Economies and markets operate on the assumption that U.S. debt securities (“Treasuries”) are risk-free. This means that the United States is expected to pay its debts. Also, Treasuries are supposed to trade easily and efficiently in secondary markets. Unsurprisingly, the rate at which the U.S. borrows represents a risk-free rate against which any number of financial contracts (e.g. corporate loans, derivative securities) are priced. After the 2008 financial crisis, regulation requires financial firms to deepen their reserves of Treasuries as protection against another collapse. Perhaps most importantly, this risk-free status has enabled the U.S. to confidently rely on global capital markets as a means for financing the apparatus of state and for backstopping ambitious national policy projects at relatively low cost.
In a recent article, I challenge the assumption that Treasury markets are risk-free despite the unimpeachable credit of the United States. First, the regulation of Treasuries is deeply fragmented and unsuited to the task. While this approach has remained virtually unchanged for decades, Treasuries themselves have undergone a transformation in their trading structure. Over the last 10 years, the Treasury market has morphed from a relatively staid space where transactions took place using telephones, mediated by a small, homogeneous group of top-tier financial firms – to one that is now largely automated and populated by a heterogenous cohort of expert algorithmic traders competing at high frequency with the traditional players. These rapid changes have introduced new fragilities. But a fragmented and lax system of regulation has failed to keep pace. Second, private self-regulation by Treasury traders cannot fill the gap. Whereas a small homogenous group of dominant, repeat players might once have offered a source of private self-regulation, relentless competition from high frequency traders limits the feasibility of relying on Treasuries traders to self-police and impose discipline on themselves. These arguments – and their implications – are described more fully below.
Treasuries have assumed enormous economic significance in the wake of the financial crisis. From about $5 trillion outstanding in August 2008, Treasury borrowing has surged to over $16 trillion in marketable debt today. This borrowing has afforded the U.S. expansive policy power to, for example, stabilize the economy following 2008’s financial collapse. This increasing supply has also made them a key regulatory lever, with financial institutions required by law to enhance their reserves of Treasuries. Critical to this overall power is the belief that Treasuries offer a ready and reliable store of value, capable of being bought and sold by investors with a high degree of predictability and few transaction costs. Absent default and trading risks, investors have no reason to apply a premium to what they charge the United States for debt capital. In other words, the U.S. gets to borrow cheaply because investors recognize it as a safe-haven where they will always be repaid and where their securities will be highly tradeable (i.e. “liquid”).
Despite an average trading volume of around $620 billion in March 2019 (compared with an average daily trading volume of around $330 billion for U.S. equities) and their unique significance for global economic well-being, Treasury markets are subject to a surprisingly under-regulated and fragmented system of oversight. Treasuries lack a primary regulator (like the Securities and Exchange Commission for equities). Rather, oversight is split between five public financial regulators: Department of the Treasury, Federal Reserve, Federal Reserve Bank of New York, SEC, and Commodities Futures Trading Commission (CFTC). The Financial Industry Regulatory Authority (FINRA) as well as banking regulators also oversee Treasury broker-dealers. No single regulator has primary status, and so agencies are required to coordinate with one another in order to effect market-wide rulemaking and supervision.
Importantly, the rulebook that applies to Treasury markets is much thinner than that pertaining to equities or derivatives markets. Up until 2017, Treasuries lacked a systematic real-time reporting mandate. According to one industry expert, out of the thousands of FINRA rules that apply to equity broker-dealers, only about 46 apply to Treasury traders. Indeed, there is considerable confusion about exactly which rules do apply and how: The SEC and FINRA are undertaking a review to provide a more definitive answer. Moreover, trading platforms that only intermediate dealings in Treasuries are exempt from the slew of regulations that normally apply to equity exchanges or trading platforms.
This fragmented and hands-off regulatory posture might perhaps have made sense for the relatively uneventful marketplace that Treasuries have long inhabited. Historically, Treasuries have relied on a cohort of primary dealers to maintain the primary and secondary markets. These pre-selected financial firms, chosen for their deep pockets, reputation, and client networks, have been repeat purchasers of the debt issued by the Treasury – and have dominated the secondary market to buy and sell this debt with their clients. The secondary market has also included an “interdealer” market, where dealers can interact with one another to modulate their private supply of Treasuries. Transactions in both the client-dealer and the interdealer markets have traditionally taken place using telephones or computer screens for posting quotes about what is available to buy and sell and at what price.
Over the last decade, however, Treasury markets have transformed, while regulation has remained largely unchanged. Just as with equities, inter-dealer trading in Treasuries is dominated by high-speed algorithms. Rather than traders using telephones to make deals, pre-set automated computer programs submit orders for the sale and purchase of Treasuries. Computerization enables trades to occur in milliseconds. This high frequency trading (HFT) accounts for over 60 percent of all traded volume in the interdealer market. It has helped improve markets in various ways, such as their ability to respond to new information. In addition, primary dealers now compete with expert automated traders. According to one survey, eight out of the top-10 traders on the leading interdealer trading platform were high frequency traders, not primary dealers. Crucially, high speed securities- trading firms are generally subject to much lighter regulation in Treasuries than primary dealers: Major high frequency traders have not applied for the designation of primary dealer, and some traders are able to avoid the regulation altogether by transacting for their own books and not holding themselves out as broker-dealers.
These transformative dynamics create risks for Treasuries, especially when regulators are poorly equipped to act quickly and comprehensively. First, pre-set, high-speed algorithms inherently generate greater risk of market fragility. Because they have to be pre-programmed in advance of trading (humans cannot transact at high frequency in real time), algorithms are liable to misfire, respond to fake-news, trade in similar ways to similar input or fail to function in unforeseen, extreme circumstances. While errors are an unavoidable part of trading, the speed at which such errors can spread in automated markets renders their trajectory difficult to anticipate and hard to control. In Treasuries, the costs of such disruption are especially high. Unlike the diverse mix of claims in equity markets – where a glitch in trading Alphabet (Google) or Apple shares might affect a single company, or maybe a sector – Treasuries are more homogenous and errors can potentially affect all Treasuries and the prices of virtually all asset classes. Regulators have deliberated and developed rules to respond to some of the risks of automation in equities markets. But similar vulnerabilities have not yet been seriously addressed in Treasuries.
Secondly, private oversight by Treasuries traders is unlikely to fill this gap. Both primary dealers and expert automated traders have incentives to be risky, careless, or even deliberately disruptive. The cost of such risk-taking is small. Regulation is limited and the chance of discovery and sanction low, particularly given the coordination and monitoring difficulties of the fragmented regulatory framework. Indeed, traders have little incentive to cooperate with one another. Primary dealers and high frequency traders are subject to asymmetric compliance burdens. A small, homogenous group of repeat players might have had an economic stake in ensuring the market functions well, raising the cost to single players of defecting. But a more crowded field of competing heterogenous players has limited reasons to invest in self-discipline and oversight, especially where risk-taking is easy and exit is cheap.
Secondary trading in Treasuries currently faces under-regulated risks of disruption and misfeasance, raising significant concerns about price discovery and fragility. In concluding, my article surveys ways to reform the Treasury market, examining the feasibility of creating more robust coordination between regulators, and also mandating greater engagement from private traders. The article is the first part of a larger research project to examine the regulation of this all-important but understudied market that is critical to the future of the American and global economies.
 Dep’t of the US Treasury, Monthly Statement of the Public Debt of the United States (Mar. 2019), https://www.treasurydirect.gov/govt/reports/pd/mspd/2019/opds032019.pdf. Dep’t of the US Treasury, Monthly Statement of the Public Debt of the United States (Aug. 2008), https://www.treasurydirect.gov/govt/reports/pd/mspd/2008/opds082008.pdf.
 SIFMA, US Treasury Trading Volume (March 2019); SIFMA, US Equity Trading Volume (March 2019).
 Kevin McPartland, TRACE “Unlocks” the Treasury Market for the Official Sector. Everyone Else Gets a Peek Through the Keyhole, Greenwich Associates, Oct. 3, 2018
 United States Treasury et al., Joint Staff Report: The U.S. Treasury Market on October 15, 2014, 15-19, 25-29 (Jul. 13, 2015)
 Portia Crowe, High-Frequency Traders are Now Dominating Another Huge Market, Business Insider, September 23, 2015.
This post comes to us from Professor Yesha Yadav of Vanderbilt University Law School. It is based on her recent article, “The Myth of Risk Free Markets,” available here.