The Securities and Exchange Commission just made the first official move to keep the market from breaking. It proposed on Wednesday to force more trading in government bonds through central clearinghouses. Clearing reduces the risk that either party to a trade will fail to deliver their end of the deal. It can also allow multiple parties to net-off exposures against one another at the same time, which should give everyone more capacity to trade.
If enough banks, investors and other dealers can and do use clearing it will help, but it is no panacea. There are many other changes that should be pursued with the longer term goal of encouraging more market players to be able to trade directly with each other rather than rely so heavily on the 25 primary dealer firms that are obligated to bid at Treasury auctions and authorized to trade with the Fed. The giant US bond fund manager, Pacific Investment Management Co., came out in support of so-called all-to-all trading last week.
The capacity of dealers to intermediate Treasury trading is the core problem and it is making episodes of market stress and dysfunction more frequent, according to a report last year from former central bankers, regulators and academics known as the Group of 30. The panic of March 2020 was particularly extreme: It was when the US and Europe woke up to the severity of the Covid-19 pandemic and led investors to sell almost everything and load up on cash. Instead of acting in their usual role as a haven in times of turmoil, Treasury prices unexpectedly collapsed as liquidity dried up, sending yields soaring
Events like that are likely impossible to guard against, but the seizure in money markets in September 2019, which saw huge spikes in overnight borrowing rates, was down to the Fed pursuing tighter monetary policy, something that it needs to be able to do without blowing up markets. No-one is sure exactly how today’s quantitative tightening is going to play out, but it’s very likely to be a rough and unpredictable ride.
Also, the Treasury market is expected to keep growing and reach $40 trillion by 2032 as the government borrows to finance big budget deficits. If banks are struggling to intermediate today, it would be crazy to rely solely on them to handle a much larger market in future. That’s the argument from non-bank market makers such as Citadel Securities and it’s hard to disagree.
The volume of trades that banks process has shrunk dramatically versus the size of the Treasury market: Before 2008, primary dealer volumes were equivalent to about 15% of the value of Treasuries outstanding; now that is just 2.5%, according to Bank of America Corp, which is a primary dealer.
Banks such as JPMorgan Chase & Co., also a primary dealer, argue that the problem is rule changes imposed after the financial crisis to make banks safer and less vulnerable to sudden losses of funding. The new rules have made it more difficult for banks to quickly absorb extra assets during an explosion of market activity, especially during times when everyone wants to sell. The biggest banks want the calculation of leverage ratios, which measure the size of their balance sheets, to be changed to exclude the safest assets – something the UK and other jurisdictions have already done. They also want the extra capital charges for being systemically important banks to be cut. Such changes would cut their capital requirements and improve their returns, but it’s hard to say they would definitely ensure the smooth functioning of the Treasury market.
More important in 2019 were the rules on the amount and type of highly liquid assets big banks have to hold, which include Treasuries and central bank reserves. These rules led some banks to prefer reserves over Treasuries — and that made them less willing to lend against Treasuries in money markets, which helped contribute to the mayhem that year.
Tweaking rules to help banks handle more trading and financing would definitely benefit Treasury markets, but making it less reliant on banks as intermediaries should be the bigger goal. Banks may argue that many electronic market makers or principal trading firms are “fair weather” liquidity providers that disappear when markets get tricky, but they will also always have a limit to how much they will trade during the most stressful times. That was true long before 2008.
The Fed could lend against Treasuries to more market participants than just banks, which could help smooth trading stress in a crisis. It would need the right risk management to protect taxpayers, but such a “dealer of last resort” role for Treasuries makes sense for the toughest moments. Ultimately, the best way to avoid frequent crises would be to promote more diversity in the size and types of traders, dealers and market makers that can trade with each other. A greater variety of balance sheet types and motivations ought to help ensure that some remain active when others are pulling back.
More central clearing as the SEC proposes should help with that, but more transparency on what trades are being done and at what prices and sizes is also necessary to give different parties a better idea of where their holdings should trade. It works in other assets so it should help in the most important market in the world, too.More From Other Writers at Bloomberg Opinion:
• The Case Against a Mega 1% Fed Rate Increase: Robert Burgess
• The Fed Wants to Save America, Not the World: Marcus Ashworth
• Will Central Banks Kill or Nurture the Polar Bear?: John Authers
This column does not necessarily reflect the opinion of the editorial board 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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