Don’t even think about it. That is the message from financial regulators to those tempted to manipulate the $4 trillion market in American government debt. It recently emerged that the Securities and Exchange Commission (SEC) had opened an investigation into the activities of treasury bond dealers at UBS, Europe’s largest bank by assets. Another Swiss bank, Credit Suisse, is also in the spotlight after a bond trader left under a cloud.
At least no one can say that they didn’t see it coming. Regulators have been wagging their fingers for months. On September 27th James Clouse, a Treasury official, told an uncomfortable audience from the Bond Market Association, a trade group, that although the market was “highly efficient almost all the time”, the last two years have seen an increase in questionable practices among its 22 prime dealers (those licensed to buy paper directly from the Federal Reserve). In some cases firms appeared to have gained control over scarce issues, then used that power to distort prices and make a dishonest buck.
How might they do this? With some note and bond issues, it seems, banks can “squeeze” the market by getting their hands on much of the paper and then restricting supply, sometimes by parking it with custodian banks. When notes are in short supply, holders can profit by using them as collateral for loans. They do this in the busy repurchase (repo) market, where treasuries are sold for cash with agreement to buy them back later. The scarcer the security you want to swap, the lower the interest rate you pay for the cash, known as the repo rate. On some issues this year the repo rate has fallen close to zero.
Rising interest rates may have encouraged traders to play this game. Overnight money now costs 5.25% after 17 straight hikes. If a little market-cornering gets you funds in the repo market for a small fraction of that, why not? The onset of electronic trading, and the resulting tightening of spreads, has only increased the temptation. Some dealers might see the gains on offer as fair reward for taking on risk and making markets. But Mr Clouse views it as “an exercise in monopoly pricing”.
It is hardly surprising that the Treasury is touchy. The market for its debt is the world’s deepest and most liquid, with an average daily volume of $600 billion—many times more than America’s share markets. It is not only where the government borrows but also where the Fed implements monetary policy. And, crucially, it provides the risk-free benchmark against which other credit is measured. If it is not squeaky clean, investors could turn tail, raising the country’s borrowing costs.
Traders argue that manipulating the market would be difficult because of its size. And regulators concede that large positions held by banks can be benign. Nevertheless, the financial policemen may be onto something. One cause for concern is the sharp increase in treasury settlement “fails” in the past few years, caused by a failure to return securities on time to the lender (see chart): these tend to jump when the repo rate is low and bonds are scarce. Another is the reported fall in the number of bonds in short supply after Mr Clouse’s ominous speech. Coincidence?
Mr Clouse said there could now be a “strong sense of history repeating itself”—a reference to the scandal at Salomon Brothers in the early 1990s, in which the investment bank was caught dodging rules on treasury auctions in order to gain control over certain issues. In its aftermath, senior heads rolled and regulators introduced a joint surveillance programme: these days the Treasury, the Fed and the SEC compare notes on the market every fortnight. They may now feel it’s time to get tougher. The Fed’s New York arm, which oversees the banks, and the Treasury have aired their concerns at a meeting with the prime dealers on November 6th.
Among those present included UBS, which must now try to ensure that any bad smells at its bond-trading desk do not pollute other businesses, particularly its prized wealth-management arm. The bank delivered more bad news on October 31st, announcing a 21% drop in third-quarter profits. The cause was largely put down to poor trading: the bank admitted to, among other things, having been “incorrectly positioned” in the treasury market. Whether that applies in more ways than one remains to be seen.