US Treasurys Trading Under Investigation

Trading in U.S. Treasurys is drawing scrutiny from regulators and plaintiff lawyers, setting the stage for a legal challenge that cuts to the heart of how financial markets work. Allegations of rigging at auctions of U.S. government debt, the world’s most liquid securities, are the subject of government probes by the Justice Department and the New York Department of Financial Services, said people familiar with the matter. At least two private lawsuits have been filed seeking class-action status, court documents show. 

At the center of these actions are questions about whether bank traders have colluded to bolster their own profits by depressing prices at U.S. government debt auctions. It isn’t known what specific instances of possible manipulation are prices at auction and whether firms may have colluded to manipulate futures prices that affect the auctions. The accusations come on the heels of investigations into alleged bank misconduct in everything from foreign-exchange markets to interest-rate benchmarks affecting trillions of dollars of securities, cases that have resulted in billions of dollars in fines. The probes into Treasurys trading are in their early stages, and regulators haven’t accused banks of any wrongdoing, according to people familiar with the matter. But the inquiries and the private lawsuits take aim at an arrangement that is at the center of all markets, observers said. The challenge for regulators and plaintiffs in the Treasurys market is showing alleged wrongdoing as distinct from the routine information-sharing that banks have historically done in the context of market making, or buying and selling securities on behalf of customers, said Craig Pirrong, professor in finance at the University of Houston. “The conundrum for the regulator is separating communication that improves liquidity in the context of market making from that which distorts prices,” he said.

Banks that deal in government securities and purchase directly at auction are known as primary dealers. One of the main purposes of the primary dealer system is to make sure the government can readily find buyers for its debt, analysts said, an arrangement that essentially gives the dealers the right to make profits in exchange for their commitment to purchase securities. The cases come as the liquidity-creating function of dealers is at a premium. Some analysts and investors are warning that even the $12.8 trillion market for Treasurys, arguably the most trusted financial assets in the world, appears vulnerable to large price swings driven in part by a reduced willingness by banks and other market makers to smooth trading by buying and selling. Any finding that Treasury prices have been gamed by traders could have far-reaching effects and may threaten to shake confidence in the Treasury market.
Some lawyers with knowledge of the matter said regulators are interested in the relationship between Treasury auctions and prices on Treasury futures, which often are closely aligned but where banks can profit from discrepancies. Some regulators are looking into whether banks have pushed around futures prices in the moments leading up to an auction, in an attempt to influence its price.
Other lawyers familiar with the situation said, based on available data on Treasurys, it is hard to find anything that convinces them banks have rigged the market for Treasury auctions.  Each month, the Treasury Department holds auctions to issue debt maturing in between four weeks and 30 years, raising hundreds of billions of dollars to finance the U.S. government. Primary dealers, which include Wall Street firms and some non-U.S. banks, are required to bid in all Treasury auctions. 

About a week before an auction, a “when-issued” market starts trading, in which dealers and traders bet on the interest rate, or yield, that will be offered by the securities to be issued. Treasury yields move inversely to their prices. The preauction market is designed to attract deeper trading, or liquidity, and better set up for the auction. The “when-issued” market continues to trade and settles on the auction day. At auctions, dealers help clients such as mutual funds, pensions and foreign institutions to place orders through an electronic bidding system. These buyers will later show up as “indirect bidders” in auction results.  But in recent years, the Treasury Department has allowed more investment funds, insurance companies and foreign central banks to bid directly at auctions, after some investors became concerned about disclosing information about their bids to dealers who were buying for themselves on the same day. Dealers have gradually lost their edge in gauging the market sentiment because they now have fewer customers placing indirect orders through them. From 2010 to 2015, the average allotment to dealers at Treasury auctions has fallen from 15.1% to 8.3%, according to official data. Element Capital Management LLC, a $6 billion New York hedge fund, has been the biggest purchaser at dozens of recent Treasury auctions, as reported by The Wall Street Journal. The hedge fund, an indirect purchaser, is said to be using a “bond-auction strategy,” aiming to exploit small price discrepancies in the “when-issued” market and at the auction.

In the 1991 Salomon Brothers scandal, the firm, which later was subsumed into Citigroup Inc., bought as much as 85% of a Treasury note auction in a bid to corner the market and was fined by regulators. The firm’s traders would often be big players in the when-issued market and at times buy so much at Treasury auctions that other firms would have to buy the notes and bonds from Salomon at a premium. Treasury rules limit one bidder to 35% of each debt sale.