Wednesday's $39 billion monthly 10-year Treasury auction marked a historic shift, with primary dealers receiving only 4.2% of the allocation—the lowest level since the Treasury Department began publishing bidding data in 2003. This outcome highlights the continued decline in primary dealer participation within the ever-expanding U.S. Treasury market.

Currently, there are 25 Fed-designated primary dealers that must participate in all Treasury auctions and are responsible for underwriting and providing market liquidity. However, in this auction, only 4.2% of the securities were allocated to primary dealers' proprietary accounts, with the remainder flowing to direct bidders and indirect bidders. Direct bidders include large asset management companies and pension funds, while indirect bidders encompass global investors such as foreign central banks and sovereign wealth funds.

In July's 7-year Treasury auction, primary dealers received just 4.1% of the allocation, setting a historical low for regular Treasury auctions. Tuesday's 3-year Treasury auction also established a new record low for that maturity. This trend indicates that primary dealers' dominant position in the Treasury market is being systematically eroded.

Industry experts attribute the long-term decline in primary dealer allocation to two main factors: first, while the U.S. Treasury market continues to expand, primary dealers' capital strength has not grown proportionally, diluting their capacity to absorb new bond issuances; second, the rise of passive investment vehicles such as index mutual funds and exchange-traded funds (ETFs), which automatically allocate to Treasuries to match benchmark indices, has created new major buying forces that divert share from dealers.

Prior to the 2008 financial crisis, primary dealers virtually monopolized the primary distribution market for U.S. Treasuries, typically securing over 80% of auction allocations with a floor of 60%. Today, this landscape has completely transformed.

From a market perspective, exceptionally low primary dealer allocation ratios are not necessarily negative. With more Treasuries flowing to long-term investors, there is reduced selling pressure on these bonds, helping to alleviate secondary market pressure and stabilize yields.

However, John Fath, former partner at BTG Pactual's U.S. asset management division and former primary dealer Treasury trader, warns that this trend could pose risks. He notes that if primary dealers are frequently "marginalized" in auctions, it will undermine their bidding enthusiasm and could potentially lead to dealers being completely squeezed out of auctions within the next five years.

Fath explains that this situation creates pain for traders who must participate in bidding and hedge in advance. When primary dealers fail to receive their desired allocation in auctions, they often must repurchase bonds in the secondary market at higher prices, potentially causing yields to decline sharply and triggering market rallies similar to the short-term surge following Wednesday's auction.

He emphasizes that if he were at the Treasury Department or the New York Fed, he would be concerned about this trend. As U.S. fiscal deficits remain elevated and Treasury issuance continues to reach record levels, the transformation in investor composition has become a long-term trend. Long-term capital sources such as global central banks and large asset management companies are gradually becoming the primary force in Treasury auctions, while primary dealers' role is shifting from dominant distribution to maintaining liquidity and market regulation.

Analysts believe that if this trend continues, the U.S. Treasury market's price formation mechanism may become increasingly dependent on the allocation behavior of foreign investors and passive funds, potentially increasing market volatility. For policymakers, balancing primary dealer incentives with market competition will become a critical issue requiring resolution in the coming years.