Malt Liquidity 66

DEFCON-Treasury

Before we begin

The clown show that is the FTX saga lurches onward, as SBF further disgraces himself by pulling a Scaramucci by popping off to a reporter and not clarifying that he was talking off the record. FTX’s lawyers, meanwhile, are cobbling together whatever financials they can find, and put out a court filing detailing the sorry state of affairs:

Keep in mind, this is the guy who was in charge of liquidating Enron. The document essentially states that the accounting was made up and the assets have no tracking over what belongs to which subsidiary. Enron, in some senses, was an accounting marvel — as a public company, its financial statements were under heavy scrutiny. So they probably had to pull off some wild stuff to conceal what they were doing. In this case, however, the notion of accounting seems to be filling out an Excel sheet sporadically while three sheets to the wind.

Notable statements include that Alameda was exempt from FTX’s auto-liquidation protocol and that only a tiny fraction of the overall assets (and potential customer deposits!) have even been located, ~$300mm of which is in FTT (which is virtually worthless now, given FTX has shut down and exchanges are pulling its listing.)

I think what’s most surprising to me is that they didn’t even keep track of their trades through any sort of daily reconciliation process. In a bank, every trade has to have both a paper and electronic record, and everything has to match at the end of every day. Apart from accounting, your risk profile and capital able to be deployed is going to be off every single day if you have a fly by night operation like this. Alameda might be the least sophisticated large trading operation I’ve ever heard of — even small funds with ~8 figures have better practices than this.

Well, this is a bummer

Oof:

A whistleblower who provided the US Securities and Exchange Commission with information that led to a successful enforcement action lost his bid for a monetary award because he’d been convicted in a related action, the Second Circuit said.

For context, the SEC has a rule where if a whistleblower’s actions aid an investigation and over $1 million is recouped, they can be awarded a certain percentage of the funds recovered. I think the program is pretty logical — while the SEC has awarded “more than $1.3 billion to 281 individuals since issuing its first award in 2012”, the funds for rewards come out of the penalty payments that go directly to the SEC, not the funds that are recovered for harmed investors. Some of these rewards can get pretty large, with the record being $114 million.

Doe applied for a whistleblower award after providing the SEC with information about an international bribery scheme. The agency denied the application because Doe had pleaded guilty to bribery charges in a related enforcement action.

I must admit, I didn’t think I’d ever see this argument laid forth. “Here’s a crime I had a part in abetting! Pay me a reward for reporting it!” It’s like if Al Capone’s accountant turned Capone in for tax evasion and got a cut of the formerly unpaid taxes he helped prepare. Anything’s worth a try, I guess.

What’s Going on with Treasuries?

If you’ve ever come across the risk-free rate in financial or option modeling, you know that while there is no such thing as “risk free”, treasury rates are about the closest it gets as an input. Treasuries underpin dollar hegemony — it is the world’s deepest debt market. Naturally, the Federal Reserve plays a large part in the Treasury market, utilizing both the Federal Funds Rate and the addition/subtraction of treasuries to its balance sheet to adjust the money supply and fulfill its mandates of low unemployment and stable inflation. As such, the Fed cares a lot about overall bond market liquidity. But we’ll save that discussion for another day. Let’s look at why we should care about specifically Treasury market liquidity, which seems to be slipping.

Liquidity in the market — one crucial measure of how well it is functioning — is at its worst levels since March 2020 after a dramatic decline in the past year. Market depth, a measure of liquidity which refers to the ability of a trader to buy or sell Treasuries without moving prices, is also at its worst level since March 2020…

In the time since the Fed backstopped the bond market’s liquidity during the pandemic, two things have happened. One, as we’re all aware of, is persistent inflation, where essentially too much money is chasing too few goods. Two, as a result of this, the Fed mandate requires that they control the money supply, which is done by raising interest rates to incentivize savings and liquidating securities (primarily treasuries) from their balance sheet that they accumulated to increase liquidity and the money supply (and therefore incentivize growth and investment) during the pandemic and ZIRP. Both of these actions put a lot of pressure on the treasury market — rising rates, even though these increases are fairly telegraphed, induce volatility, which widens spreads, and when you have a known large seller liquidating into a market, you need sufficient bidders to absorb the size being dropped on the market.

Why does this matter? Think back to the risk-free rate. If the risk-free rate is no longer risk free, the calculus changes for assessing the safety of every other potential investment pathway. The effects would reverberate through stocks, bonds, currencies, and more, as massive investors rush to reposition (and potentially rush to cash) and suck up liquidity (thereby inducing volatility) across the board.

To be clear, the relationship between liquidity and volatility is inverse. Higher volatility realized correlates with lower liquidity, and vice versa. If you don’t believe me, look at any stock that’s realizing high vol — you’ll see that spreads are wider and depth is smaller because it’s much riskier to get hit (as a market maker) on an order you’ve put out when the quantity you can pair it off against is smaller and less reliable. Thus, market makers pull their quotes a bit. Of course, as I outlined in an older post,

…this is where market makers are incentivized to tighten the spreads, so they can make money! A precipitous balancing act starts to occur, where each firm is concurrently trying to undercut the other liquidity providers, yet also expose themselves to as little price risk as possible…

(If you want an HFT/MM refresher, I recommend reading that post.)

However, for some seasoned observers of US Treasuries, the causal relationship has begun to swing in the opposite direction, where illiquidity is now driving some of the volatility.

You don’t want the tail wagging the dog because it’s an indication that firms are wary of undercutting others to provide liquidity and capture spreads. Which makes our markets unhealthier, traders warier, liquidity thinner across the board, volatility higher, yada yada yada. It’s certainly not worth doom-spiraling over, but it is something to watch going forward, especially if it leads to the end of the Fed’s balance sheet reduction program to guarantee Treasury market liquidity, which would fly in the face of their efforts to control the monetary supply, and would affect how to individually position in the future. The golden rule of trading is “don’t trade against the size” — and it doesn’t get much larger than the Fed.