Treasury traders hit back at 'flash crash' warning

A warning about turbulent trading in US government bonds by a senior Federal Reserve official has highlighted tensions between regulators and dealers that transact in the world's largest fixed income market.

Late on Monday, Simon Potter, head of the Federal Reserve Bank of New York's Markets Group, told a gathering of primary dealers, who underwrite the nation's regular debt sales, that further sudden swings in bond prices would become more common.

He called for Treasury dealers to act as "good citizens" and stressed their role in supporting the $12.5tn market during volatile periods such as the one in October, when prices swung wildly in a matter of minutes.

Many in the Treasury market say maintaining overall liquidity - or the ease with which bonds can be sold - has become onerous in recent years against the backdrop of a tougher regulatory and operating environment.

Mr Potter told dealers: "Whether a firm has a large position, or represents a sizeable share of market activity, it has the responsibility to help support market functioning and liquidity.

"Making significant changes to either such a position or trading activity could disrupt market functioning and liquidity if not done with care, and the Treasury Market Practices Group calls for such positions and activity to be managed with particular vigilance."

His words rankled with some dealers, who have been cutting staff amid lower market volatility, increased automation and higher capital costs.

Meanwhile, the central bank's massive bond purchases via several rounds of quantitative easing have removed some $2.5tn of Treasury debt from the market, harming liquidity, according to dealers.

John Brady, managing director at RJ O'Brien, said banks and trading firms had to answer to their shareholders in the course of conducting their market making activities - unlike the Fed's balance sheet, which is backed by taxpayers.

"I think he [Mr Potter] is saying that it's OK to stand in front of a runaway train," he said.

Thanks to the Fed's QE, the rise of much larger asset managers, with huge global demand for US government bonds, had compromised liquidity in the Treasury market, Mr Brady added.

"The sandlot has got smaller, while the players have become bigger."

Evidence of this can be seen in how the share of Treasury coupon auctions awarded to dealers in the past 10 months has fallen below 40 per cent from nearly half as investors have sought more bonds.

US regulators continue investigating the reason for October's dramatic swing in Treasury prices, which illustrated how the world's largest government bond market was not immune to sudden bouts of illiquidity.

"Liquidity is important to the market place and it has deteriorated," said one trader. "QE extracted liquidity and we are going to see a repeat of volatility bouts like last October."

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