On Oct. 15, 2014 at 9:33 a.m. in New York, something went wrong with the massive global Treasury market. Without warning—and for no apparent reason—Treasury yields dropped a harrowing 16 basis points. Then just as suddenly they snapped back. It was all over by about 9:45 a.m. And no one had any idea why.
"When October 15th happened, people were in a frenzy mode," said a person familiar with the Treasury market. "This had never happened."
But when officials finished their investigation into the October surprise, they couldn't say what, exactly, had gone wrong. And they couldn't reassure markets that it wouldn't happen again.
"No single cause is apparent in the data," the government's report concluded. An A-Team of financial regulators recommended several bland-sounding next steps, including "further study," "continued monitoring," and "an assessment of the data."
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While the investigators were flummoxed as to an exact cause of the mini meltdown, they did spend the remaining 68 pages of their report detailing the surprising things they found when they looked under the hood of the global Treasury market. It was not clear to the authors of the report whether what they found had direct bearing on the flash crash. But it did paint a picture of a Treasury market that is not what many people think it is.
What they found is that the Treasury market, long assumed to be a sleepy, low-risk market involving the U.S. government and the nation's largest banks, had actually become an electronic bazaar dominated by high-frequency traders.
On the day of the flash crash, principal trading firms—a term the report used to describe a group that includes many of the biggest high-frequency trading firms on Wall Street—"accounted for more than 50 percent of the total trading volume across various maturities in both cash and futures markets," the report found.
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The market, they found, is also rife with the elements that give such speedy traders an advantage in the market that some have argued can be unfair or even manipulative: large amounts of trade cancellations, high message rates and "latency build up," or delays that can create millisecond advantages for speedy computer traders.
Worse, they found that somebody in this market may be breaking the law.
The investigators said they found "a heightened level of self-trading during portions of the event window."
That means that some traders inside banks, hedge funds or high- frequency trading firms were trading with themselves or with people inside their own firms. Or, more likely, their computer algorithms were.
The report defined self-trading as "a transaction in which the same entity takes both sides of the trade so that no change in beneficial ownership results." It's also known on Wall Street as "wash trading," and it's a practice that regulators frown on in some contexts because it can be used to trick investors into thinking there's a lot of activity in a trade when there is not.
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The investigators found a surprising amount of self-trading going on during the Treasury flash crash—an amount they called "substantially higher than average." At the 10-year maturity, the report said, self-trading reached 14.9 percent of the cash market, and 11.5 percent of the futures market as prices moved up. Then, as prices went down self-trading nearly vanished, dropping to 1.2 percent in cash and 4.8 percent in futures.
That's a red flag for fraud and should be investigated further, said a source familiar with the drafting of the report. "I am appalled at the self-trading that happened on that day," the source said. "You're basically trading with yourself. You can spoof the markets." The source said high-frequency traders can use self-trading to essentially force the market to tick higher on a thin trading day, and then buy ahead of the market uptick they themselves are creating.
"You can fool other programs in a very thin market by trading with yourself," the source said. "And the cherry on top is you get more rebates from the exchange."
Officially, the government report punted on the question of cheating in the Treasury market. In a footnote on page 32, investigators wrote: "At times, self-trading may reflect unlawful conduct. ... This report is not making any findings on the legality of any self-trading that occurred on the days covered in this analysis."
Pressed on this at a background briefing for reporters, officials said they had not gone into the investigation looking for fraud, and it was not their job to determine if anyone had broken the law. They would not say whether they had referred any of their findings to enforcement divisions at any federal regulator.
A spokesman for the CME Group, the derivatives exchange, said "self-trading does not inherently violate exchange rules, the Commodity Exchange Act, or CFTC regulations." But he added that CME has issued guidance to traders about certain self trades that do violate exchange rules.
"We continually monitor our markets for conduct that may violate this guidance, including instances where algorithms more than incidentally trade against other algorithms or traders within the same firm," said the spokesman, Michael Shore. "Where we identify conduct that violates our rules or the guidance we've issued, we vigorously pursue sanctions against the individual traders, operators of algorithms, and/or their firms."
Potential fraud in a key global financial instrument is bad enough, the source said. But the primary Treasury market is how the United States raises money to pay for its massive annual deficits. And the government depends on a robust secondary market of buyers with an appetite to bet on the U.S. government. Recurring glitches in the Treasury market could spook buyers in deeply interconnected markets, and grind the gears of a global market investors now see as nearly risk free.
The source raises a question: What happens if there's another Treasury flash crash—just as the U.S. government is auctioning off new Treasurys? "We don't want to be in a market where people are not buying the stuff that we're selling," the source said. "That's the day U.S. debt becomes not risk free. That is not good. That would be scary for the United States."
Asked about concerns raise by the source, a Treasury Department spokesman offered this statement: "First, the report was focused on the secondary market, not the primary market which is how we fund the government," it said. "Secondly, as the report highlights, trading was continuous throughout the day. But we must remain vigilant and ensure that the Treasury market remains the deepest, most liquid market in the world."