Five regulatory agencies failed to explain the cause of a wide boomerang in prices and high volatility in the market for US Treasury securities, futures and related financial instruments on October 15, 2014 – sometimes referred to as the “Treasuries Flash Crash” – in a joint staff report issued last week. According to the study, issued by the US Department of Treasury, Board of Governors of the Federal Reserve System, Federal Reserve Bank of New York, the Securities and Exchange Commission and the Commodity Futures Trading Commission, intraday modulations in prices on October 15 were only less severe than “have been seen on three occasions since 1998, and unlike October 15, all [prior incidents] were driven by significant policy announcements.” The report indicated that the types of firms engaging in market activity on October 15 – principal trading firms and bank-dealers – did so in similar proportions as on other days. Bank-dealers generally widened their spreads during the period of the large price swing while the PTFs mostly kept tight bids and offers but reduced the quantity of their offers. This conduct seemed to be a response to market conditions, not a cause, said the report. However, “[b]oth sets of actions prompted the visible depth in the cash and futures order books to decline at the top price levels,” said the study. In addition, there were two other noticeable patterns of activity during the period of the large price swing: a high level of cancellations (which increased the time for futures exchanges’ matching engines to process new orders) and a higher level than normal of self-trades (i.e., transactions in which the same entity takes both sides of the trade). Although this self-trade activity was mostly observed among the PTFs, the report indicated that this might have been “due to the fact that such firms can run multiple separate trading algorithms simultaneously,” and did not find the self-trading problematic. As a result of the incident, the report recommended that the evolution of the US Treasury market (and the implications for market structure and liquidity) continue to be studied; trading and risk management practices in the US Treasury market continue to be monitored (including government oversight over participants); and inter-agency coordination related to the US Treasury market be promoted, including efforts to strengthen monitoring and surveillance.
My View: In response to the five-agency report on events of October 15, Luis Aguilar, an SEC commissioner, quickly made numerous recommendations to “revisit” the oversight of the US Treasury market. Among other things, he recommended considering revising Regulation Alternative Trading Systems (Reg ATS) and Regulation Systems compliance and Integrity (Reg SCI) to include alternative trading systems that trade US Treasury instruments exclusively. However, it is likely premature to consider any recommendations to a one-off situation that, despite the dedication of substantial government resources, is still not well understood if understood at all. Regulation by crisis is not effective and, as we learned through the implementation of Dodd-Frank, often leads to many unintended consequences. There may be valuable lessons learned from the events on October 15, 2014, but for now, let any enhancements to best practices evolve naturally rather than be forced upon industry participants. This is particularly important when unintended consequences in US Treasury markets may detrimentally impact liquidity and have grave consequences for the US government to fund itself.