The $24 trillion Treasury market needs more than just clearing


The $24 trillion US Treasury market has become too big even for the “masters of the universe”. As the Federal Reserve cancels its bond-buying program and more government securities return to the hands of dealers, banks, investors and traders, the risks of extreme and unhealthy volatility increase. We are at the time regulators and market participants feared, that is to say there will be more episodes like in March 2020 and September 2019 when parts of the market seized up and prices are deranged. This is important because the Treasury market is considered the most important of all as the foundation of dollar-denominated financial assets around the world.

The Securities and Exchange Commission has just taken the first official action to prevent the market from crashing. He proposed on Wednesday to further force government bond trading through central clearinghouses. Netting reduces the risk that either party to a transaction will not fulfill its part of the agreement. It can also allow multiple parties to offset exposures against each other at the same time, which should give everyone more ability to trade.

If enough banks, investors and other brokers can and do use clearing, that will help, but it is not a panacea. Many other changes should be pursued with the longer term aim of encouraging more market participants to be able to trade directly with each other rather than relying so much on the 25 main trading companies who are forced to bid at Treasury auctions and authorized to trade with the Fed. The giant US bond fund manager, Pacific Investment Management Co., came out last week in favor of so-called global trading.

Dealers’ ability to trade intermediate Treasuries is the central problem and is making episodes of market stress and dysfunction more frequent, according to a report released last year by former central bankers, regulators and academics known as name of the Group of 30. The March Panic 2020 was a particularly extreme year: it was when the United States and Europe realized the seriousness of the Covid-19 pandemic and led investors to sell almost everything and stock up on cash. Instead of acting in their usual role as a safe haven in turbulent times, Treasury prices unexpectedly crashed as liquidity dried up, pushing yields higher

It is probably impossible to hedge against such events, but the seizure of money markets in September 2019, which saw huge spikes in overnight borrowing rates, was due to the Fed pursuing a tighter monetary policy. , which she must be able to do without blowing. markets. Nobody knows exactly how today’s quantitative tightening will play out, but it’s very likely to be a difficult and unpredictable course.

In addition, the Treasury market is expected to continue to grow and reach $40 trillion by 2032 as the government borrows to finance large budget deficits. If banks are struggling to step in today, it would be crazy to rely solely on them to manage a much larger market in the future. That’s the argument of non-bank market makers like Citadel Securities and it’s hard to disagree.

The volume of transactions handled by banks has declined significantly relative to the size of the Treasury bill market: prior to 2008, primary dealer volumes were equivalent to around 15% of the value of outstanding Treasury bills; now it’s just 2.5%, according to Bank of America Corp, which is a primary trader.

Banks such as JPMorgan Chase & Co., also a primary trader, argue the problem lies with rule changes imposed after the financial crisis to make banks safer and less vulnerable to sudden funding losses. The new rules have made it harder for banks to absorb additional assets quickly during a burst of market activity, especially during times when everyone wants to sell. The biggest banks want the calculation of leverage ratios, which measure the size of their balance sheets, changed to exclude the safest assets, something the UK and other jurisdictions have already done. They also want the additional capital charges of being systemically important banks to be reduced. Such changes would reduce their capital requirements and improve their returns, but it is difficult to say that they would permanently ensure the proper functioning of the Treasury market.

More important in 2019 were rules on the amount and type of highly liquid assets big banks must hold, including treasury bills and central bank reserves. These rules led some banks to prefer reserves to treasury bills – which made them less willing to lend against treasury bills in the money markets, which contributed to the chaos that year.

Adjusting the rules to help banks handle more transactions and funding would certainly benefit Treasury markets, but making it less reliant on banks as intermediaries should be the more important goal. Banks may argue that many electronic market makers or major trading firms are “good weather” liquidity providers who disappear when the markets get tough, but they will also always have a limit on how much they will trade during times the most stressful. This was true long before 2008.

The Fed could lend against Treasuries to more market participants than just banks, which could help ease business stress in a crisis. It would take good risk management to protect taxpayers, but such a “dealer of last resort” role for Treasuries makes sense for the most difficult times. Ultimately, the best way to avoid frequent crises would be to promote greater diversity in the size and types of traders, traders and market makers who can trade with each other. A wider variety of balance sheet types and motivations should help ensure that some remain active when others retreat.

More central clearing, as proposed by the SEC, should help with this, but greater transparency about what trades are being made and at what prices and sizes is also needed to give different parties a better idea of ​​where their holdings should be. negotiated. It works in other assets, so it should also help in the most important market in the world.

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This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Paul J. Davies is a Bloomberg Opinion columnist covering banking and finance. Previously, he was a reporter for the Wall Street Journal and the Financial Times.

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