Bonds and swaps struggled in virus volatility

Low liquidity and wider spreads amplified by remote working, traders claim

Covid-19-volatility montage

As collapsing oil and stock prices caught the world’s attention on March 9, rates markets were hit by a liquidity shortage that left traders groping for the right comparison.

The head of European rates at one US bank said conditions were “worse than in the financial crisis”. A senior rates trader at a European bank said trading was “as bad as when Greece was looking to drop out of the euro – maybe even worse”.

Worryingly for markets that are bracing for further bouts of volatility, traders claimed remote working arrangements played a part in the stress. In order to protect their trading businesses from the spreading coronavirus, a number of large dealers have split up their trading teams, leaving some on the main floor while others work from back-up facilities or from home. This is inhibiting normal working practices.

“Any impact of the global news has been exacerbated somewhat by the fact that a lot of banks are starting to implement their Covid-19 plans, splitting up their trading floors. That has the short-term impact of reducing liquidity and exaggerating some of the moves we’re seeing,” said the US bank’s European rates head.

The senior rates trader at a European bank said he had been executing almost exclusively over the phone – partly because he was working remotely.

“I haven’t actually logged into Trad-X today because I’ve been too busy, and I’m at my disaster recovery site so I don’t even know if it works,” he said.

In a note published on March 10, interest rate strategists at JP Morgan linked the impact of remote working to a number of unusual market dynamics, including wider bid/offer spreads for US Treasuries on BrokerTec, the principal interdealer market. In all, around two-thirds of trading during the New York session on March 9 was executed at bid/offer spreads that were wider than the 0.5-tick minimum price increment – a 50% spike from the previous trading day, and far higher than in any other recent bout of volatility.

The note warns that the “mass relocation of a significant fraction of market-making over a few weeks has almost no historical precedent in terms of its reach or scale” and argues it could expose weaknesses in market microstructure.

I haven’t actually logged into Trad-X today because I’ve been too busy, and I’m at my disaster recovery site so I don’t even know if it works
Senior rates trader at a European bank

Other causes of the day’s dramas were more conventional.

The US bank’s European rates head said that as flight-to-safety trading pushed rates lower, some asset managers and bank market-makers were being stopped out of risk positions across a range of instruments and strategies. When rates stabilised later in the day, speculative hedge funds came in to take on new positions.

With a lot of one-way flow coming through, traders say internal offsets were harder to find, leading to more aggressive use of the broker market – dealers were more willing than usual to pay the bid/offer spread in order to hedge.

During the day, bid/offer spreads quoted to buy-side traders widened significantly. A senior swaps trader at one large US asset manager says spreads were at least 50% wider in the short and intermediate portion of the US curve, and worse in the long end. He was quoted prices at least 1.5 basis points from mid on a 30-year swap on sizes of around $10–15 million.

That kind of level is backed up by bid/offer spreads shown on Bloomberg’s ALLQ function. Average screen bid/offer spreads in mid-February were as low as 0.6bp for a 10-year US dollar interest rate swap, rising to around 1.55bp on March 9.

“It’s quite a day. Liquidity has been terrible,” said a derivatives trader at one large US insurer. He said interest rate futures that would normally quote with a spread of between 0.5bp and 1bp surged on the day – reaching around 4bp.

“Dispersion between dealers has been very wide relative to normal. Activity is light, with very low liquidity,” he added.

The insurer already had a number of macro and tail hedges in place, the trader said, and decided there was little need to add more, given rates had compressed towards zero.

“At this point you’re adding hedges at all-time lows. It’s hard to see how that benefits you given the Fed’s reluctance to go negative rates, unless you’re hedging a move upwards in rates – or if you want to try playing the game that negative rates will show up in the US. I suppose that could be one line, but not one we’re ready for,” he said.

A derivatives trader at a second US insurer said the market warranted wider bid/offer spreads, but “if one were trying to force trades, then it would be extremely difficult”.

The trader was unable to complete the full amount he wanted to execute on the day.

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