The Securities and Exchange Commission has just taken the first official step to prevent the market from collapsing. She proposed on Wednesday to force more government bond trading through central clearinghouses. Clearing reduces the risk that one of the parties to a trade will not meet their end of the deal. It can also allow multiple parties to offset risks against each other at the same time, which should give everyone more trading capacity.
If enough banks, investors, and other traders can and do use clearing, it will help, but it’s not a panacea. There are many other changes that should be pursued with the longer 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 who are required and eligible to bid at Treasury Auctions are trading with the Fed. Huge US bond fund manager Pacific Investment Management Co. spoke out in favor of so-called all-to-all trading last week.
Dealers’ ability to broker Treasury trading is the core problem, leading to episodes of market stress and dysfunction, according to a report last year by former central bankers, regulators and academics known as the Group of 30. The panic of March 2020 was particularly extreme: it was as the US and Europe became aware of the severity of the Covid-19 pandemic, prompting investors to sell almost everything and load up cash. Rather than acting in its usual role as a haven during times of turmoil, Treasury prices unexpectedly plummeted as liquidity dried up, sending yields higher
There’s probably no defense against events like this, but the September 2019 money market seizure that led to a huge spike in overnight rates was thanks to the Fed tightening monetary policy, something it must do without busting upward markets. No one is sure how today’s quantitative tightening will play out, but it’s very likely to be a bumpy and unpredictable road.
Also, the Treasury market is expected to continue growing and reach $40 trillion by 2032 as the government borrows to fund large budget deficits. If banks are struggling to intermediate today, it would be crazy to rely on them alone to serve a much larger market in the future. That’s the argument made by non-bank market makers like Citadel Securities, and it’s hard to argue with.
The volume of transactions handled by banks has shrunk dramatically relative to the size of the treasury market: prior to 2008, primary dealer volumes were about 15% of the value of outstanding treasuries; now it’s down to just 2.5%, according to Bank of America Corp, which is a primary dealer.
Banks like JPMorgan Chase & Co., also a primary dealer, argue the problem lies in rule changes introduced 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 quickly absorb additional assets during an explosion in market activity, especially at times when everyone is looking to sell. The biggest banks want the calculation of leverage ratios, which measure the size of their balance sheets, changed to exclude the safest assets – something the UK and other jurisdictions have already done. They also want the additional capital costs for systemically important banks to be reduced. Such changes would lower their capital requirements and improve their returns, but it’s hard to say that they would definitely ensure the smooth functioning of the treasury market.
More important in 2019 were regulations on the amount and type of highly liquid assets big banks must hold, including government bonds and central bank reserves. These rules led some banks to favor reserves over Treasuries – and that made them less willing to lend against Treasuries in the money markets, contributing to the chaos this year.
Adjusting the rules to help banks do more trading and financing would definitely benefit Treasury markets, but the larger goal should be to make them less dependent on banks as intermediaries. Banks may argue that many electronic market makers or master trading firms are “fair weather” liquidity providers who disappear when markets get tough, but they will also always have a limit on how much they will trade during the most stressful times. That was long before 2008.
The Fed could lend against Treasuries to more market participants than just banks, which could help alleviate trade stress in a crisis. It would take the right risk management to protect taxpayers, but such a “dealer of last resort” role for Treasuries makes sense in the most difficult moments. Ultimately, the best way to avoid frequent crises would be to encourage greater diversity in terms of sizes and types of traders, traders and market makers to trade with each other. A greater variety of balance sheet types and motivations should help ensure some remain active when others are retiring.
More centralized clearing, as the SEC is proposing, should help, but more transparency into what trades are being made and at what prices and sizes is also needed to give different parties a better idea of where their holdings should be trading . It works in other assets, so it should help in the most important market in the world as well. More from other authors at Bloomberg Opinion:
• Arguments against a mega 1% rate hike: 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 represent the opinion of the editors or of Bloomberg LP and its owners.
Paul J. Davies is a Bloomberg Opinion columnist covering banking and finance. He was previously a reporter for the Wall Street Journal and the Financial Times.
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