World’s most important market needs some work

Treasury securities play a crucial role in global finance. They’re widely viewed as a close substitute for dollars, a safe place to park everything from a company’s cash to a central bank’s reserves. They provide a benchmark for determining the value of a vast array of assets, including mortgages, corporate bonds and shares in public companies. They’re the ultimate expression of the reliability of America’s capital markets.
It’s thus troubling that the Treasury market has faltered at critical moments, raising fears of further disruptions as central banks end a long period of easy money. Authorities can and should take steps to ensure the market works as smoothly as possible — but they must be mindful not to weaken the broader financial system in the process.
The Treasury market’s challenges stem from a fundamental imbalance. As deficit spending has driven up the US government’s debt, the value of publicly traded Treasuries has ballooned to more than $23 trillion. This has far outpaced the financial resources of the group of large dealer banks that, as market makers, are supposed to facilitate orderly trade in this market.
As a result, the dealers are occasionally unable or unwilling to handle the volume of trades that investors want to make. That’s what appears to have happened in March 2020, when a sudden surge in pandemic-related selling overwhelmed the market, sending prices and yields gyrating in ways that had little to do with the government’s underlying creditworthiness. It also helps explain a September 2019 disruption that sent interest rates sharply higher in the repo market, where investors borrow cash and post Treasuries as collateral. Given that US government debt isn’t likely to shrink anytime soon, the best solution is to increase the market’s trading capacity. One way to do so, favored by the banks, is to loosen capital regulations — specifically, to exclude Treasuries from the “leverage ratio,” which limits their total assets to 20 times their loss-absorbing equity. This might help at the margin, but it would also have the significant downside of allowing big, systemically important banks to take on potentially infinite leverage, making them even more fragile than they already are.
A better approach: Relieve the pressure on the dealers’ balance sheets by getting more institutions involved. There’s plenty of interest from asset managers and other financial companies — either in acting as intermediaries or in bypassing the dealers by trading directly with one another.
But potential entrants face obstacles that the Fed needs to address. For one thing, it should grant such companies access to its standing repo facility, a crucial financial backstop that allows dealers to borrow cash against the collateral of Treasuries. It should also head off counterparty risks by requiring more trades to go through a central clearinghouse that holds collateral and guarantees settlement. More central clearing would have the added advantage of netting positions, allowing the same balance sheets to accommodate more trades.
Beyond that, regulators need better information on what’s happening in the Treasury market, so they can spot disturbances earlier and respond more effectively. Officials seeking to understand the events of March 2020 had to wait weeks to get data showing who was selling and who was buying. Enhanced reporting requirements should allow for relevant analysis in real time.
Most people are happily oblivious to the Treasury market’s importance — it just works in the background, and even its glitches don’t matter much to anyone other than those directly involved. Best to keep it that way.
—Bloomberg