As COVID-19 rocked financial markets in March 2020, the Treasury market failed to perform its role of maintaining financial stability. Unable to respond to the surge of investors liquidating their Treasury holdings to raise cash, the secondary market ground to a virtual halt. Liquidity disappeared. Trading costs skyrocketed. And the price of Treasuries – a common benchmark for financial assets – crashed with other assets, instead of remaining stable or rising.[1]

In a new article, we argue that this breakdown in the Treasury market undermined the credibility of Treasuries as the safe asset in financial regulation, and the collateral of choice for private contracting in short term credit markets. Regulators must now reevaluate whether Treasuries can, in fact, provide the protection they are assumed to offer firms and markets, particularly during a crisis.

Treasuries are supposed to be not only safe but also highly tradable – investors can buy and sell them with ease in the secondary market, cheaply and without affecting their prices.[2] Because of these attributes, financial regulation relies on Treasuries to protect firms and markets. Financial firms must maintain a sizable store of Treasuries as part of post-2008 capital buffers.[3] Importantly, Treasuries are also key in private contracting. Rather than undergo major reform post-2008, the $6 trillion repurchase (or repo) market – where financial firms lend each other securities and cash daily on a short-term basis – relies on Treasuries to secure the debt. Because it is assumed that Treasuries can be sold easily, a cash lender can be confident of being repaid if the borrower cannot pay. Around $4 trillion of the repo market is backed by Treasuries as collateral.[4]

Our article makes two arguments. First, while Treasuries themselves may be risk-free, the market in which they trade is not. The Treasury market depends on an opaque, conflicted, and complex system of intermediation that inextricably connects both the Treasuries-backed repo market and the secondary market for buying and selling Treasuries. Key to this are the common, shared intermediaries called primary dealers – currently numbering 24 top banks and investment firms. They use their own balance sheets to transact with investors in the secondary market and they also connect borrowers and lenders in the repo market. They can themselves also be repo borrowers and lenders. Primary dealers face enormous hurdles. For one, opacity is endemic. This occurs by design in the repo market, where short-term, Treasuries-backed debt is viewed as informationally insensitive, making due diligence unnecessary. However, transparency in the secondary market is also limited. Public reporting of secondary market trades occurs only weekly and in aggregate. Granular trade-by-trade reporting exists by dint of a 2017 mandate on broker-dealers and banks to report to regulators. Importantly, this regime has significant gaps, with major traders like hedge funds falling outside of it.[5] Information costs make it extremely costly and difficult for primary dealers to predict likely demand for cash or Treasuries and to intermediate efficiently across both repo and secondary markets.

Crucially, joint intermediation of secondary and repo markets requires primary dealers to navigate a conflict between these two spaces. The repo market forces around $4 trillion of cash and Treasuries to be “locked-in” to support private lending. But with such enormous amounts of assets caught within the repo market, primary dealers are restricted in how easily they can source cash or Treasuries for the secondary market. These constraints become pressing in a crisis when collateral must be tightly captured by the repo market to prevent default and a credit crunch. That said, the secondary market is likely to see a spike in demand for Treasuries and cash from investors precisely during crisis. Primary dealers must decide which market they might favor. Given the significantly larger daily transaction volumes, lower risks, and their dominant presence in the repo market, primary dealers have an incentive to protect the repo market by reducing intermediation in the secondary. In any event, conflict between the two spaces means that both are vulnerable to the private decisions of self-interested firms that may favor one over the other or decide to step back from intermediation across both markets.

Second, our article argues that the design of public regulation is not equipped to map out the interconnected risks between Treasury-backed repo and the secondary market for Treasuries. As Yesha Yadav points out in earlier writing, the structure of public oversight is fragmented among at least five regulators, none of which has lead status.[6] Rulemaking and supervision are stymied by bureaucratic apathy, coordination costs and inaction. Further and importantly, the repo and secondary markets are overseen in accordance with two separate paradigms. The repo market, notably, represents a prudential space where regulators favor systemic stability at the cost to disclosure and transparency. By contrast, the secondary market is more securities orientated, focused on price formation and liquidity. This divergence raises the costs of regulatory cooperation and makes it much more difficult for authorities to develop a picture of the connected risks underlying the Treasury market.

In concluding, our article advocates for a series of reforms to increase transparency in both the repo market and the Treasury secondary market. It also pushes for the creation of affirmative market-making obligations for key traders that would require them to continue trading rather than exit easily in a crisis. Finally, it argues for more consolidated, coordinated supervision of the Treasury market under the Financial Stability Oversight Council.

ENDNOTES

[1] Jeffrey Cheng et al., How did COVID-19 Disrupt the Market for U.S. Treasury Debt?, Brookings (May 1, 2020.

[2] Antoine Bouveret et al., Fragilities in the U.S. Treasury Market: Lessons from the “Flash Rally” of October 15, 2014 5-6.

[3] See e.g., Liquidity Risk Management Standards, 12 C.F.R. §§ 329.1–.50 (2020).

[4] Sifma, US Repo Market Chart Book (Apr. 27, 2020).  On tri-party repo, Federal Reserve Bank of New York, Tri-Party/GCF Repo, https://www.newyorkfed.org/data-and-statistics/data-visualization/tri-party-repo/index.html#interactive/volume/collateral_value (Jul. 9, 2020).

[5] James Collin Harkrader & Michael Puglia, Principal Trading Firm Activity in Treasury Cash Markets, Fed Notes, Aug. 4, 2020.

[6] Yesha Yadav, The Failed Regulation of U.S. Treasury Markets, 121 Colum. L. Rev. 1173(2021).

This post comes to us from professors Pradeep Yadav at Oklahoma University’s Price School of Business and Yesha Yadav at Vanderbilt Law School. It is based on their recent paper, “Fragile Financial Regulation,” available here.