Under Pressure: Liquidity risks roil Treasury securities market.

The world financial system runs on bonds.? Casual observers tend to focus on the daily gyrations of the stock market, but its value is dwarfed by the trade in bonds.? The World Economic Forum recently estimated the value of the US bond market at $51 trillion (39% of the world bond market total). By contrast, the market value of the entire S&P 500 is about $37 trillion.? About $33 trillion of those bonds are United States Treasury obligations, which form the bedrock of the world financial system.? Recent disruptions to the Treasury market – traditionally a source of stability and liquidity regardless of financial conditions – have led to proposed changes that could drastically shift the balance of power in this enormous market.

US Treasuries exert influence over financial markets above and beyond their already large trading volumes.? Considered the closest thing to cash, investors use them as safe havens in times of financial distress.? Their rates are used as benchmarks for virtually every other fixed income instrument, from credit cards to complex derivatives.? The Treasury “repo” market – a form of short-term secured lending – is an important tool in the Federal Reserve’s adjustments to monetary policy and a source of liquidity and financing for many other types of financial activity.

Because of the sheer size of the market and the traditionally rock-solid creditworthiness of Treasuries, stable market conditions were more or less taken for granted for many years.? Multiple factors have recently led to significant market liquidity crunches. Dodd Frank-era capital requirements and larger auctions of new securities by the Treasury Department caused the system’s “primary dealers” – the banks and broker-dealers designated by the New York Fed as mandatory participants and market makers in all Treasury auctions – to pull back from their traditional role as intermediators for trading in multiple Treasury issues.? The unwinding of the Fed’s massive “quantitative easing,” or bond buying program, pushed more securities onto the market.? International buyers, traditionally a reliable source of demand for Treasury securities, have pulled back as they seek to defend their own currencies. Rate hikes by the Fed and generally uncertain economic conditions have caused unprecedented volatility in yields.

These factors, combined with the ever-growing heft of the Treasury market – it is three times bigger than it was ten years ago - have combined to reduce liquidity and increase volatility.? Daily volume as a percentage of Treasury debt outstanding – a central measure of liquidity – has been on a steady decline. The depth of the market – the amount of a security that can be sold without moving the price – has fallen by as much as 85%, especially for “off the run” issues that have been outstanding for some time.? This has led to three recent incidents of severe market disruption that have required Fed intervention, most recently during the so-called “dash for cash” in March 2020 that forced the Fed to become a buyer of last resort.

With these changed market conditions in mind, regulators and market participants are considering changes to longstanding Treasury market practices.? Unlike the market for traditional bonds, most Treasury securities transactions are not centrally cleared.? Dealers trade so-called “on the run” (recently issued) securities with each other, clearing the transactions directly.? Customers wishing to purchase off the run securities must purchase either directly or indirectly from a primary dealer or principal trading firm.? Transactions among customers and their brokers – so-called “all to all trading” – are virtually unknown in the cash Treasury market.? These conditions create balance sheet and capital pressure for primary dealers, which has increased recently as the government’s issuance of new debt has greatly increased.

Observers and industry participants have discussed four principal ideas for reforms that would reduce volatility and increase liquidity in this essential market:

·?????? Central clearing of transactions.? The SEC issued a notice of proposed rulemaking that would require a much larger segment of the cash Treasury market to be centrally cleared.? The SEC estimates that only 13% of the cash market is currently centrally cleared, all of it through the Fixed Income Clearing Corporation (FICC). (Most Treasury futures are centrally cleared on the Chicago Board of Trade, and BNYMellon clears all triparty Treasury repos).? A central clearing agency would allow netting of trades, reduce the risk of failures and counterparty risk, and improve risk management.? But it would also concentrate risk in a single counterparty, likely increase costs and reduce the profitability of the large banks’ status as primary dealers.

·?????? “All-to-all” trading.? Much of the liquidity crunch in the Treasury market has occurred in off the run issues.? Large banks have become less willing to make a market in many of these securities because of the increased issuance of on the run Treasuries, as well as capital and balance sheet constraints. Encouraging customers or brokers who are not primary dealers to trade with each other could increase the number of market participants, improve price discovery and reduce liquidity constraints.? But it is not clear that these benefits would accrue during a systemic event, when all participants are attempting to liquidate their holdings as quickly as possible. More market participants might also shrink the primary dealers’ market leverage, causing them to increase spreads to customers.

·?????? Bank capital reforms.? Large banks who are also primary dealers were severely constrained when regulators imposed the Supplemental Leverage Ratio (SLR), which required them to hold capital against Treasuries despite their arguably risk-free character.? Federal banking agencies granted emergency relief to the banks during the COVID-induced crisis of 2020, allowing them to exclude holdings of Treasuries from SLR calculations, but that relief has expired.? Easing SLR requirements for Treasury holdings could allow primary dealers to avoid pressure on spreads to customers and prevent a recurrence of the capital problems large banks experienced in 2020, when many banks discouraged institutional customers from depositing cash. As new Treasury issuances continue to require primary dealers to commit more of their balance sheets, however, it is not clear whether regulatory reform would encourage them to become more active market makers or would simply compensate for the increased capital requirements incidental to their new holdings.

·?????? Improved availability of market information.? Currently all transactions in Treasury securities are tracked on a proprietary system known as Trace.? But the data is not publicly available, and the system provides trading data only on an aggregate basis and with a significant delay.? A June 2022 Treasury Department Request for Information sought public comment on “additional post-trade transparency” in the Treasury markets.? A recent survey of market participants by SIMFA, a bond market trade group, showed broad support for disclosure of average daily prices, trade counts and traded volume for each individual Treasury CUSIP.?

The viability and effectiveness of these proposals remains uncertain, and new market risks continue to emerge.? Regulators ?have recently expressed concern about hedge funds with large exposures to a so-called basis trade, in which funds take a short position by means of a futures contract, with a corresponding long position financed by a repo.? The trade seeks to take advantage of price differences in the same securities over time.? But spikes or drops in interest rates could cause one side of the trade or the other to become unprofitable, creating an incentive for the hedge funds to rapidly unwind it and create more challenges for market liquidity.? Continuing record issuances of US debt by the Treasury will also continue to challenge the balance sheets of primary dealers, especially as the Fed, which at one point held 20% of all outstanding US debt, continues to reduce the size of its holdings.? Investors in a market which once looked boring and rock solid now find themselves contending with unprecedented liquidity and market risks.

?SIMFA’s recent study of the structure of the Treasury market is available at https://www.sifma.org/explore-issues/treasury-market-structure/.

?My podcast,?“Risk Management for Financial Institutions - How Banks Stay Safe and Sound,” is?available at?https://youtu.be/2kNWCLQp678.

?Fred Egler is an independent consultant who advises on operational risk issues at financial institutions, including banking, securities and insurance.??He can be reached at?[email protected].

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