Information and data in the US Treasury market

Author: Hirak Biswas
22 February 2017

In the age of electronic trading, information is a commodity – and one that is either fiercely guarded, highly sought after or immensely profitable – depending on your line of business and which side of the trade you sit on.

While advances in trading technology have lowered transaction costs and delivered significant efficiencies for US Treasuries participants, the execution models deployed on some of the most widely used electronic platforms have created a number of undesirable side effects related to the treatment of information. In the dealer-to-dealer market, information leakage also has a considerable knock-on effect on liquidity.

Participants are now increasingly wary of using certain platforms for fear of unnecessarily exposing their activity and impacting price movement before they have moved their entire risk. Fortunately, thought leaders have developed forward-thinking market structures that have been carefully designed to avoid the unwanted dissemination of information. One of the keys being that they do not seek to profit from the distribution of market data.

The dealer-to-customer market

The electronic dealer-to-customer market in the US Treasuries space is dominated by the request-for-quote (RFQ) model, facilitating 95% of all electronic trades[1]. RFQ is a protocol in which liquidity consumers query market-makers to request prices on an order of a particular size, while disclosing their desired direction.

On electronic platforms, the customer is typically limited to requesting a quote from a maximum of five counterparties, which may not lead to the best price possible; even prices submitted back are executable only for the on the wire time.

There are a number of issues here. The inherent flaw with the RFQ model is that the customer is immediately showing their hand to five different dealers, only one of which they will end up doing business with. The other four receive sensitive insight as to the customer’s intentions for zero cost and without ever having to provide liquidity.

The negative impact is twofold – the customer is exposed to signal risk and the successful dealer is subject to what has become known as the ‘Winner’s Curse’. Its four competitors now know the size and side of the trade in question and can use that information to their advantage, to the detriment of the market maker who won the trade.

In the long run this can often result in dealers providing less competitive pricing to customers using the RFQ protocol because they factor in the risk of information leakage amongst their peer group.

The dealer-to-dealer market

The dealer-to-dealer market presents a different challenge. Here the central limit order book (CLOB) protocol dominates, accounting for 90% of all electronic trading volumes[1]. A CLOB is a transparent, anonymous system that matches bids and offers and enables participants to see market depth through the full stack of orders.

Again, signal risk is a major issue on electronic CLOB platforms. The transparent nature of the CLOB protocol means traders inadvertently broadcast sensitive information to the entire market, even though the trade itself is between a limited amount of counterparties, often just two.

This has encouraged strategies looking solely to capitalize on information that is made public through high speed market data, usually at the detriment of the trader looking to move real risk.

The guaranteed anonymity of the CLOB model means trading accountability – once a key element of relationship-based trading models – has been removed from the equation. This has been fueled further by the rampant commercialization of market data by platform operators. The availability of inexpensive low-latency market data, combined with lightning fast fiber optic cables, means that participants with larger budgets gain sensitive information in real-time and have the technology required to act on it to their advantage.

This together with the major primary dealers investing their resources in enhancing their technology to better internalize flow, while at the same time being less willing to show their hand within the CLOB has been a contributing factor in a lack of firm, executable liquidity on the exchanges. Anecdotal evidence suggests the depth of market on CLOB-based electronic venues is as little as 50% of what it was just five years ago.

The path forward

The drawbacks of CLOB protocols and some of the shortcomings of RFQ have become increasingly visible in recent years, leading to innovation in trading technology and the evolution of the market structure for the US Treasury market.

Through our flexible peer-to-peer model, at LiquidityEdge we are looking to capitalize on the growing influence of market making PTGs, and the advanced internalizing e-trading groups at the primary dealers, to create a new method of liquidity provision through the platform. These providers stream liquidity bilaterally or into bespoke pools to consumers they wish to price to on their own terms. The consumers also benefit from being able to create their own customized pool of liquidity with those they choose to interact with.

We provide a private trading network that minimizes information leakage and market impact by publishing data only to the participants of the trade, and enabling them to customize price streaming amongst a known and trusted network of counterparties. No market data is published, so the opportunity for gaming and toxic trading strategies is eliminated.  This peer-to-peer model allows all types of participants to interact and trade with each other, leading to providers comfortably showing larger sizes and tighter prices, while eliminating the winner’s curse.

By fostering a healthier trading ecosystem, in which liquidity providers and consumers can work through large orders efficiently without fear of falling victim to disruptive trading strategies, this innovative model re-introduces trust and confidence in the market which has been negatively impacted by signal risk and information leakage.

[1] BIS: Electronic trading in fixed income markets (January 2016)

[2] BIS: Electronic trading in fixed income markets (January 2016)