The world’s largest financial market is not fit for purpose

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Eeverybody want to trade treasury bills. Big banks hold them for cash management, pension funds hold them for long-term returns, hedge funds use them to bet on the economy, people’s savings are stored in them, and central banks use them. to manage foreign exchange reserves. The treasury bill market, most of the time, is deep and liquid. Some $640 billion in government bonds change hands every day, at prices that become the benchmark risk-free rate by which all financial instruments are priced and lending rates set.

So why don’t they sometimes change hands? Several times in the recent past, the market has collapsed. In 2014, a “flash rally” led to wild price swings for no clear reason. In 2019, rates soared in the “repo” market, where Treasury bills can be exchanged for cash overnight. In March 2020, extreme illiquidity caused yields to soar, although in times of panic they typically fall as investors rush into safe assets. Now the problems are looming again: volatility measures have reached levels not seen in 2020 and the gaps between supply and demand are widening.

The problem is that the Treasury market has doubled in size over the past decade, even as its infrastructure has shrunk. Trading is done by primary dealers, nominated institutions that are mostly large banks, and regulatory requirements now constrain them. The leverage ratio, which limits the value of assets banks can hold relative to their capital, doesn’t care whether the asset is super safe treasuries or subprime mortgage debt. So when a customer calls to sell a bond, banks need to find a customer who wants to buy it, rather than holding it in inventory when another customer calls. In times of stress, this system is overwhelmed.

The fixes fall into three categories: let banks trade more bonds with investors, let investors trade more bonds with each other, or let investors trade or trade more bonds with the Federal Reserve.

Start by letting the banks do more. The solution would be to exempt treasury bills and other safe assets, such as bank reserves, from inclusion in leverage ratios. The Fed and other banking regulators did this for a year from March 2020 to help alleviate market chaos. The logic behind the move was pretty solid. Treasury bills are not risky assets, likely to default, and therefore do not require a lot of capital to be held against them. Yet the leverage ratio is attractive because it is simple to administer and cannot be gambled. And with Democratic banking regulators in charge, who don’t want to appear to be undoing financial regulation, the idea is a no-start.

How about letting investors deal more with each other? Portfolio Managers at pimco, a leading bond investment firm, proposed that investors trade on a platform where asset managers, brokers and non-bank liquidity providers can trade on a “level playing field, with a equal access to information”, similar to how stocks are traded. That might be fine, if it’s actually possible. Matching buyers and sellers of Treasuries is more difficult than matching buyers and sellers of stocks. All of Microsoft’s actions are the same; there are dozens of treasury bills with maturities of about five years.

A final solution would be to let investors do more with the Fed. Last year, the central bank created a permanent repo facility, which allows a treasury bill to be exchanged overnight for cash. But the facility is reserved for primary traders, who do not always pass on liquidity. Opening it up to more participants would solve this problem. It would also expose the Fed to a range of riskier counterparties, but this could be mitigated by forcing companies to exchange greater value in Treasuries than the central bank is giving in cash.

The problem is not a lack of plausible reforms. It is that none of them have been implemented. The heady bull market collided with the reality of high inflation and much higher interest rates. Financial markets have already entered a new phase of returning volatility, stress and fear. Any grand plan to overhaul the Treasury market cannot be implemented on the fly, in the midst of an emerging crisis.

If the Treasury market seizes up again – as the UK government bond market did after ministers announced a package of unfunded tax cuts on September 23 – the task of fixing it will fall to the Fed and its bond buying programs. Relaunching asset purchases at the same time as raising rates to fight inflation would be very uncomfortable. Given that regulators have failed to fix the Treasury market when they had the chance, they could be left with little choice.

Learn more about Buttonwood, our financial markets columnist:
Investment Banks Sharpen the Ax (September 29)
How to Rename Stock Indices (September 22)
Why Investors Should Forget Delayed Gratification (September 15)

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