THE TREASURY MARKET IS TREADING IN DANGEROUS WATERS / THE FINANCIAL TIMES MARKETS INSIGHT

The Treasury market is treading in dangerous waters

Bank balance sheets lack capacity to intermediate the surging amount of trading in the US government bonds

Manmohan Singh

The current size of the US Treasury market stands at around $30tn © Bloomberg

Even before recent geopolitical frictions, there were signs of strains in the smooth functionality in the Treasuries market.

The announcement late last year that the Federal Reserve will be buying $40bn of short-term Treasuries every month to prop up bank reserves offers the clearest sign yet there are concerns over serious systemic fragility from the demands being placed on the large banks that deal in such bonds. 

When the Fed purchases Treasuries in the secondary market, it is typically from non-banks which then deposit their cash into the banking system, propping up reserves.  

This provides short-term relief for symptoms. 

But this action fails to deal with the real problem, namely that bank balance sheets lack capacity to intermediate the surging size of the US Treasury market and related repurchase, or repo, transactions. 

In this repo market, financial institutions borrow cash from each other on a short-term basis (usually overnight), using US Treasuries as collateral.

The current size of the US Treasury market stands at around $30tn and since 2007, the total size of primary dealer balance sheets per dollar of Treasuries outstanding has shrunk by a factor of nearly four, according to the Bank Policy Institute.

In September 2019 and February/March 2020, these banks did not have sufficient balance-sheet space to smooth out serious liquidity shortfalls in the repo and Treasury markets. 

The Fed had to clear up the mess. 

This begs the obvious question: if primary dealers do not have the balance sheets to make markets for Treasuries, who besides the Fed is left to hold the bag when things go wrong?

Policy fixes being offered by regulators are unlikely to address this fundamental problem. 

For one, US regulators are planning to adjust the supplementary leverage ratio for banks, a broad measure of the capital banks must maintain as a percentage of their assets. 

The idea is to exclude Treasuries, reducing the capital banks must hold.

But again, there is little comfort that this move is guaranteed to work. 

Any freed-up balance-sheet space can be deployed much more lucratively by a primary dealer for prime brokerage services for hedge funds and trading derivatives.

Likewise, plans to clear more Treasuries traded at central counterparties might have unintended consequences. 

It is meant to offload Treasuries from dealer bank balance sheets, providing more space to intermediate in markets. 

But the mandate comes with costs, such as the creation of a too-big-to-fail institution. 

If it needed emergency liquidity in a crisis, the impact would be catastrophic.

Finally, among solutions suggested the problems include a new kind of digital security, the Perpetual Overnight Rate Treasury Securities (Ports) designed to be issued daily at auctions with settlement on a blockchain. 

But they come with downsides. 

Any switch of funds into them might come at the cost of reduced appetite for longer-dated Treasuries and for overnight repo (why bother with repo, when one can just invest in Ports?). 

With a more muted role for repo, other related markets such as open interest futures will also take a hit and reduce the efficacy of plumbing across financial markets.

Policymakers have faced limited blowback in taking their time to address the Treasury market’s problems. 

The lack of any viable other option to Treasuries has offered cover for this neglect. 

But such thinking is under strain. 

The overall size of the sovereign bond markets of Switzerland and Germany — two markets sometimes considered by investors as havens — are insignificant relative to Treasuries but might see greater demand given geopolitical strains. 

And the next biggest debt market, China, is making a case for itself as an alternative. 

Chinese government bonds are accepted as collateral by some intermediaries in Hong Kong.

And London Clearing House is now accepting  the use of such bonds denominated in euros and dollars as collateral while possibly doing the same with Chinese government debt in renminbi.

The crisis facing the Treasury market is not going away. 

If anything, it will get worse. 

The Big Beautiful Bill allows the Treasury to borrow up to $5tn, meaning primary dealers can expect a deluge of incoming debt. 

Market conditions and geopolitics are also dicey and can motivate sovereigns to sell Treasuries, reduce how much they invest or look for alternatives. 

Volatility is to be expected. 

In short, urgent attention is needed to strengthen resilience of Treasury market plumbing.

The writer is editor in chief of the Journal of Financial Market Infrastructures and a former IMF economist

Yesha Yadav, Milton R. Underwood Chair and Professor of Law at Vanderbilt University Law School, contributed to this article