Fixing the Bond Market Will Take More Than Repos
(Bloomberg Opinion) -- The market for U.S. Treasury securities is a lynchpin of global finance, providing funds for the government, a safe place to park money and a benchmark for interest rates everywhere. Yet on too many recent occasions, this crucial market has malfunctioned, unnerving investors and casting doubt on the reliability of America’s financial system.
This week, the U.S. Federal Reserve took an important step toward fixing the problem. This is good news, but more must be done.
Sophisticated investors typically finance their Treasury holdings in the “repo” market, using the government debt as collateral for short-term loans from securities dealers, many of which are part of large banks. In recent years, though, a rapidly growing supply of U.S. government debt has outpaced the amount of financing available. This vulnerability contributed, for example, to the Treasury-market turmoil that helped destabilize the financial system at the onset of the coronavirus crisis last spring, forcing the Fed to provide trillions of dollars in emergency liquidity.
Now, help is on the way. The Fed announced a $500 billion standing repo facility, meaning the central bank will stand ready to lend to a select group of “primary” dealers, against the collateral of Treasuries and certain government-guaranteed securities. It also made permanent a similar facility available to foreign central banks. Both will charge an interest rate higher than normal market rates, to ensure they are used only when absolutely necessary.
More moves are probably coming. For one, I expect the Fed to change the way it calculates the supplemental leverage ratio, which requires banks to maintain a minimum level of capital as a percentage of total assets. Lately, the requirement — intended as a backstop to other capital rules -- has become more binding as the Fed’s stimulus efforts have boosted banks’ cash reserves, which are completely risk-free but count as assets. This, in turn, has limited banks’ appetite to provide financing for Treasuries — and could limit their willingness to use the standing repo facility in times of stress. With some modest changes, the Fed could remove the problematic constraint without reducing the overall amount of capital banks must have to ensure their safety and soundness.
Welcome as they are, even these reforms don’t go far enough. Broader changes are needed to ensure the smooth functioning of the Treasury market, as a working group of the Group of Thirty (of which I am a member) argues in a new paper.
For one, the Fed should expand access to the standing repo facility beyond the primary dealers. This would provide a financing backstop to a broader range of Treasury investors, leaving the whole market less exposed to the balance-sheet constraints of banks and securities dealers. The Fed’s liquidity guarantee would thus become an attribute of Treasury securities, rather than a benefit accruing to a privileged subset of market participants. The result could be lower borrowing costs for the U.S. government.
One counterargument is that a liquidity guarantee would encourage investors to take on outsized risks. But this moral hazard problem is minor compared with the benefits, and can be mitigated by requiring ample collateral to cover any losses due to price changes (there’s no relevant credit risk, because the collateral is an obligation of the U.S. government). It’s the ad hoc, emergency interventions like what happened during the pandemic that create serious moral hazard. A more permanent backstop could obviate the need for such extraordinary measures.
Second, more Treasury trades should be done through central counterparties, which stand between buyer and seller and ensure the delivery of collateral, cash and securities. This would help reduce risk because for each participant, bilateral obligations across multiple counterparties would collapse to a single obligation to the central counterparty. It would also facilitate “all-to-all” trading, in which investors wouldn’t be forced to access the Treasury market through dealers. Granted, this won’t be easy to accomplish: A proper Treasury clearing house would be costly to set up, would become a new systemically important entity and might face opposition from entrenched dealers.
Third, the Treasury market needs to be more transparent, with trades reported in real time — as they already are in the equity and corporate bond markets. This would help make the market more efficient, and would help market participants and regulators assess market conditions and potential risks. That said, it would also impinge on the advantages of incumbents who currently enjoy informational advantages — so again, I expect opposition.
The U.S. can’t take the preeminence of the Treasury market for granted. To maintain it, ambitious reforms are needed. The Fed has made a good start. Let’s keep going.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Bill Dudley is a Bloomberg Opinion columnist. He is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.
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