How to Save the Treasury Market

One of our obsessions here is the health of the Treasury market, which has cracked ominously since at least October 2014, and nearly exploded scarily in March 2020.

Since then, there has been an outpouring of angst over the health of one of the most important pillars of the financial system, and dueling reports over the root causes and triggers for the occasional eruption of fragility. bizarre in the US government bond market.

But little has happened, leading Bank of America rates strategist Ralph Axel to warn earlier this month that “declining liquidity and resilience in the Treasury market arguably constitute one of the greatest threats to global financial stability today”, surpassing even the real estate bubble of the 2000s.

Pimco, the world’s largest fixed income store, has now waded into the debate, laying out some interesting arguments about what should be done to stiffen the nerves of the Treasury market – and what should be avoided. As Libby Cantrill, Tim Crowley, Jerry Woytash, Jerome Schneider and Rick Chan explain, the stakes are high:

A well-functioning US Treasury market is essential for global financial markets. Given the growth of the Treasury market, the current structure makes it vulnerable in times of stress to further episodes of extreme price volatility seen in March 2020. In our view, changes are urgently needed to reduce dependence on towards primary traders to make markets work, while increasing banks’ ability to hold treasury bills. Without these changes, we believe Treasury market liquidity will disappear again during bouts of turbulence, ultimately leaving investors and the US government exposed.

First on his wish list is to expand access to the Federal Reserve’s Permanent Repo Facility, which allows financial institutions to borrow money from the central bank using Treasury bills and high-quality mortgage-backed bonds as collateral.

The big banks that lubricate Treasury trading (known as primary dealers) already have access to the SFR. Pimco argues that a much wider set of financial institutions should be able to do this.

Early in the crisis, the Fed attempted to prop up the Treasury market by providing over $1 billion in repo funding to primary traders. Yet while other market participants struggled to secure funding, primary traders used less than half of available Fed funding, according to PIMCO estimates based on public data.

We believe that any counterparty concerns that may arise from broader access to the SRF can easily be addressed by requiring proportional haircuts – potentially depending on the type of institution, its size and the extent of regulation to which it is submitted. Another safeguard could require the clearing of SRF transactions – which already happens to some extent – ​​and would subject counterparties to the requirements of the Fixed Income Clearing Corporation (FICC). The Fed has already expanded its funding operations: it expanded access to its reverse repo operations beyond its usual core dealers starting in 2019.

Another potential benefit of expanding access to SRF: it can help reduce any potential stigma associated with using SRF, which could encourage more banks and brokers to sign up for SRF.

Along the same lines, Pimco believes that a broader group of market participants should also be allowed direct access to Fed bond-buying programs, allowing investors like Pimco to sell Treasury directly to the central bank rather than always going through primary dealers.

Now, this all sounds pretty hostile to master resellers. But Pimco still thinks they have a role to play and actually wants the government to free up the banks a bit to make it a bit easier for them.

The benefits of the Dodd-Frank Act reforms to the banking system were clear in March 2020: banks survived the market turmoil largely unscathed, protected by generally strong balance sheets, high-quality capital and ample liquidity. . At the same time, however, their ability to take risk was significantly limited, even for Treasury bills, which are backed by the full trust and credit of the US government. Accordingly, we believe that policymakers should assess some of the existing requirements of the Dodd-Frank Act with a view to achieving a better balance between market functioning and security and soundness. We believe the review of these rules is particularly timely given the doubling in size of the Treasury market since the enactment of the Dodd-Frank Act.

At a minimum, as recommended by many reviewers. . . We encourage the Fed to make permanent the temporary changes it imposed in March 2020 to the Supplemental Leverage Ratio (SLR): exclude US Treasury securities and reserves from the SLR calculation. We believe that such a change will not compromise the stability and soundness of the banking system, but will allow banks to make deals more easily, especially in times of crisis.

However, Pimco’s latest suggestion is the most intriguing and controversial. The bond house wants the U.S. government to not only condone, but encourage Treasuries to move to an “all-in” business model.

Remember, while stocks trade on a sprawling ecosystem of electronic exchanges with everyone able to buy and sell to each other – be it retail brokers, hedge funds, sovereign wealth funds, pension plans or high-frequency traders – bond trading is much more fractured.

Treasuries trade primarily “over-the-counter”, with dealers acting as intermediaries between the actual investors and inter-dealer brokers intermediating between the banks themselves. Trading takes place on a limited set of electronic trading platforms and often even over the telephone.

Banks are at the heart of this system, but as Pimco points out, in times of stress their willingness and/or ability to lubricate trading can disappear. And it’s a source of systemic fragility that could be mitigated by overhauling the way US government debt is traded.

. . . We’d like to see the entire Treasury market move to global trading – a platform where asset managers, brokers and non-bank liquidity providers can trade on a level playing field, with equal access to information. This is happening in certain pockets of the bond market and, of course, this is how stocks are traded. Yet for the vast majority of the bond market, including most segments of the Treasury market, liquidity remains intermediate, making the market more fragile, less liquid and more sensitive to shocks. Even in cases where the market has moved to global trading, this may only be in name: while some hedge funds and professional trading firms have been granted access to these platforms, often large asset managers assets and other institutional participants are excluded.

For this reason, we believe that policy makers could play an important convening role, bringing together different stakeholders to decide the rules of the road for trade for all. In our view, an effective global treasury bill platform would operate similarly to a public utility and 1) include all legitimate and professional market participants; 2) require participants to trade under the same rules with the same access to price, information, etc. ; and 3) allow complete anonymity of all trades at the time of trade, similar to the central limit order book (CLOB) rules that dictate the futures market. While it’s theoretically possible for the market to move this way organically, we’re skeptical that it will happen quickly, if at all, as the market has been little moved for decades. As such, we believe that policymakers, such as the Fed and Treasury (potentially in the context of the FSOC), could use their convening power to bring together different stakeholders to discuss a framework and a potential destination for global trade, pushing the bond market into the modern era, with greater liquidity and greater resilience to financial shocks.

Of course, Pimco is partly talking about his book here. The suggestions he makes would clearly be a boon for large asset managers and would trigger cries from big brokers, who have profited enormously from their central position in the fixed income trading ecosystem.

Pimco’s self-interest can be seen in its recommendations on what not to do, which is to move treasury bills to clearing cash and publishing real-time public reports on treasury transactions.

FT Alphaville is inclined to agree that central clearing would not have solved a crisis like the one in March 2020, but does not see how that would hurt and can see many ways it would help the functioning of the market. And resistance to public post-trade reporting is purely self-interested.

Pimco admits it would be “theoretically beneficial” but mumbles about “unintended consequences”. It is true that in the absence of other changes, greater transparency on transactions would probably make banks even less able/willing to create markets in Treasuries. But it would also encourage broader participation and be in line with Pimco’s overall advocacy direction (though the prospect of Citadel suddenly dominating the entire Treasury market might be a little distasteful).

For FT Alphaville, the sudden illiquidity of the Treasury at the height of the market turmoil in March 2020 was from afar the most chilling sign of near total financial dysfunction and impending system collapse, which was only averted by central bank OTT action.

So we’re prone to kitchen sink solutions and saying “all of the above, please”.

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