Brookings Institution: Loose ends in the US Treasury market

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Nellie Liang, Miriam K. Carliner Senior Fellow in Economic Studies, Brookings Institution.

A paper published by Nellie Liang, the Miriam K. Carliner senior fellow in Economic Studies at the think tank Brookings Institution and Pat Parkinson, a special advisor at lobby group the Bank Policy Institute, has proposed several structural changes in the US Treasury market intended to increase the provision of market liquidity in stress periods and thus increase market resilience.

Pat Parkinson, special advisor, Bank Policy Institute.

The US Treasury market has been beset by scandal and unexplained activity for over a decade; in 2014 it saw a sudden, massive price movement and reversion – the ‘flash rally’ – that has been unexplained to date; manipulation of the market by JP Morgan over a seven-year period including 2014 – yet which agencies have not investigated as a cause of the flash rally – was uncovered and prosecuted in 2020; March 2020 also saw a withdrawal of liquidity by dealers during a massive market sell-off which led to “exceptionally wide bid-ask spreads and difficulty in executing transactions or finding liquidity in Treasury markets” according to members of the Federal Reserve’s Treasury Market Practices Group speaking in March 2020.

Lael Brainard, member of the Board of Governors of the Federal Reserve.

The incomprehensible nature led Lael Brainard, member of the Board of Governors of the Federal Reserve System, to note in 2018, “the fact that sharp market movements – some on the order of seven or eight standard deviations outside the norm – can occur even in the absence of clear news drivers remains a concern and highlights the potential risks to financial stability posed by the high-speed transmission of price and liquidity shocks across multiple markets and trading venues.”

The paper by Liang and Parkinson sets out measures which are intended to tackle the supplement potential regulatory changes that could “reduce demand surges for market liquidity under stress, especially procyclical demands from nonbank financial institutions, including prime money market mutual funds, open-end bond funds, and leveraged funds. We seek to complement those efforts by considering and proposing measures that are intended to increase the supply of market liquidity in stress periods.”

The first proposal is for a new standing repurchase agreement (repo) facility set up by the Federal Reserve to support market liquidity in periods of broad stress through regulated dealers under pre-established arrangements.

“The Fed would use a repo to make a loan to a dealer collateralised by Treasury or agency securities,” the authors wrote. “Currently the Federal Reserve can provide liquidity directly only to commercial banks and other insured depository institutions, except in emergency situations. This patchwork backstop is ineffective for supporting credit in stress situations when the credit needs of the US economy now are met more through bond issuance in markets than through bank loans.”

In the view of the authors, a standing repo facility would encourage more dealers to invest in market-making capacity and therefore better supply liquidity to US bond markets in normal periods and to be able to accommodate clients’ needs in abnormal periods.

“It would be open to both bank-affiliated and independent dealers that meet prudential requirements established by the Federal Reserve, in consultation with the Securities and Exchange Commission (SEC), to reduce any moral hazard brought about by the facility. The requirements would be tailored to the size and complexity of the individual dealer, which would allow smaller dealers to compete more effectively with large dealers. The facility would provide secured funding at prudent haircuts and at an interest rate modestly above the current market rate, high enough to ensure the facility is used only in abnormal times but not so high as to stigmatise the use of the facility and defeat its purpose. By increasing confidence in the availability of repo financing, a facility could also reduce the ‘dash for cash’ motive that was evident in March, when investors rushed to liquidate their Treasury securities for cash,” they wrote.

The second proposal is for the use of central clearing in Treasury trading as it would ease constraints around bank capital and leverage requirements via the multilateral netting of cleared trades, thereby mitigating risk.

“It might also eventually enable more all-to-all trading, which could reduce the need for dealer intermediation altogether by permitting investors to provide the flexibility in the system, as in the equity markets,” they wrote. “To be sure, central clearing raises concerns about concentrations of risk in CCPs and in clearing firms, so expanded clearing would make their regulation even more important. Thus, a thorough study should be conducted to assess the costs and benefits.”

The third proposal is that changes are made to bank regulations that the authors cite could improve liquidity provision by bank-affiliated dealers, without reducing their overall safety and soundness.

“Specifically, the Federal Reserve in March temporarily exempted deposits at Federal Reserve Banks and holdings of US Treasury securities from the supplementary leverage ratio (SLR) to alleviate constraints that were hindering dealers from providing liquidity during the pandemic crisis,” they wrote. “We propose that reserves at the central bank be permanently excluded because they are riskless. We do not support permanent exclusion of Treasuries, which have interest rate risk. We also propose replacing some of the higher static buffers of the enhanced SLR (eSLR) with a countercyclical component, which could be released in episodes of market-wide stress to support liquidity of Treasury markets and other bond markets. We also suggest that the Federal Reserve should review certain elements of the methodology for determining the GSIB capital surcharge, which that may be unnecessarily restraining market-making by bank-affiliated dealers in times of market stress.”

The fourth and final proposal is regarding increased data collection for bilateral uncleared repo and disclosure to improve transparency about broker-dealers and leveraged funds. Greater transparency has been called for in the Treasuries market already, as trading data is not disclosed as it is for corporate bond trading.

As the authors note, “These data are critical to better monitor funding risks and leverage in nonbank financial intermediation and to reduce moral hazard from a standing facility.”

These structural changes could be supplemented by regulatory proposals to both increase transparency of reported data and to place interdealer Treasury trading venues within the regulatory framework of Reg ATS, which would collectively create a considerably more structured framework for US bond markets than exists today.

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