How to save the Treasury market

One of our obsessions here is the health of the Treasury market, which has been ominously creaking since at least October 2014 and was eerily close to exploding in March 2020.

Since then there has been an eruption of fears about the health of one of the most important pillars of the financial system and dueling reports about the root causes and triggers of the US Treasury market’s occasional eruption of unusual fragility.

But little has happened that prompted Bank of America rates strategist Ralph Axel to warn earlier this month that “declining liquidity and Treasury market resilience poses arguably one of the greatest threats to global financial stability today” and even outperformed the real estate bubble of the noughties.

Pimco, the world’s largest fixed income store, has now entered the debate, making some interesting arguments for what should be done to strengthen the tendons of the Treasury market – and what should be avoided. As Libby Cantrill, Tim Crowley, Jerry Woytash, Jerome Schneider, and Rick Chan pointed out, the stakes are high:

A well-functioning US Treasury market is critical to global capital markets. Given the growth of the Treasury market, the current structure makes it vulnerable to further bouts of extreme price volatility in March 2020 during times of stress. In our view, changes are urgently needed to reduce reliance on primary dealers to make markets, and at the same time banks strengthen ‘ ability to hold Treasuries. Without these changes, we believe Treasury market liquidity will disappear again during turmoil, ultimately leaving investors and the US government exposed.

First on the wish list is expanding access to the Federal Reserve’s standing repo facility, which allows financial institutions to borrow cash from the central bank using government bonds and high-quality mortgage-backed bonds as collateral.

Large banks that lubricate Treasury trading (known as primary dealers) already have access to the SRF. Pimco argues that a much broader group of financial institutions should be able to do this.

At the start of the crisis, the Fed attempted to support the Treasury market by providing over $1 trillion in repo funding to primary dealers. But while other market participants struggled to secure funding, primary dealers used less than half of the Fed’s available funding, according to PIMCO estimates based on public data.

We believe that any counterparty concerns that might arise from broader SRF access can easily be addressed by requiring appropriate haircuts – possibly depending on the type of institution, its size and the level of regulation to which it is subject. Another guard rail could require the clearing of SRF transactions – which some already do – and would subject counterparties to Fixed Income Clearing Corporation (FICC) requirements. The Fed has expanded its funding operations before: starting in 2019, it expanded access to its reverse repo operations beyond its typical primary dealers.

Another potential benefit of expanding SRF access: It can help reduce potential stigma associated with using the SRF, which could encourage more banks and broker-dealers to sign up with the SRF.

Similarly, Pimco believes that a broader group of market participants should also be given direct access to the Fed’s bond-buying programs, allowing investors like Pimco to sell government bonds directly to the central bank, rather than always going through primary dealers.

Well, that’s all pretty primary trader unfriendly. But Pimco still believes they have a role to play, and actually wants the government to unleash a little on the banks to make it a little bit easier for them.

The benefits of the Dodd-Frank Act reforms to the banking system became clear in March 2020: banks weathered the market turmoil largely unscathed, protected by generally robust balance sheets, with quality capital and ample liquidity. At the same time, however, their risk-bearing capacity has been significantly reduced, even for government bonds backed by the full confidence and creditworthiness of the US government. Therefore, we believe that policy makers should evaluate some of the existing Dodd Frank Act requirements in terms of a better balance between market functioning and safety and soundness. With the treasury market doubling in size since the Dodd-Frank Act came into force, we think a review of these rules is particularly appropriate.

At least as recommended by many interest groups. . . We encourage the Fed to make permanent the temporary changes it imposed on the Supplementary Leverage Ratio (SLR) in March 2020: excluding US Treasuries and reserves from the SLR calculation. We believe that such a change would not threaten the stability and soundness of the banking system, but would allow banks to facilitate markets, especially in times of crisis.

However, Pimco’s final proposal is the most intriguing and controversial. The bond house wants the US government to not only condone Treasuries but encourage them to move to an all-to-all trading model.

Keep in mind, while stocks trade on a sprawling ecosystem of electronic exchanges where anyone can buy and sell — whether they’re retail brokers, hedge funds, sovereign wealth funds, pension plans, or high-frequency traders — bond trading is far more fragmented.

Treasuries are mostly traded “over the counter,” with dealers acting as intermediaries between actual investors and interdealer brokers between the banks themselves. Trading takes place through a limited number of electronic trading venues and often even over the phone.

Banks are at the heart of this system, but as Pimco points out, during times of stress their willingness and/or ability to lubricate trades can dwindle. And that’s a source of systemic vulnerability that could be mitigated by an overhaul of how US Treasuries are traded.

. . . We want the entire treasury market to transition to all-to-all trading – a platform where wealth managers, traders and non-bank liquidity providers can trade on a level playing field and with equal access to information. This is happening in some areas of the bond market and, of course, in the way stocks are traded. However, for the vast majority of the bond market, including most parts of the Treasury market, liquidity remains intermediate, making the market more vulnerable, less liquid and more vulnerable to shocks. Even in those cases where the market has moved to all-to-all-like trading, this can only be done in name: while certain hedge funds and professional trading firms have been admitted to these platforms, these are often large wealth managers and other institutional participants excluded.

For this reason, we believe that policymakers could play an important role in bringing different stakeholders together to decide on the rules of the road for all-to-all trade. In our view, an effective all-to-all Treasury platform would function much like a utility and 1) involve all legitimate, professional market participants; 2) require participants to trade under the same rules with the same access to prizes, information, etc.; and 3) allow for complete anonymity of all trades at the time of transaction, similar to the Central Limit Order Book (CLOB) rules that dictate the futures market. While it’s theoretically possible for the market to organically shift in this direction, we’re skeptical that it will happen quickly, if at all, given the market’s little development in decades. As such, we believe that policymakers like the Fed and Treasury (possibly in the context of FSOC) could use their convening powers to bring together diverse stakeholders to discuss and advance a framework and potential target for an all-to-all trade the bond market into the modern age, with greater liquidity and greater resilience to financial shocks.

Of course, Pimco is partially voicing his book here. The propositions it makes would clearly be a boon to big money managers and draw outcry from big traders who have benefited enormously from their central position in the fixed income trading ecosystem.

Pimco’s self-interest is evident in its recommendations on what Not to do, namely the shift from government bonds towards cash clearing and real-time public reporting of government bond trading.

FT Alphaville is inclined to agree that central clearing would have narrowly failed to address a crisis like the one in March 2020, but cannot see how it would hurt and can see many ways in which it would help the functioning of the market. And opposition to public post-trade reporting is purely self-interest.

Pimco concedes it would be “theoretically beneficial” but mutters about “unintended consequences.” It is true that without other changes, more transparency in trading would likely make banks even less able/willing to make government bond markets. But it would also encourage broader participation and would be in line with Pimco’s unwavering endorsement thrust (although the prospect of Citadel suddenly dominating the entire treasury market might be a bit uncomfortable).

For FT Alphaville, Treasury’s sudden illiquidity was at the height of the market turmoil in March 2020 by far the scariest sign of a near-total financial dysfunction and imminent systemic collapse that could only be averted by the actions of the OTT central bank.

We therefore tend towards kitchen washing solutions and say “everything together please”.

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