Joe Rennison’s recent article in the Financial Times highlights the increasingly important role that principal traders now play in Treasury markets.
Until 1992, the interdealer cash market was only accessible to primary dealers; principal traders only gained access in the mid-2000s. Today, principal trading firms (PTFs) account for “more than half of the trading activity in the futures and electronically brokered interdealer cash markets,” according to the Joint Staff Report on the U.S. Treasury Market on October 15, 2014.
Principal traders and primary dealers both provide liquidity, but they operate differently. Principal traders serve a critical role in price discovery. Rennison explains: “When banks cannot offset, or ‘hedge’, client trades with one another or internally, they turn to the interdealer market and PTFs. PTFs trade in smaller size and at tighter prices, concentrated in the most recently issued, or ‘on-the-run’, bonds.” FIA PTG member Matt Haraburda, President of XR Trading, emphasizes the value of diversity: “I don’t think HFTs can replace banks. Proprietary trading groups don’t have the balance sheets that banks have to hold massive positions overnight.”
Diversification has created new dynamics in Treasury markets, as the article notes: “As banks reduce their presence in the market, the importance of PTFs as a potential alternative liquidity provider is amplified.”
Rennison concludes that, “regulators have been cautious not to wade in clumsily, instead vowing to further analyse the issue — even prompting discussion on a blog run by the Federal Reserve.”
This analytical approach is important, and FIA PTG is looking forward to contributing to thoughtful policy discussions. As Governor Jerome Powell of the Federal Reserve recently said, “I believe that markets will adapt to [new dynamics] over time. In the meantime, we have a responsibility to make sure that market and regulatory incentives appropriately encourage an evolution that will sustain market liquidity and functioning.”