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You may have noticed that FT Alphaville (some of it at least) has an entirely healthy but above-average interest in the functioning of the US Treasury market. Or more specifically, when it stops functioning.
Luckily, amid all the usual guff about r-stars, obsolete playbooks and how Volcker loved fly-fishing, this year’s Jackson Hole confab yielded an interesting paper on the topic by Stanford’s Darrell Duffie. Yay!
Duffie is a bit of a Treasuries savant, having written extensively on the subject before. This latest instalment lays out his core argument that the US government bond market’s alarming lack of resiliency in March 2020 was because the swelling size of the market has overpowered the capacity of banks to intermediate trading in times of stress, and lays out some potential fixes.
The longtime Stanford prof’s two main focuses will not surprise regular Alphaville readers: central clearing of Treasury trading, and shifting the market to an all-to-all trading ecosystem. As Duffie puts it:
Central clearing increases the amount of trade that can be effectively intermediated on existing dealer balance sheets. All-to-all trade adds intermediation capacity to the market through better matching efficiency for some types of trade and by allowing some trade that does not necessarily require dealer intermediation.
If you want to know more, Duffie’s Jackson Hole paper goes deep into both issues. But he also almost casually throws out three more controversial additional measures to ameliorate the danger of another Treasury market shambles.
One, the government could impose comprehensive realtime Treasury trading data on a consolidated public tape, à la equities. This would bring a lot of new players into the Treasury market and make it more vibrant. But it could also bring a lot of new players into the Treasury market and make it more fragile. It really depends on your vantage point (basically whether you work at JPMorgan or Citadel Securities).
Two, ditching the “Supplementary Leverage Ratio” rule that can occasionally impede a bank’s ability to make markets in Treasuries and replacing it with “higher risk-based capital requirements”.
This is controversial because while the bluntness of the SLR — it requires large systemic banks to have capital equal to at least 5 per cent of assets, whatever the assets — can obviously impede trading by making otherwise profitable trading unattractive, it also helps solidify the banking system as a whole.
Treasuries were for a time (rightly) exempted from the SLR calculation when it became clear the trouble it caused in 2020. But the whole Silicon Valley Bank debacle has shown the value of a broad, asset-neutral capital rules that don’t treat Treasuries or anything else as riskless. Ideally, we wouldn’t need to improve financial stability by doing something that possibly erodes financial stability at the same time.
Two, the Federal Reserve could broaden access to some of its new financing programmes — specifically the Standing Repo Facility, the Bank Term Funding Program (more affectionately known at FTAV Towers as “Buy Them at Fucking Par”) and the Foreign and International Monetary Authorities Repo Facility.
Doing so would be a powerful tool to pre-empt stress, as a lot of big potential forced sellers could then repo them with the Fed to raise cash rather than just ditch them in the open market. But formally turning the Fed into the permanent broker-dealer of last resort for almost all market participants is the kind of thing that raises hackles with people who think the US central bank’s footprint is already far too big.
Here’s the paper’s conclusion, which basically sums up Duffie’s argument pretty well.
Volatility is likely to explain the majority of variation in illiquidity in many financial markets, except when a market becomes dysfunctional. The extent of illiquidity in excess of that predicted by volatility could be viewed as an index of market dysfunction, despite some limitations of this measure. In the US Treasury market, this dysfunction index is reasonably well explained by heavy loading of dealer balance sheets, which places the resilience of the Treasury market at risk just when safe-haven investors are most dependent on intermediation. A resilient US Treasury market supports financial stability, dollar dominance, effective monetary policy, capital market efficiency, and the provision of safe-haven services to global investors.
The total amount of Treasuries outstanding will continue to grow rapidly relative to the intermediation capacity of the market because of large and persistent US fiscal deficits and the limited flexibility of dealer balance sheets, unless there are significant improvements in market structure. Broad central clearing and all-to-all trade have the potential to add importantly to market capacity and resilience. Additional improvements in intermediation capacity can likely be achieved with real-time post-trade transaction reporting and improvements in the form of capital regulation, especially the Supplementary Leverage Ratio. Backstopping the liquidity of this market with transparent official-sector purchase programs will further buttress market resilience.
Further reading:
– Should we all get to trade Treasuries?
– US Treasuries: the lessons from March’s market meltdown
