The $24 trillion treasury market needs more than just clearing

The $24 trillion US Treasury market has become too big for even the “masters of the universe” to absorb. With the Federal Reserve reversing its bond-buying program and more government securities flowing back into the hands of traders, banks, investors and traders, the chances of extreme and unhealthy volatility increase. We are at the moment when regulators and market participants fear, that there will be more episodes like March 2020 and September 2019 when parts of the market stalled and prices plummeted. This is important because the treasury market is considered most of all as the basis for dollar-denominated financial assets around the world.

The Securities and Exchange Commission just took the first official step to prevent the market from crashing. On Wednesday, he proposed imposing more trading in government bonds through central clearinghouses. Clearing reduces the risk that either party to a trade will fail to execute its conclusion. It can also allow multiple parties to net exposures against each other at the same time, giving everyone more ability to trade.

If enough banks, investors and other dealers could and did use clearing, it would be beneficial, but it is not a panacea. There are many other changes to pursue with the long-term goal of encouraging more market players to be able to trade directly with each other rather than relying too heavily on the 25 core dealer companies that are obligated to bid at and authorized treasury auctions. Trade with the Federal Reserve. The manager of the giant US bond fund, Pacific Investment Management, came out in support of so-called mass trading last week.

Dealers’ ability to broker treasury trading is the primary problem and it is increasing the frequency of episodes of market stress and dysfunction, according to a report last year from central banks, regulators and former academics known as the Group of Thirty. 2020 was particularly extreme: It was when the US and Europe woke up to the severity of the Covid-19 pandemic and prompted investors to sell almost everything and load up on cash. Instead of fulfilling their usual role as a safe haven in times of turmoil, Treasury prices unexpectedly collapsed as liquidity depleted, sending yields soaring.

It would probably be impossible to guard against such events, but the September 2019 takeover of the money markets, which saw massive hikes in borrowing rates overnight, was due to the Federal Reserve’s tighter monetary policy, something it should be able to do. it without spoiling. Even the markets. No one is quite sure how quantitative tightening will be implemented today, but it is very likely to be a difficult and unpredictable journey.

Also, the treasury market is expected to continue growing to reach $40 trillion by 2032 as the government borrows to finance a large budget deficit. If banks were struggling to mediate today, it would be crazy to rely solely on them to handle a much larger market in the future. This is the argument from non-banking market makers like Citadel Securities and it is hard to disagree.

The volume of deals handled by banks has shrunk dramatically against the size of the treasury market: before 2008, the volumes of primary dealers were equivalent to about 15% of the value of outstanding treasury bonds; Now that’s only 2.5%, according to Bank of America Corp, a primary trader.

Banks such as JPMorgan Chase & Co. argue. , which is also a major trader, says the problem is 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 difficult for banks to absorb additional assets quickly during an explosion of market activity, especially at times when everyone wants to sell. The biggest banks want to change the calculation of leverage ratios, which measure the size of their balance sheets, to exclude safer assets – something the UK and other jurisdictions have already done. They also want to reduce capital surcharges for being systemically important banks. Such changes would reduce capital requirements and improve its returns, but it is difficult to say that it will certainly ensure the smooth functioning of the treasury market.

Most important in 2019 were the rules regarding the size and type of highly liquid assets that major banks must hold, which include Treasury bills and central bank reserves. These rules led some banks to prefer reserves over Treasuries—this made them less willing to lend against Treasuries in the money markets, which helped contribute to the chaos that year.

Tweaking the rules to help banks handle more trade and financing would certainly benefit treasury markets, but making them less dependent on banks as intermediaries should be the bigger goal. Banks might argue that many electronic market makers or major trading firms are “fair weather” liquidity providers that vanish when markets get tough, but that they will always have a limit on how much they trade during more stressful times. This was true long before 2008.

The Federal Reserve can lend Treasuries to more market participants than just banks, which could help ease trading pressures in any crisis. You’ll need to manage the right risk to protect taxpayers, but this “trader of last resort” role for Treasuries makes sense in the toughest moments. Ultimately, the best way to avoid recurring crises is to promote greater diversity in the size and types of traders, dealers, and market makers that can trade with each other. A variety of balance sheet types and drivers should help ensure that some remain active when others decline.

More centralized clearing as suggested by the Securities and Exchange Commission should help with this, but more transparency about what trades are being taken and at what prices and volumes is also necessary to give different parties a better idea of ​​where their holdings should be trading. It is working in other assets so it should help in the most important market in the world as well.

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

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

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