Pressure builds for a revamp of US Treasuries market

The $22tn US Treasury market is ill-equipped to finance whatever US spending packages are finally delivered by Congress. The administration and market regulators know that, and are preparing to formally develop a new market structure.

Work has started even before the Federal Reserve board has confirmed (or reconfirmed) the next chair and vice chair. Officials including Nellie Liang, the under secretary of the Treasury for domestic finance, and Gary Gensler, chair of the Securities and Exchange Commission, have already been laying out preliminary sketches.

Their shared concept is to shift to a market where the liquidity is provided by a diversity of large and small participants, rather than a couple of dozen “primary dealers” and 50 big hedge funds.

As Gensler put it this week: “The principle is something that humankind has understood since antiquity. If you bring vendors into a public square and they compete selling apples, it’s clear what the prices are, and the townspeople benefit from those competitive prices.”

The Treasury, the Fed and regulators like Gensler are haunted by the Treasury market’s seize-up in March last year, which shook global markets. As a paper co-authored by Liang has put it, “large and widespread selling of bonds . . . overwhelmed the supply of liquidity by the securities dealers that act as bond market intermediaries.”

OK, so never again. The would-be market redesigners, though, do yet not have the information they would require on the workings of the existing market machine.

As one strategist for a major dealer describes the March episode last year, “this was like 2007 and 2008; nobody knew where all the risk in the system was, and how it was marked (valued) . . . It’s all a complete waste of time until you find out where the leverage is. And that leverage happens mostly in Treasuries.”

Look at the New York Fed’s study “Sizing hedge funds’ Treasury market activities and holdings” released on October 6. The NY Fed measured hedge funds’ activities by their “gross market exposure”. This is defined as “the sum of their long and short exposures” to both Treasury securities and derivatives.

That amounted an astonishing $2.4tn by February 2020, larger than the amounts now being haggled over for the Congressional Democrats so-called reconciliation budget bill. So when the funds dumped $173bn of that in March 2020, it hurt.

Notice the study came out a full year and a half after the traumatic events. And drilling down, some data are estimates that “follow an algorithm” and so on. Treasury market functioning “may have been affected” by the activities of hedge funds that trade on the relative value of assets. But who can be sure?

And this lagging information does not tell up how many times a Treasury security was lent by investors, banks, and hedge funds to market participants for temporary re-use as high quality collateral in high-speed foreign exchange or interest rate derivative trades.

According to IMF collected statistics, there was $9.4tn of such collateral held by the world’s 18 largest dealers at the end of 2020. From the Treasury’s point of view, collateral lending provides a lot of demand for the securities it is issuing, makes selling them easier. It also helps loosen financial conditions as a form of secured leverage. But has this lending or relending become too rapid-fire and unstable?

Even with the uncertainties on the data, officials including Liang, Gensler, and Fed board member Lael Brainard are intent on investigating how “central clearing” of all Treasury transactions can reduce dependence on hedge funds and the major dealers. This sort of complex mechanism would simultaneously act as a seller to all buyers and a buyer to all sellers.

Sifma, a US securities market association, argued in a note from March this year that: “Even with most Treasury trades being centrally cleared, it is highly unlikely that sufficient capacity would have been freed up to absorb the ‘dash-for-cash’ by investors that occurred last year.”

You could argue Sifma is focused on its members’ interest, not the public’s. But Manmohan Singh, an IMF expert in market plumbing, asserted in a May 2021 note that central clearing of Treasuries would necessarily be linked to the CME’s clearing of Treasury derivatives.

In his view, “that would cram more of the most important bond market in the world into already too-big-to-fail institutions ultimately puttable to the taxpayer. That would likely require greater scrutiny from the Fed, and maybe the guarantee of further liquidity lines.”

I have to admire the courage of the Treasury officials and regulators in hacking through the jungle of Treasury market redesign. I wonder if or when they will emerge with a plan.