Lower Volume in the US Treasury Market Does Not Mean Incorrect Pricing

Bloomberg published a story yesterday which noted that turnover in the US Treasury market is currently 18% below its 10 year average of USD 502B per day. Bloomberg argued that the decline in volume is one reason that interest rates have fallen so much this year. The claim is that a small group of traders have manipulated bond yields lower, as the larger market makers have reduced their commitment to Treasuries.

The premise that high trading volume is necessary for market efficiency is entirely wrong. One of the major insights of efficient market theory is that information driven arbitrage motivates trading decisions. If one agent knows something that another does not, then he can try to profit from that information. But the uninformed agents are not stupid – they know there are sharks in the market – and once confronted with a bid or an offer, they adjust their price expectations accordingly. The result is a ‘full information revealing equilibrium’ which means that prices adjust to reflect their fair value without generating arbitrage profits. What’s more, THERE IS NO TRADE IN EQUILIBRIUM! (1)

The fact that efficient price discovery does not require any actual trading is often lost in policy discussions surrounding market structure. The popular press believes, for instance, that banks withdrawing capital from their trading desks is both reducing liquidity and increasing volatility, but neither is correct.

If old-style market making was prone to inefficiency then modern computer driven trading can rectify this. Electronic trading has the advantage of responding to information driven traders as computers can rapidly react to abnormal sized trades. Prices adjust before trading takes place in the electronic markets. Therefore, a side-effect of the rise in electronic trading is likely to be declining transaction volumes. This may be what the US Treasury market is experiencing.

(1) More precisely, there is no ‘information driven’ trade in equilibrium. Liquidity motivated trading will take place between agents cashing in assets to consume and those buying assets for saving.