Regulators Issue Joint Staff Report on Volatility in Treasury Markets

Staff members from the U.S. Treasury Department (“Treasury”), the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, the SEC and the CFTC (the “Regulators”) issued a joint report that analyzed the “significant volatility” in the Treasury markets on October 15, 2014.

The joint report highlighted specific developments that most likely created or contributed to the volatility, including: (i) changes in investor positions and sentiments about global risk, (ii) a decline in order-book depth and (iii) changes in order flow and liquidity provisions.

The report also recommended possible methods for increasing the public and private sectors’ understanding of changes in the structure of the Treasury market and their implications. These changes included: (i) increased focus on trading and risk management practices and (ii) continued efforts to strengthen monitoring and inter-agency coordination related to trading across the Treasury cash and futures markets.

Lofchie Comment: Staff writers recognized the argument that regulatory changes may have contributed to the extreme volatility that occurred on October 15. In this regard, the report notes the following: “Some market participants have argued that recent regulatory initiatives have increased trading and inventory costs and forced a reduction in risk-taking, prompting them to shift their allocation of capital away from market making for low margin transactions, and instead towards other business areas that may yield greater returns on equity. Indeed, some of this capital reallocation could have been expected from regulatory changes intended to increase the resiliency of financial institutions and of the financial system” (emphasis added).

To put this differently, rules that are intended to have a beneficial effect can, when implemented, have a negative effect. In particular, imposing high capital requirements on all firms might seem to make each firm safer when viewed in isolation, but if the effect of the requirements is to discourage any firm from acting as a buyer when markets fall, then the net effect of the requirements will be to make all firms riskier in the aggregate. See, e.g., The Bank for International Settlements Issues 85th Annual Report (with Lofchie Comment) emphasizing increased systemic risk.

On another note, regulators’ inability to identify the causes of the volatility on October 15 demonstrates how absurd it was for the CFTC to announce that improper trading by a reasonably small-time futures trader had caused the Flash Crash. See, e.g., Finance Professor Calls CFTC Allegations That Nav Sarao Caused Flash Crash ”Outrageous” (with Lofchie Comment and Video Selection).

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