U.S. Treasury Securities

Overview

Interdealer Brokers (IDBs) facilitate trading among dealers in the secondary market; the role they play in the U.S. Treasury market is very important for its success and growth.

The clients of an IDB are dealers, not institutional investors. Many of the dealers are also Primary Dealers authorized by the Federal Reserve to participate in Treasury auctions and to trade directly with the Fed.

IDBs act as agents in the dealer community: their role is to match buyers and sellers of Treasury securities (anonymously) in a private, closed market. If they are able to make a match between a dealer who is buying and one who is selling, the IDB is paid a small brokerage fee.

Interdealer Brokers

The following are the major Interdealer Brokers in the U.S. Treasury securities market:

• ICAP (formerly Garban) the largest Treasury broker, with both voice and their Electronic Commerce Network (ECN), BrokerTec.

• BGC Partners (formerly Cantor Fiztgerald), the pioneer in screen/voice brokering and their ECN, eSpeed.

• Tullet Prebon

• TradeWeb, the largest Treasury ECN for dealers and clients, which recently entered the IDB market.

IDB Infrastructure

Some background on IDBs’ infrastructure is helpful to better understand their inner workings.

Phone Turrets

Phone Turret

The traders at the desks of dealer clients have direct voice lines to their IDBs. A trader doesn’t have to dial; pushing a button on his phone turret will connect him directly to his coverage broker at the IDB.

Trading floor phone turrets are highly configurable systems. They typically have two handsets (one for each ear). They provide access to an almost unlimited number of contacts and can be programmed so that the most frequently used contacts can be reached with extreme ease.

In addition to facilitating instantaneous external calls to brokers, phone turrets’ microphones, speakers, and squawk boxes allow for communication with the trading floor.

The phone turret is a comprehensive system that handles all of a trader’s audio communication requirements.

Trader’s Desk

Traders have IDB screens that display live trading prices directly from the brokers. As brokers key in data (using customized, ergonomic, “broker friendly” keyboards) for the bids, offers, and trade execution orders they receive from traders on direct phone lines, the information is instantaneously disseminated to the traders through these broker screens.

IDB screens are frequently referred to as “green screens” because, historically, the phosphor in the glass of the cathode ray tubes made them this color. Today (as you can see in the photo), trading desks are surrounded by multiple, high-resolution, color, flat panel monitors.

Trader's Desk

Voice Broking

Direct phone lines and broker screens are used by traders and their IDBs in the “voice broking” market. The trades are communicated over the phone and the trading activity is displaying on broker screens across all participating dealers. U.S. Treasuries are still voice brokered by IDBs today, especially when the trader wants to make a particularly large or complicated trade.

Electronic Broking

Over the past 10 years IDBs have introduced “electronic broking”, in which traders submit orders to an automated trade-matching engine.

Electronic Commerce Networks (ECNs) are used to facilitate trading over private networks using proprietary trading software. The popular IDB ECNs are BrokerTec (owned by ICAP), eSpeed (owned by BGC Partners) and more recently TradeWeb (owned by a consortium of dealers and Thomson Reuters).

Instead of communicating trade orders over the phone, traders can submit their orders using IDB supplied software directly to the IDB’s computer over a secure, private communications network. These orders are matched electronically and the confirmed orders and trades are communicated back to traders through this system of high-speed networks and desktop software.

Electronic trading has grown dramatically because of its high-speed and low-cost.

Hybrid Voice and Electronic Broking

In the early days of electronic trading, the voice and electronic broking businesses of the IDBs were run separately.  IDBs have since combined the two, creating hybrid voice and electronic broking operations. Orders and trades coming in over the phone are combined with those being submitted electronically into a larger liquidity pool that is distributed over screens and software.

Representative IDB Screen

Representative IDB Screen

 The screen above displays the most recently auctioned issue of each type of security that the Treasury issues. These are called the “active”, “on-the-run”, “current”, or “benchmark” issues. It includes the 3-month (13-week), 6-month (26-week) and 12-month (52-week) Treasury Bills (“T-Bills” or “Bills”). Following are the Treasury Notes (also called “T-Notes” or “Notes”): 2-year, 3-year, 5-year, 7-year and 10-year. Lastly is the 30-year bond, also called the “long bond” because it has the longest maturity of all the Treasury issues.

Coupon and Maturity

The next two columns on the screen, “Coupon” and “Maturity”, describe the issue. T-Bills do not pay an intermediate interest payment (coupon), therefore this area is left blank. Instead, the yield or interest on a Bill is the difference between its full value and the price that is paid for it (also known as the discount). At maturity, the owner of the Bill receives this full value. Notes and Bonds have both a coupon and maturity; the owner of either is paid interest semi-annually and receives the principal back at maturity.

Price

The “Price” column has both the bid price (left) and the offer price (right), separated by a slash (/). Bills are quoted in discount rate, whereas Notes and Bonds are quoted in percent.

Let’s take the 2-year Treasury as an example: the bid price is “100-02” which is equivalent to 100 and 2/32nds of a percent. Notice that the offer is “022″. The “100″ (also called the “handle”) is implied in the offer price. Yet the complication doesn’t stop there: the first two digits after the dash(-) are in 32nds, while the 3rd digit is in 8ths of a 32nd or 256ths. So the offer price of the 2-year Note is actually 100 + 2/32nds + 2/256th percent.

Size

The next column (“Size”) displays the quantity that is being bid (left of the slash), and the quantity that is being offered (right of the slash) in millions. Let’s use the same 2-year Note example: a dealer (whose identity is unknown to the viewer) is willing to buy $5 million of the current 2-year Note at a price of 100-02. Some other dealer (though it could actually be the same one) is willing to sell $10 million of the security at a price of 100-022.

If there is not a bid or offer for a security, the size column is blank (as is the corresponding price). Note from the screen that the 7-year Note has a bid, but no offer; therefore the offer portions of the Price and Size columns are blank.

In fact, a bid or an offer in trader jargon is called a “picture”, because it means that there is something to see. When there is no bid or offer, traders will say that there are “no pictures” for that security. On our screen, the current 3-year Note has “no pictures.”

Yield

The last column is the Yield (also called “Yield to Maturity” or “YTM”) for the security. This number is calculated from the price and indicates the effective rate of return on the security until it matures.

More than One Bid or Offer

If there are multiple traders making a bid or offer, the best bid (or highest price) and the best offer (lowest price) are displayed. If there are multiple bidders (or multiple offers) at the same price, then the total of all bids (or offers) at the best price is displayed.

Live Executable Prices

The IDB broker screen displays “live executable prices”; the dealer who made the bid or offer must honor the amount and price unless he cancels the order. This is called a “Good ‘Til Cancelled” or “GTC” order. If he does tell the broker to cancel, his bid or offer is taken down and the next best bid or offer, if one exists, is displayed.

If a dealer wants to sell a security off the screen, he asks the broker to “Hit” the bid. The broker makes a match between the buying dealer (the one who posted the original bid) and the selling dealer (who just agreed to the amount and price off the screen) and the trade is executed. The broker flashes “HIT” and the amount on the screen. Notice the 5-year Note: it is in fact trading on the screen. The red “HIT” indicates that the $10 million are being sold. (On an actual screen these figures will blink for a few seconds.)

Similarly, when a dealer wants to buy a security off the screen, he tells the broker to “Take” (or “Lift” or “Tak”, for short) the offer. On our screen, $5 million of the current 10-year Treasury is being bought, as indicated by the red “TAK” and “5.”

IDB screens are one of the most important sources of market data on the trading floor because they show real trading prices and display live trades as they happen. U.S. Treasury screens are by far the most popular because U.S. Treasury interest rates are the benchmark for the U.S. capital and global financial markets.

The Role of the Interdealer Broker

Interdealer brokers are extremely important to the U.S. Treasury Markets. IDBs provide dealers with three major benefits:

1. Price Discovery

2. Liquidity

3. Anonymity

Price Discovery

As the representative screen illustrates, IDBs provide important information about the value of securities. Live executable prices from dealers trading in their own private, wholesale markets are displayed on these screens. The IDB screens reflect the cumulative knowledge and expertise of the trading desks across the major dealers. And because screens show the best bid and offer among all traders for each security, it has the tightest markets (with the highest bids and lowest offers). There is no better source of prices than the IDBs.

Liquidity

Dealers make markets and provide liquidity to their institutional clients. They stand ready to buy or sell Treasuries for their clients throughout the trading day. Whenever a client is looking to buy (or sell) a security, the dealer is willing to make an offer to sell (or a bid to buy) the security. A good dealer will know the fair price of the security and try to re-trade it to make a small profit.

Dealers’ positions change as they execute deals and foster liquidity for clients. For example, let us say that a trader has an inventory of $10 million of the current 5-year Treasury at the beginning of the day. In Wall Street-speak, he is “ten million long in the five-year.”

At 8:00 a.m., when the market opens, he buys $8 million from Client 1. Now the trader is “long $18 million.” Client 2 calls a few minutes later and wants to buy $25 million of the 5-year Note. Even though the trader has only $18 million, he agrees to sell Client 2 the $25 million she wants. Now the trader doesn’t have any 5-year Treasuries in inventory, but is instead short $7 million (the $18 million he had prior to the trade less the $25 million he just sold).

Essentially the trader sold something he didn’t have, which is perfectly fine when trading U.S. Treasury securities. However, the trader must cover his short position.

He can do this in one of two ways: he can (1) buy or (2) borrow the securities from someone else. Here’s where the IDBs comes in—they provide liquidity by allowing dealers to trade among themselves, in a private and anonymous setting.

Anonymity

When dealers need liquidity, their best option is other dealers. But dealers are usually reluctant to call one another directly for fear that they will come across as desperate or weak (and that the seller will adjust the price unfavorably).

With an IDB, which has direct access to the entire dealer community, a trader can post his order anonymously in front of a large group of peers. Many of them will also be looking to buy or sell. Some of them specialize in making markets and will always be willing to buy/ sell with a bid/offer spread (in what are called “two sided markets”).

Another advantage of anonymity is size. If a trader is looking to buy a large quantity of Treasuries (a “big block”), he does not necessarily want to alert the marketplace and have it move against him. Let us take, for example, a big buyer of $100 million; he will drive the price up because the demand in that instant will far exceed the supply. A clever trader will build the position slowly with the help of his broker. He’ll buy $10 million initially and the broker will determine if there are other sellers. If there are, he’ll begin “working up” the trade until he fills the $100 million order for his trader.

Summary

The Interdealer Broker plays an extremely important role in the U.S. Treasury Markets. Though conceptually simple, many years of experience are required to understand the markets’ dynamics and the job’s nuances.

Wall Street attracts the best, brightest, and the most competitive people to its trading floors. These traders do battle with one another through the IDBs and their scorecard is their profit and loss (P&L). Naturally, trading is often times intense, intellectually challenging, and unpredictable.

As Texas Hold’em legend Doyle Brunson once said, ”Poker takes a few minutes to learn, but a lifetime to master.” This holds true for trading Treasuries, especially in the IDB markets.

Links

Icap and BrokerTec: www.icap.com

BGC Partners and eSpeed:  www.bgcpartners.com

Tullet Prebon: www.tulletprebon.com

TradeWeb: www.tradeweb.com