The $ 24 trillion treasury market needs more than just clearing

The US $ 24 trillion Treasury market has outgrown even the “Masters of the Universe”. As the Federal Reserve reverses its bond buying program and more government bonds return to the hands of dealers, banks, investors and traders, the chances of extreme and unhealthy volatility are increasing. We are at a time when regulators and market participants feared, which is that there will be more episodes like in March 2020 and September 2019, when parts of the market have taken over and prices have gone haywire. This is important because the Treasury market is considered the most important of all as the basis for dollar-valued financial assets around the world.

The Securities and Exchange Commission has just made the first official move to prevent the market from breaking. On Wednesday he proposed to force more government bond trading through central clearing houses. Offsetting reduces the risk that one party to a trade will fail to complete the trade. It can also allow multiple parties to offset exposures against each other at the same time, which should give everyone greater ability to trade.

If enough banks, investors and other dealers can and do use offsetting, this will help, but it’s not a panacea. There are many other changes that should be pursued with the long-term goal of encouraging more market participants to be able to trade directly with each other rather than relying so heavily on the 25 primary dealer firms they are obligated to do. offered at Treasury auctions and authorized to trade with the Fed. Giant US bond fund manager Pacific Investment Management Co. came out in support of so-called all-to-all trading last week.

According to a report last year by former central bankers, regulators and academics known as the Group of 30, the ability of dealers to broker Treasury trades is the main problem and is making episodes of market stress and dysfunction more frequent. . 2020 was particularly extreme: it was when the United States and Europe realized the gravity of the Covid-19 pandemic and led investors to sell almost everything and accumulate cash. Instead of acting in their usual safe haven role in turbulent times, Treasury prices plunged unexpectedly as liquidity ran out, sending yields soaring.

Such events are likely to be impossible to avoid, but the seizure of money markets in September 2019, which saw huge spikes in overnight lending rates, was due to the Fed pursuing a tighter monetary policy, which must be able to do without blowing up bull markets. No one is sure how today’s quantitative tightening will turn out, but it is very likely to be a tough and unpredictable race.

Furthermore, the Treasury market is projected to continue to grow and reach $ 40 trillion by 2032 as the government borrows to finance large budget deficits. If banks are struggling to be an intermediary today, it would be crazy to rely solely on them to manage a much larger market in the future. This is the argument of non-bank market makers like Citadel Securities and it’s hard to disagree.

The volume of transactions that banks process has drastically reduced compared to the size of the Treasury market: before 2008, the volumes of primary dealers were equivalent to approximately 15% of the value of Treasuries in circulation; it’s now just 2.5%, according to Bank of America Corp, which is a primary dealer.

Banks like JPMorgan Chase & Co., also a primary broker, argue that the problem is the rule changes imposed after the financial crisis to make banks safer and less vulnerable to sudden funding losses. The new rules have made it harder for banks to absorb extra assets quickly during a blast of market activity, especially during times when everyone wants to sell. Bigger banks want the calculation of leverage ratios, which measure the size of their balance sheets, to be changed to exclude safer assets, which the UK and other jurisdictions have already done. They also want to reduce the additional capital requirements for systemically important banks. Such changes would reduce their capital requirements and improve their returns, but it is difficult to say that they would certainly ensure the smooth functioning of the treasury market.

More important in 2019 were the rules on the amount and type of highly liquid assets large banks must hold, including Treasuries and central bank reserves. These rules led some banks to prefer reserves to Treasuries and this made them less willing to lend against Treasuries in the money markets, which contributed to the chaos of that year.

Changing the rules to help banks handle more trading 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 “good weather” liquidity providers that disappear when markets get rough, but they will also always have a limit on how much they will trade during stressful times. This was true long before 2008.

The Fed could lend against Treasuries to more market participants than just banks, which could help ease trading stress in a crisis. It would need the right risk management to protect taxpayers, but such a “trader of last resort” role for the Treasury makes sense in the most difficult times. Ultimately, the best way to avoid frequent crises would be to promote greater diversity in the size and types of merchants, retailers, and market makers that can trade with each other. A greater variety of balance sheet types and motivations should help ensure that some remain active when others retire.

A more centralized clearing proposed by the SEC should help with this, but more transparency is also needed about what trades are carried out and at what prices and sizes to give different parties a better idea of ​​where their holdings should be traded. It works with other resources, so it should also help in the most important market in the world. More opinions of other writers on Bloomberg:

• The case against a mega 1% Fed rate hike: Robert Burgess

• The Fed wants to save America, not the world: Marcus Ashworth

• Will central banks kill or feed the polar bear ?: John Authers

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

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

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