficient Treasuries to satisfy most but not all the markets’ demand for deposits
at the Fed. Secondly, the Desk buys Treasuries via repurchase (repos) agreements (overnight and
for terms of several days) to achieve a desired repo rate that influences the federal funds rate and
other short-term interest rates through arbitrage.
To determine day-to-day actions, every morning, staff at both the Division of Monetary Affairs
of the Board of Governors of the Federal Reserve System and the Desk forecast that day’s demand
for reserve balances. The Desk staff also consults market participants to get their views on financial
conditions. The relevant Desk and Board staffs then exchange views in a 9 am conference call.
Finally, the relevant Desk staff, the Board staff, and at least one of the voting Reserve Bank
Presidents then confer during a second conference call at about 9:20 am. The Desk staff summarizes
market conditions, projects actions for the day and asks the voting Reserve Bank President(s) for
comments. Open market operations commence shortly after the conclusion of this call.
When the Desk buys Treasuries, it increases available liquidity (reserves) in debt markets and
tends to lower interest rates. Selling Treasuries has the opposite effect, lowering reserves and
raising interest rates. If the intention is to make a permanent change in reserves, then outright
purchases or sales are undertaken. In contrast, if the Desk anticipates that only temporary changes
in reserves are necessary, it uses repos (for purchases) or reverse repos (for sales). Bernanke [7]
notes that actual open market sales of debt instruments are rare; it is more common for the Federal
Reserve to allow such securities to expire without replacing them. Both open market sales and
allowing the Fed’s securities to expire have the same balance sheet effects: The Fed holds fewer
bonds and more cash, while the public will hold more bonds and less cash.
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The Federal Reserve provides several valuable references on its operating procedures. The
Annual Report of the Markets Group of the Federal Reserve Bank of New York describes open
market operations and current procedures (Federal Reserve Bank of New York, Markets Group
[26]). Meulendyke [57] provides a comprehensive view of Federal Reserve monetary policy operations with a historical perspective. Akhtar [1] explains how monetary policy is decided and how
such policies affect the economy. Finally, Harvey and Huang [43] gives some historical perspective
on operating procedures in the 1980s.
5.2
Primary dealers
Among the most important private sector players in the Treasury markets are the 21 primary
dealers. The Federal Reserve Bank of New York explains that primary dealers must “participate
meaningfully in both the Fed’s open market operations and Treasury auctions and…provide the
Fed’s trading desk with market information and analysis that are helpful in the formulation and
implementation of monetary policy.” The Federal Reserve does not regulate primary dealers, but
does subject them to capital requirements. The Federal Reserve can withdraw a firm’s primary
dealer designation if it fails to participate in auctions or open market operations or if its capital
reserves fall below desired levels.
The daily average trading volume in U.S. Government securities of all the primary dealers was
approximately $550 billion during 2005.
5.3
Interdealer Brokers
Prior to 2000, voice-assisted brokers dominated secondary market trading in Treasuries. Except
for Cantor-Fitzgerald, all these brokers reported their trading activity to GovPX, a consortium.
In the face of demands by the Securities and Exchange Commission and bond market dealers for
greater transparency, five IDBs formed GovPX as a joint venture in 1991. In March 1999, CantorFitzgerald opened up its internal electronic trading platform, eSpeed, to clients. The eSpeed
system quickly grabbed a dominant market share, and Cantor Fitzgerald spun off eSpeed as a
public company in December 1999. In 2000, a competing electronic brokerage, BrokerTec, joined
the market. As in foreign exchange and equity markets, most interdealer and institutional trading
in Treasuries quickly migrated from voice networks to these electronic communications networks
(ECNs), which have dominated trading in Treasury instruments since 2001. Mizrach and Neely
[58] describe the transition from voice assisted trading, largely through the primary dealers, to
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electronic trading in the Treasury market.
As of November 2007, the two dominant ECNs are eSpeed and BrokerTec. London-based ICAP,
PLC, owns BrokerTec while eSpeed merged in the summer of 2007 with BGC, another London
based interdealer brokerage. eSpeed and ICAP compete for both on- and off-the-run liquidity.
Hilliard Farber and Tullett-Prebon hold the largest brokerage share outside of the dominant two
platforms.
6. Stages of the Treasury Bond Market
The sale of Treasuries undergoes four distinct phases: when issued, primary, on-the-run and offthe-run. Each of these stages has a distinct market structure.
6.1
The Primary Market
In the primary market, the U.S. Treasury sells debt to the public via auction. The U.S. Treasury
usually publishes a calendar of upcoming tentative auction dates on the first Wednesday of February, May, August, and November and bids may be submitted up to 30 days in advance of the
auction. In practice, however, the Treasury only announces firm auction information several days
in advance and most bids are submitted at that time. Since August 8, 2002, the Treasury has made
auction announcements (for all new securities) at 11:00 AM Eastern Time (ET). 13- and 26-week
bills are auctioned weekly; 2- and 5-year notes are auctioned monthly; 10-year notes are auctioned
eight times a year. 30-year bonds, which were reintroduced on February 9, 2006 after a five year
hiatus, are auctioned four times a year.
The U.S. Treasury has used a single price auction exclusively since November 1998. Garbade
and Ingber [35] discuss the transition from multiple price auctions to the current format single price
auctions. All securities are allocated to bidders at the price that, in the aggregate, will result in the
sale of the entire issue. This mitigates the risk of a “buyer’s curse”–the highest bidder paying more
than other auction participants. To prevent a single large buyer from manipulating the auction, the
Treasury restricts anyone from buying more than 35% of any single issue. Bids may be submitted
up to thirty days prior to the auction, and large institutions make use of the Treasury Automated
Auction Processing System (TAAPS). Retail investors can participate through the Treasury Direct
program. The Treasury allocates a portion of nearly every auction to small investors at the same
price as the large institutions. These are called non-competitive bids, and they are quantity only
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orders that are filled at the market clearing price.
Primary dealers dominate the auction process. In 2003, they submitted 86% of auction bids,
totalling more than $6 trillion. They were awarded $2.4 trillion, or 78% of the total auction supply.
6.2
The Secondary Market
The secondary market is composed of the when-issued, on-the-run and off-the-run issues.
When-Issued
Even prior to the primary auction, there is an active forward market in Treasury securities
(apart from TIPS) that are about to be issued. Trading in the when-issued security market
typically begins several days prior to an auction and continues until settlement of auction purchases.
Nyborg and Sundaresan [61] document that when-issued trading provides important information
about auction prices prior to the auction and also permits market participants to reduce the risk
they take in bidding. Fabozzi and Fleming [25] estimate that 6% of total interdealer trading is in
the when-issued market. Just prior to auctions though, these markets become substantially more
active. In the bill market, when-issued trading volume exceeds the volume for the bills from the
previous auction.
On-the-Run
Upon completion of the auction, the most recently issued bill, note or bond becomes onthe-run and the previous on-the-run issue goes off-the-run. Overall Treasury trading volume is
concentrated in a small number of on-the-run issues. Trading in these benchmark on-the-run
issues, which Fabozzi and Fleming [25] say constitutes approximately 70% of total trading volume,
has migrated almost completely to the electronic networks. Mizrach and Neely [58] estimate a 61%
market share for the BrokerTec platform and a 39% share for eSpeed in 2005, which is consistent
with industry estimates.
Off-the-Run
With more than 200 off-the-run issues trading in October 2007–44 bills, 116 notes, and 45
bonds–most off-the-run volume takes place in voice and electronic interdealer networks. Barclay,
Hendershott and Kotz [5] document the fall in ECN market share when issues go off the run.
They also report that transaction volume falls by more than 90%, on average, once a bond goes
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off-the-run. The ECN market share falls from 75.2% to 9.9% for the 2-year notes, from 83.5% to
8.5% for the 5-year notes, and from 84.5% to 8.9% for the 10-year notes. Several IDBs handle most
off-the-run securities t…
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