Why the World’s Biggest Bond Market Needs a Revamp

The $21 trillion Treasuries market is the bedrock of the global financial system. It’s not good when bedrock shivers, let alone shakes! But bouts of Treasuries turmoil have been happening more frequently and at times triggering large-scale interventions from the U.S. Federal Reserve. Pandemic-sparked volatility in March 2020 caused liquidity in the world’s biggest bond market to plunge to its worst since the 2008 financial crisis, sparking the Fed to go on a buying spree of Treasuries and mortgage-backed securities that peaked at more than $100 billion a day to support smooth market functioning. While that crisis passed, further shivers have created doubts about the long-touted mantra that Treasuries represent the world’s deepest and most liquid market. Treasury Secretary Janet Yellen, who was Fed chair during one market wobble, says “extreme policy interventions” are a sign that some repair work is needed.

1. Why is the Treasuries market so important?

There’s lot of reasons. One, because it’s estimated that the value of more than $50 trillion in assets around the globe are priced off Treasuries. So turmoil in government debt markets can have ripple effects on other asset classes, creating volatility that may push investors to run to the safety of cash. Beyond that, the U.S. government will have to ramp up its debt sales to finance a budget deficit that was growing even before the coronavirus led to trillions in new spending.

2. What caused those market backflips?

It’s complicated. In 2020 the catalyst for the disruption was of course a once-in-a-century event, as the Covid-19 outbreak wreaked havoc on equities and commodities and caused wild gyrations in Treasuries. Asset managers said dealers pulled back from market making as things unraveled, and a blow out of hedge funds in leveraged Treasury trades exacerbated the sharp movement in yields. But pinning down causes of sharp market movements can be hard. Regulators have never quite given a definitive answer for what sparked on Oct. 15, 2014, a 12-minute crash and rebound in 10-year Treasury yields that’s been dubbed the “flash rally.” And there was the September 2019 blowup in the “repo” (repurchase agreement) market, which provides the funding for many Treasuries trades.

Why the World’s Biggest Bond Market Needs a Revamp

3. Are there any common themes?

Most agree that all of these issues have transpired against a backdrop of regulations adopted after the 2008 financial crisis. While financial stability was their goal, some argue that the rules have crimped banks’ ability to make markets, which has opened the door for more frequent bouts of liquidity troubles. And Federal Reserve Vice Chair for Supervision Randal Quarles in 2020 warned that the sheer size of the Treasury market itself was creating a burden on dealers’ market-making capacity. “It is clear that growth in Treasury issuance is outstripping the ability of primary dealers to absorb, redistribute and intermediate across buyers and sellers given their existing balance sheets and current regulations,” Barclays Plc strategist Joseph Abate says.

4. What fixes to the Treasuries market have been proposed?

A growing consensus of policy makers and analysts argue that major structural changes are needed to ensure the U.S. bond market can function without having to look to the Fed for help so often. Confidence in the ability to easily buy and sell Treasuries without triggering exaggerated price swings -- a favored measure of liquidity -- is crucial. Speaking after convening the Financial Stability Oversight Council on March 31, Yellen said post-2008 regulations helped banks survive the pandemic panic, but the need for “extreme” measures “should serve as a clear reminder: We have to do more to address vulnerabilities in the financial system.” Here are some of the major fixes being discussed for Treasuries:

Central Clearing

To prevent another flareup, Fed officials -- including Chairman Jerome Powell -- have raised the possibility of fortifying the market’s foundation with a broad-based central clearinghouse to back up trades and handle surges in activity in times of stress. A central clearinghouse (CCP) that handles many if not all Treasuries trades, supported by capital supplied by its members, could limit the need for Fed interventions. Presently, only about a fifth of the market goes through the Depository Trust & Clearing Corp.’s Fixed Income Clearing Corp. unit, the only central clearinghouse in Treasuries. Shifting trades there would mirror what regulators did after derivative losses almost crashed the global economy in 2008, when they pushed most interest-rate swap activity onto CCPs. But some see such action as raising costs. Others argue that a clearinghouse could make matters worse by concentrating risks.

Standing Repo Facility (SRF)

When people say Treasuries are highly liquid, the proof is in the repo market, where banks and other big investors swap Treasuries for cash in short-term deals that amount to collateralized loans. Repo makes the wheels of finance turn a little more easily -- except when it doesn’t. In September 2019, the Fed had to flood the repo market with hundreds of billions after interest rates spiked in a sign of distress. Afterward, Fed officials postulated the idea of setting up a standing repo facility, or SRF. That would mean the Fed having a permanent presence in the market, allowing eligible banks to convert Treasuries into cash on demand, as an ever-ready backstop. This idea has come back to the fore as many say an SRF would have reduced the turmoil of March 2020 by assuring banks that they would be able to offload Treasuries at the Fed temporarily. Nellie Liang, President Joe Biden’s pick to serve as the Treasury’s undersecretary for domestic finance, has advocated the creation of a standing repo facility.

All-to-All Trading

As with a standing repo facility, the idea is to create alternative counterparties for the times when Wall Street dealers are hunkered down. Enhancing the ability of investors to trade more directly with each other, known as all-to-all trading, is seen by some as a way to reduce dependence on the Fed’s primary dealers, a group of 24 that is dominated by big banks such as JPMorgan Chase & Co. and Bank of America Corp. One idea floated is to allow investment managers into the primary dealer fold. Bond giant Pacific Investment Management Co. has argued that asset managers should be included in the group. Getting more all-to-all trading going won’t necessarily be easy: OpenDoor Securities recently shut its Treasuries trading platform, which over four years had tried to bring buyers and sellers directly together.

Transparency

Many feel the Treasury market is still too opaque, a situation that can contribute to market nervousness. After years of reviewing the hotly debated issue of the public release of trading data, former Treasury Secretary Steven Mnuchin’s team decided in September 2019 to only allow weekly aggregate statistics. That fell short of what many had desired, given that prices of stocks and corporate bonds are reported instantly or with a small lag throughout the day. Big trading firms like Citadel LLC are pushing for more clarity. Stephen Berger, global head of government and regulatory policy at Citadel, has argued that bolstering public reporting is the easiest first step to modernizing the Treasury market structure.

Regulatory relief

Liang, in a December paper she wrote with Pat Parkinson from the Bank Policy Institute, also proposed targeted changes to bank regulations “to improve liquidity provision by bank-affiliated dealers without reducing their overall safety and soundness.” They advised that reserves at the central bank be permanently excluded from banks’ supplementary leverage ratio (SLR) calculations given they are riskless (Treasuries should not be exempt, they say, because they have interest-rate risk). In response to the pandemic the Fed in 2020 let lenders exclude Treasuries and deposits from SLR calculations, in effect allowing them to lend more. But the central bank allowed that relief to lapse on March 31 as originally planned, despite many in markets calling for it to remain. The Fed did say it is considering some type of permanent adjustment to SLR in the future.

The Reference Shelf

  • QuickTakes on turmoil in the Treasury and repo markets.
  • Nellie Liang’s article on “Enhancing the liquidity of U.S. Treasury markets under stress.”
  • A Treasury Department report on the 2014 “flash rally.”
  • A N.Y. Federal Reserve blog post examining its bond-buying market interventions in 2020.
  • Yellen’s March 31 statement to the Financial Stability Oversight Council.
  • Bloomberg News articles on liquidity drying up in March 2020.

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