Liquidity Trends in U.S. Treasury Market: The Impact of Aging Securities

The U.S. Treasury debt surpasses $30 trillion, yet a striking statistic emerges: less than 4% of this amount, attributed to the most recently issued Treasuries—termed “on-the-run” securities—accounts for approximately 65% of the average daily trading volume. In contrast, the seasoned issues, known as “off-the-run” securities, are primarily displaced by newer benchmarks and their trading dynamics reveal substantial patterns regarding investor behavior, liquidity, and market mechanics.

Role of Trading Dynamics in the Treasury Market

This analysis hinges on transaction-level data collected from the Trade Reporting and Compliance Engine (TRACE) since July 2017. Through this lens, we primarily focus on 2-year nominal coupon securities, although our findings extend to other maturities such as 5-, 10-, and 30-year notes. The limitations of our dataset include the absence of quote information, affecting our liquidity measures, which focus on active trading securities.

The segmentation of the Treasury cash market delineates a clear distinction between dealer-to-customer trading and interdealer activity. On-the-run securities dominate trades in the interdealer market, particularly on electronic trading platforms, whereas off-the-run securities rely more heavily on dealer-to-customer channels. For instance, during the first half of 2024, daily trading volumes averaged $262.9 billion for on-the-run notes in interdealer platforms, compared to $51.3 billion for off-the-run notes. This shift illustrates how Treasury securities evolve in their trading environments as they age.

The Decline in Trading Volume

Upon transition to off-the-run status, trading volume decreases significantly. For example, a 2-year on-the-run note averages $56.3 billion daily, while the first off-the-run averages merely $5.5 billion, followed by $1.6 billion for the second off-the-run. This reduction in volume is consistent across other maturities as well, signifying that movement off-the-run correlates directly with decreased trading activity. The frequency of trades echoes this shift: the 5-year on-the-run experiences about 37,900 trades each day, while the first off-the-run only reaches 465 trades. Such figures underline the stark contrast in trading dynamics before and after a security loses its benchmark status.

In addition to trade counts, the average trade size reflects this transition. Notably, in the 5-year sector, average trade sizes increase from approximately $3 million for on-the-run notes to $16 million for the first off-the-run. Similarly, the average in the 10-year sector rises from $2 million to $10 million. This trend signals a movement away from high-frequency trading toward larger transactions typically associated with dealer-to-customer activity.

Effective Bid-Ask Spreads and Liquidity

The liquidity of Treasury securities deteriorates as they age, evidenced by widening effective bid-ask spreads. Calculated as the divergence between average prices of customer buy and sell trades, effective spreads signal changes in liquidity. For the 2-year securities, the on-the-run security has an average effective spread of 0.66 basis points, while the first off-the-run increases to 1.22 basis points, and the second off-the-run rises further to 2.23 basis points. The move from on-the-run to off-the-run effectively doubles the bid-ask spread in many instances—indicating a notable decline in liquidity. These trends are amplified during market stress, as seen in March 2020, where the effective spread for the 2-year on-the-run increased significantly, reflecting a weakened capacity of the market to absorb selling pressure.

However, interpreting spreads for deeper off-the-run issues can be misleading. Infrequent trading often accompanies narrower effective spreads during periods of poor liquidity, which might misrepresent actual market conditions.

The Exception: Cheapest-to-Deliver Securities

Interestingly, certain off-the-run securities maintain a higher degree of liquidity when they become the cheapest to deliver (CTD) into Treasury futures contracts. This status is crucial for hedging and trading strategies, contributing to enhanced trading volumes. Statistical analysis shows that CTD classification can generate up to $1.31 billion in additional trading volume within the 5-year sector, and $0.75 billion in the 10-year sector. For 2-year securities, the CTD status leads to an augmentation of about $0.51 billion in trading activity.

This insight serves to illuminate that diminished liquidity in off-the-run securities doesn't solely stem from age; it results from changes in investor utility, trading behavior, and overall market dynamics.

Conclusion

The findings illustrate a palpable shift in market conditions when Treasury securities transition to off-the-run status. As these securities age, trading flows from the interdealer market toward dealer-to-customer venues, characterized by reduced volumes, decreased trade frequency, and wider bid-ask spreads. These trends begin immediately as securities lose their benchmark status and become more pronounced as they age. However, exceptions arise when securities hold significant roles in futures and hedging, showcasing that not all off-the-run securities partake in the same liquidity fate as their age progresses. Understanding these dynamics is critical for market participants, including traders, financial analysts, and policymakers who monitor the Treasury market’s functionality and liquidity environment.