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How to save the Treasury market

One of our obsessions around here is the health of the Treasury market, which has creaked ominously since at least October 2014, and came spookily close to exploding in March 2020.

Since then there has been an outpouring of angst over the health of one of the financial system’s most important pillars, and duelling reports into the core causes and triggers of the occasional outbreak of freakish fragility in the US government bond market.

But little has happened, leading Bank of America’s rates strategist Ralph Axel to warn earlier this month that the “declining liquidity and resiliency of the Treasury market arguably poses one of the greatest threats to global financial stability today”, even outstripping the noughties housing bubble.

Pimco, the world’s biggest fixed income shop, has now waded into the debate, setting out some interesting arguments on what should be done to stiffen the sinews of the Treasury market — and what should be avoided. As Libby Cantrill, Tim Crowley, Jerry Woytash, Jerome Schneider and Rick Chan lay out, the stakes are high:

A well-functioning US Treasury market is critical for global capital markets. Given the Treasury market’s growth, the current structure leaves it vulnerable in times of stress to further bouts of the extreme price volatility seen in March 2020. In our view, changes are urgently needed to lessen reliance on primary dealers to make markets, while increasing banks’ capacity to hold Treasuries. Without these changes, we believe Treasury market liquidity will again disappear during bouts of turbulence, ultimately leaving investors and the US government exposed.

First on its wish list is broadening access to the Federal Reserve’s standing repo facility, which allows financial institutions to borrow cash from the central bank using Treasuries and high-grade mortgage-backed bonds as security.

Big banks that lubricate Treasury trading (known as primary dealers) already have access to the SRF. Pimco argues that a far broader set of financial institutions should be able to do so.

Early in the crisis, the Fed attempted to support the Treasury market by providing over $1tn of repo funding to primary dealers. Yet 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 any counterparty concerns that may arise from broader SRF access can easily be addressed by requiring commensurate haircuts — potentially depending on the type of institution, its size, and the scope of regulation to which it is subjected. Another guardrail could require clearing SRF transactions — which is already happening to some extent — and would subject the counterparties to requirements of the Fixed Income Clearing Corporation (FICC). The Fed has widened its funding operations before: It expanded access to its reverse repo operations beyond its typical primary dealers beginning in 2019.

Another potential benefit of broadening SRF access: It may help decrease any potential stigma attached to using the SRF, which could encourage more banks and broker-dealers to sign up for the SRF.

On a similar note, Pimco thinks that a broader group of market participants should also be allowed access to the Fed’s bond-buying programmes directly, allowing investors like Pimco to sell Treasuries directly to the central bank rather than always going through primary dealers.

Now, this is all seems pretty primary-dealer unfriendly. But Pimco still thinks they have a role to play, and in fact wants the government to unshackle banks a little to make it a bit easier for them.

The benefits of the Dodd-Frank Act reforms on the banking system were clear in March 2020: Banks survived the market turmoil largely unscathed, protected by generally robust balance sheets, with high quality capital and plentiful liquidity. At the same time, however, their risk-taking capacity was significantly constrained even for Treasury bonds, which are backed by the full faith and credit of the US government. As a result, we believe policymakers should evaluate some of the existing Dodd-Frank Act requirements with an eye toward achieving a better balance between market functioning and safety and soundness. We believe revisiting these rules is especially apropos given the doubling in size of the Treasury market since the Dodd-Frank Act was enacted.

At a minimum, as many stakeholders have recommended . . . we would encourage the Fed to make permanent the temporary changes it imposed in March 2020 to the supplementary leverage ratio (SLR): Exclude U.S. Treasury securities and reserves from the SLR calculation. We believe such a change does not compromise the stability and soundness of the banking system, but would allow banks to make markets more easily, especially in times of crisis.

However, Pimco’s last suggestion is the most intriguing and the most controversial. The bond house wants the US government to not just condone but encourage Treasuries to move to an “all-to-all” trading model.

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

Treasuries mostly trade “over the counter”, with dealers acting as middlemen between actual investors, and interdealer brokers intermediating between banks themselves, Trading takes place over a limited set of electronic trading venues and often even by phone.

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 vanish. And that is a source of systemic fragility that might be ameliorated by overhauling how US government debt is traded.

. . . We would like the entire Treasury market to move to all-to-all trading — a platform where asset managers, dealers, and non-bank liquidity providers are able to trade on a level playing field, with equal access to information. This is happening in some pockets of the bond market and, of course, it’s the way equities are traded. Yet, for the vast majority of the bond market, including most parts of the Treasury market, liquidity remains intermediated, making the market more fragile, less liquid, and more susceptible to shocks. Even in those cases where the market has moved to all-to-all-like trading, it may be in name only: While certain hedge funds and professional trading firms have been allowed onto these platforms, often large asset managers and other institutional participants are excluded.

For this reason, we believe that policymakers could play an important convening role, bringing different stakeholders together to decide on the rules of the road for all-to-all trading. In our view, an effective all-to-all platform for Treasuries would function similarly to a utility and would 1) include all legitimate, professional market participants; 2) require that participants trade under the same rules with the same access to price, information, etc.; and 3) allow for total 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 is theoretically possible that the market would shift this way organically, we are skeptical it will happen quickly, if at all, since the market has evolved little in decades. As such, we believe that policymakers, such as the Fed and Treasury (potentially in the context of the FSOC), could use their convening authority to bring different stakeholders together to discuss a framework and potential destination for all-to-all trading, pushing the bond market into the modern age, with deeper liquidity and greater resilience to financial shocks.

Of course, Pimco is partly talking its book here. The suggestions it makes would clearly be a boon to big asset managers and trigger screams from big dealers, who have benefited 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, namely moving Treasuries towards cash clearing and real time public reporting of Treasury trading.

FT Alphaville is inclined to agree that central clearing would narrowly not have addressed a crisis like March 2020, but cannot see how it would hurt and can see many ways it would help the market’s functioning. And the resistance to public post-trade reporting is just naked self-interest.

Pimco admits that it would be “theoretically beneficial” but mutters about “unintended consequences”. It is true that absent other changes, more transparency on trades would likely make banks even less able/willing to make markets in Treasuries. But it would also encourage broader participation, and would be in line with the thrust of Pimco’s all-to-all advocacy (even though the prospect of Citadel Citadel Securities suddenly dominating the entire Treasury market might be a bit unpalatable).

For FT Alphaville, the sudden Treasury illiquidity at the peak of the market turmoil back in March 2020 was by far the scariest sign of near-total financial dysfunction and imminent system collapse, which was only averted by OTT central bank action.

We’re therefore inclined to kitchen-sink solutions and say “all of the above, please”.

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