Structural Changes in Treasury Markets Suggest Policy Shift

“The US Treasury market is the single most important financial market in the world, as Treasury rates are a fundamental benchmark for pricing virtually all other financial assets.”

The Crisis

The economic uncertainty created by the pandemic resulted in a massive “dash for cash” by holders of Treasury securities. This demand was so extreme that the Treasury market was unable to absorb the widespread selling pressure that resulted. 

“Around March 11, the Treasury market became essentially dysfunctional. Heavy investor demands to liquidate Treasury securities overwhelmed the capacity of dealers to intermediate the market. Those demanding large amounts of cash in exchange for Treasuries included relative-value hedge funds, mutual funds and foreign central banks…”

As a result, financing for Treasuries via the repo markets also became scarce as the Treasury repo rate spiked (indicating a lack of willing lenders of cash for Treasuries). 

“In short, U.S. Treasuries did not serve their traditional safe-have role. Instead, dysfunction in the Treasury market exacerbated the crisis.”

Thus, the COVID-19 pandemic exposed a systemic market fragility that had been quietly lurking. The market for the single most important financial instrument in the world, the “fundamental benchmark for pricing virtually all other financial assets” had become illiquid.  

The Federal Reserve Responds

To prevent certain disaster, the Federal Reserve mounted a massive response, an essentially unlimited supply of US dollars. 

“The Fed purchased nearly $1 trillion of Treasuries within the three-week period beginning March 16. Then the Fed continued to buy Treasuries and mortgage-backed securities (MBS) at a high rate…. Among many additional measures, on April 1, the Fed exempted Treasuries and reserves held by bank holding companies from the capital requirement associated with the Supplemental Leverage Ratio (SLR).”

The bond purchase programs instituted to stabilize the bond markets were on a scale larger than ever witnessed.  

Dollar Runs and Liquidity Crises

Despite the dramatic backdrop of a global pandemic, an increase in demand for dollar-denominated reserves or a “dash for cash” is actually fairly common during times of market disruption. Effectively during times of default, there is a “run” on US dollars (the currency in which most debt is denominated). While a global pandemic was the most recent trigger (and a particularly powerful trigger), these “runs” are somewhat inevitable and occur with some degree of regularity. 

Distribution of US dollars occur largely through a relatively small group of primary dealers (i.e. banking institutions) who pass liquidity on to the market. During times of stress, however, primary dealers become less willing to pass on this cash to the market (because of regulations or internal limits on risk-taking, both of which tighten under stress), resulting in “liquidity crises” as the supply of US dollars becomes insufficient relative to the demand. 

This exhibits itself most notably in the Treasury market and Treasury repo market, where high quality collateral is normally pledged or sold in exchange for US dollars to meet cash needs. During times of crisis, primary dealers stop or decrease their rate of Treasury purchases and decrease their lending activities against Treasuries which it makes it difficult for non-bank institutions to access cash.    

Since the global financial crisis, the response to these “liquidity crises” has primarily fallen to central banks, who have “thrown cash at the problem” via asset purchase programs and a general expansion of central bank balance sheets (also known as Quantitative Easing). In so doing, central banks have “funded” these crises, by stepping directly into markets during periods of disruption and becoming a buyer of last resort, thus, providing cash to entities seeking to sell assets for which there are insufficient natural buyers. This solves the short-term liquidity crisis, but has the undesirable effect of destroying true price discovery (by distorting demand which leads to asset bubbles) and makes it difficult for the Federal Reserve to exit markets (as selling such high volumes of assets would undoubtedly cause panic as the Federal Reserve would quickly run out of buyers to whom to sell, effectively trapping the Federal Reserve in the positions taken during the crises). 

Stepping directly into the marketplace during periods of crisis, purchasing assets and then holding these assets has led many market participants to believe the Federal Reserve has become a permanent participant in these marketplaces, which has had the undesirable effect of distorting asset prices generally. Additionally, societies’ dependency on the willingness and ability of primary dealers to provide liquidity support (intermediating between the Federal Reserve and nonbank financial institutions) has also caused a fair bit of distrust and moral hazard for these systemically important financial institutions. Bailouts of these institutions and markets by the Federal Reserve are increasingly believed to be certainties.           

Thus, the solution of funding liquidity crises, is itself a problem in that, while it solves the immediate crisis, it increases market disfunction. It effectively converts a short-term problem into a long-term problem.   

Side Effects of GFC Regulation and Quantitative Easing

To be certain the fault does not lay, entirely with primary dealers. Post-global financial crisis reforms were instituted to ensure that banks were adequately capitalized even under stress. However, in so doing, these regulations also discourage certain behaviors that are beneficial to markets. 

The most significant of these is the Basel III leverage ratio (called the Supplementary Leverage Ratio or SLR in the US). The SLR is intended to constrain bank capital when risk-weighted asset calculations become low.  Or said another way, it is intended to ensure there is sufficient capital to offset elevated risk of loss.   

However, despite this intention, the SLR has been largely continuously binding for large banks (particularly US banks) because of massive growth in forced bank holdings of reserve balances at central banks due to central bank asset purchasing programs. This is due, at least in part, to the fact that when SLR was finalized in 2014, it was believed that reserve balances would decline as central banks normalized their balance sheets. The Federal Reserve under then Federal Reserve Chair Janet Yellen (now Treasury Secretary) never normalized its balance sheet (nor did most central banks globally) for fear that doing so would cause a widespread market disruption.   

Somewhat paradoxically, when SLR is binding, banks are discouraged from allocating capital to activities that are low risk, but capital intensive because the return is not worth the capital allocation. Instead, banks favor capital allocations to higher return activities (but often higher risk) to offset the albatross of maintaining a largely unproductive capital buffer. Market-making in US Treasury markets is one of these areas where banks have decreased participation since SLR has been implemented. 

Thus, regulation that was intended to increase financial stability has, in practice, reduced the depth of the most important financial market in the world, increasing systemic risk and destabilizing markets globally. Asset purchasing programs (for the sake of thwarting liquidity crises) exacerbate this problem further as central bank balance sheets continue to grow.   

Additionally, as banks have reduced allocations to market-making in Treasury markets, trading firms and independent broker dealers (who are unaffiliated with banks) and other entities outside of banking regulation have stepped into the market, decreasing transparency and regulatory oversight in the world’s most important market.  

The Proposed Solution

The primary solution proposed by the “Group of 30” and, at least in part, being implemented by the Federal Reserve and US Treasury, is to move away from “funding” liquidity crises through asset purchases (i.e. Quantitative Easing) and to instead “finance” these liquidity crises through a standing facility providing a ready supply of US dollars at a stated rate. 

Doing so, allows the Federal Reserve to readily provide cash to the marketplace and remove cash when a crisis has subsided. Doing so also, however, requires structural reform, most notably diminishing the role of primary dealers as intermediaries of central bank liquidity via a central clearing model. Central clearing by its nature concentrates risk within the clearing entity, which thereby requires additional transparency, oversight and regulation of the marketplace.  

Standing Repo Facility

A Standing Repo Facility guarantees “to a broad range of market participants the availability of repo financing for Treasury securities…allowing holders of Treasuries that want cash to obtain the cash by tapping the Standing Repo Facility rather than selling the securities.” Or said another way, during times of crisis, the need for cash can be met by pledging high quality collateral (mainly Treasuries) directly to the Federal Reserve who will provide dollars in exchange until the liquidity crisis has subsided, thus by-passing primary dealers (and other market participants) who would likely not be willing to lend in such an environment.     

The benefits of a standing facility, as opposed to an “emergency facility” are (1) there are no delays in standing up a facility while a crisis is transpiring, and (2) there is no uncertainty in the marketplace about the facilities’ terms or accessibility.   

A standing facility reduces/eliminates the need for the Federal Reserve to purchase Treasuries and mortgage-backed securities (so called “market interventions” or “Quantitative Easing”) to restore market functioning.  Rather than participating in the Treasury and mortgage-backed security markets as a buyer of last resort, the Federal Reserve can act as a lender of last resort of U.S. Dollars.   

A standing facility also, however, increases moral hazard and systemic risk by encouraging entities with access to the facility to incur higher leverage (since the risk of a dollar shortage is now mitigated).   

To limit systemic risk/moral hazard the Federal Reserve and Treasury has 3 main tools: (1) the financing rate of the facility, (2) central clearing, and (3) transparency and regulation. 

The Financing Rate

Adjustments to the financing rate of the facility can be used to control excessive use during times of normal market conditions. Fairly straightforward in application, by controlling the rate at which repo financing is extended, the Fed can effectively regulate use of the standing facility by decreasing the financing rate during times of stress to encourage use and increasing the rate to discourage use during times of normal conditions. 

Central Clearing

The Treasury market is traditionally an over-the-counter market. While trades between primary dealers are centrally cleared, trading firms and brokerage trades are rarely centrally cleared. Dealer-to-client segment are never centrally cleared. 

Central clearing is common in equities and derivatives, the primary purpose of which is to reduce counterparty risk. However, central clearing is not common in bond markets (which are typically over-the-counter). Despite this, there is already a Fixed Income Clearing Corporation (FICC) division of the Depository Trust & Clearing Corporation (DTCC). 

Bringing all counterparties into central clearing provides “greater transparency of counterparty risks and counter-party risk management, reduction of counterparty credit risks through netting of counterparty exposures and application of margin requirements and other risk mitigants.” In short, central clearing improves transparency by giving market participants and regulators information about counterparty exposures and knowledge of practices for trade settlement and margin requirements.   

The disadvantage of broadening central clearing is that it increases the systemic nature of the central clearing party (i.e. FICC), as risk and risk management naturally consolidates into the central counterparty. FICC in essence would become too-big-to-fail which would create systemic risk absent government oversight (FICC is already an SEC-regulated clearing agency and is designated as a Systemically Important Financial Market Utility.) As a result, under stress the central clearing party will inevitably be seen as guaranteed by the government. The mechanism for this federal backstop most likely coming through access to the Federal Reserve’s Standing Repo Facility. 

The advantage of having FICC stand between the counterparty and the Federal Reserve is that FICC has committed credit lines extended to it by its member firms (called a Capped Contingency Liquidity Facility) which can be drawn in the event of a member default. Thus, spreading the liquidity strains created by the default to the non-defaulting member firms first. Or said another way, a central clearing system transfers the risk of loss from counterparty defaults and associated member liquidity risks from the Federal Reserve to the FICC and its members (at least so long as the members of FICC do not become insolvent at which point the Federal Reserve assumes the risk through its Standing Repo Facility).

Transparency and Regulation

FINRA does not collect data on Treasury repos currently and regulators do not have comprehensive data on Treasury repos. By expanding the Trade Reporting and Compliance Engine (TRACE) to cover all Treasury transactions and Treasury repos, the Treasury market would become as transparent as the corporate bond market (TRACE typically reports individual corporate bond trades to the public within 15 minutes). The SEC has already issued a proposal (as of September 2020) that would end the exemption for trading platforms from public reporting regulations for Treasuries and other US government securities that are otherwise required for equities. A more comprehensive regulatory scheme and application of US securities laws to the US Treasury market should also probably be anticipated.  

Policy Implications for Market Participants

Aside from the considerable structural changes to the Treasury market, market participants should be aware that the Federal Reserve’s implementation of the Group of Thirty’s recommendations (at least in part by implementing the Standard Repo Facility) serves as a signal that the implicit policy of Quantitative Easing upon which market participants have come to depend is likely coming to an end. That is to say, the Federal Reserve and the US Treasury appear to have recognized the unsustainability of continuously “bailing-out” or “funding” liquidity crises and are in the process of converting to a system of “financed” liquidity. Under such a regime, it seems likely that tapering of existing asset purchases would be a priority for the Federal Reserve and that the Federal Reserve generally intends to take its foot off of the scale of asset prices.  

References

All quotes contained in this newsletter where sourced from: 

Group of Thirty Working Group on Treasury Market Liquidity. (2021). U.S. Treasury Markets: Steps Toward Increased Resilience. Group of Thirty. https://group30.org/images/uploads/publications/G30_U.S_._Treasury_Markets-_Steps_Toward_Increased_Resilience__1.pdf.

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