A Proposal to Restore Stability to the Shaken U.S. Treasury Market

Darrell Duffie talks about an emerging consensus on major reforms to the world’s financial safe haven.

September 22, 2021

| by Edmund L. Andrews
Signage outside U.S. Department of the Treasury headquarters in Washington, D.C. Credit: Reuters/Andrew Kelly

In March 2020, the U.S. Treasury market came dangerously close to a meltdown. | Reuters/Andrew Kelly

Right after the World Health Organization declared COVID-19 a global pandemic in March 2020, the U.S. Treasury market came dangerously close to a meltdown.

Sales of Treasury securities shot up to a new weekly record of over five trillion dollars as governments and corporations around the world raced to raise cash. Dealers couldn’t keep up with orders. Prices and yields bounced crazily and volatility soared. Suddenly, the world’s financial safe haven no longer looked like a refuge.

The Federal Reserve intervened in a major way, buying nearly one trillion dollars in “Treasuries” over three weeks and providing almost unlimited financing to large Treasury dealers. Even so, it was several weeks before the market functioned properly.

In a paper presented at the Brookings Institution in May 2020, Darrell Duffie, a professor of finance at Stanford Graduate School of Business, warned that the disruption had revealed grave weaknesses in the Treasury market, specifically that its size was growing much faster than its intermediation capacity. Without serious structural reforms, he argued, the system simply wouldn’t be up to the challenges ahead.

Duffie went on to serve as an advisor to the Group of 30, an international body of leading financial experts. Former Treasury Secretary Tim Geithner chaired a working group on Treasury market liquidity that included Lawrence Summers, head of President Barack Obama’s National Economic Council, as well as seven prominent former central bankers from several countries.

The Group of 30 recently published the working group’s proposals to shore up the system, incorporating some ideas that Duffie had proposed last year. Duffie spoke with Stanford Business about the problems exposed by the COVID-19 shock and some ideas for fixing them.

What happened in March 2020 that prompted so much worry about the Treasury market, and why is it important to the public?

The kickoff was on March 11, when the World Health Organization announced that COVID-19 could be characterized as a global pandemic. On or about the same day, the whole Treasury market became largely dysfunctional.

Investors around the world were rushing to sell their Treasuries to get cash. But the dealer banks, who handle almost all investor trades, were so stuffed with Treasuries that they had trouble accepting more sell orders at anything but very weak prices. Market “depth” disappeared, meaning that it became difficult to execute large trades.

Normally, when I sell you Treasuries, I deliver them the next day. If I can’t, that’s called a “fail.” In March, there were 1.5 trillion dollars in failed deliveries in just three weeks. That messed up the market even more.

A lot of other things indicated that the market wasn’t performing properly. Markets became very disconnected. Treasuries that were near substitutes for each other were priced differently. The yield curve became a wiggly mess.

Why is that important? Because people around the world regard U.S. Treasuries as a safe haven. Foreign central banks stock up on Treasury securities so that they can be cashed in during a crisis, which is why the U.S. dollar is a global reserve currency. Even in the depths of the financial crisis in 2009, you could still trade Treasuries in size. Because of their safe-haven status, the value of Treasuries went up then. But that service as a safe haven wasn’t offered in March 2020. Some Treasuries actually lost a lot of value.

The Federal Reserve did a fantastic job with its intervention. But even with all their guns blazing, it still took several weeks before the market functioned properly again.

This is probably not the last time this will happen. My own view is that the market structure is no longer fit for purpose. The dealer banks just aren’t big enough to handle the flows on big days. The market isn’t designed for this. Major structural changes are needed.

Before last year, the Treasury market always seemed to work smoothly. What changed?

The big change is that the volume of Treasury securities has grown much faster than the balance sheets of large banks, and thus their capacity to intermediate the market. Because of much higher U.S. budget deficits, the stock of outstanding Treasury debt has roughly doubled over the past decade, from ten trillion dollars to more than twenty trillion dollars. The dealers who buy and sell Treasuries need much more capital now to hold the inventories necessary for keeping up with all the additional trading. In moments of crisis, like March of last year, they can become overwhelmed.

What general principles came out of the Group of 30’s research?

The first broad insight is that there’s no fix that simply takes care of this problem once and for all. Tim Geithner was careful not to oversell what we were doing. As he put it, these recommendations can’t solve the whole problem, but they allow important improvements. If the government implements them, it will take a bigger crisis in the future to make the market dysfunctional.

A second big insight is that regulation matters a lot. After the financial crisis a decade ago, new regulations did a lot of good things to strengthen the capital buffers of financial institutions. However, those capital regulations also took away a lot of the appetite of banks and their dealer affiliates to acquire huge amounts of Treasuries in a short time. We should not be relying so heavily on dealers in regulated bank holding companies.

Let’s talk about your group’s specific proposals. One was for the Federal Reserve to create a “standing repo facility.” What is that and why is it important?

“Repos” are overnight repurchase agreements, essentially overnight loans between financial institutions or corporations, secured by other assets. Suppose you have one billion dollars in Treasury securities, but you need cash for the next day. You can offer those Treasuries as collateral, get the cash, and then buy back the Treasuries tomorrow. About $2 trillion of those repurchase transactions happen every day.

“This is probably not the last time this will happen. The market isn’t designed for this. Major structural changes are needed.”

The problem is that during periods of stress, people demand much higher interest rates on those overnight loans. Cash is king in a crisis. What happened in March of last year is that interest rates soared on those repurchase agreements.

A standing repo facility at the Federal Reserve would provide this cash at any time. The Fed’s new standing repo facility, which was actually announced on the day the G30 report was released, will supply that backstop financing to primary dealers. The interest rate is slightly higher than normal because it’s intended as a backstop.

You also called for more central clearing of trading Treasuries. What’s that?

If a bank is simultaneously buying and selling securities, it needs capital to cover the commitments on both transactions. With central clearing, however, the required amount of capital is lower because the commitments to buy can then directly offset the commitments to sell, because both commitments are made to the clearinghouse. As a result, the bank needs less capital.

There are other reasons to expand central clearing. You get a lot more safety and soundness, because you don’t have to worry as much about people fulfilling their side of a transaction. The system would also be more transparent and would impose more uniform constraints on leverage. In the current market, you often don’t need to post margin to carry out Treasuries transactions.

The Group of 30 also recommended easing something called the supplementary leverage ratio, a capital requirement adopted after the financial crisis of 2008 to ensure that banks set aside enough capital to handle potential losses. Why was this requirement a problem?

It used to be that the most important capital requirement was based on weighting assets by their riskiness. But banks sometimes cheated by understating the risks. After the financial crisis, regulators came in and said, “We are adding a requirement that makes you hold the same amount of capital for all types of assets, regardless of their risks.” That’s the supplementary leverage ratio. So now, even very safe assets like Treasury repos or central bank deposits are subject to the same capital requirements as very risky projects, like dodgy real estate loans.

If I’m a bank, I can often make more profit on real estate loans than I can on Treasuries. That reduces the appetite of bank-affiliated dealers to buy a lot of Treasuries at one time. In the G30 report, we recommended that regulators take another look at that, and come up with a supplementary leverage ratio that’s less binding on banks than their risk-based capital requirements. The obvious way to do that is to increase the risk-based requirements and lower the supplementary leverage ratio.

Are you optimistic that the Treasury market can indeed be shored up?

I’m always optimistic that the United States has what it takes to improve. Everybody responsible for this in the official sector understands the importance of fixing this market. One central banker told us, “This is the most important market in the world; why wouldn’t you treat it that way by doing everything possible to improve its safety, soundness, and liquidity?” The G30 recommendations will support the safe-haven benefits of Treasuries for the whole world. That will maintain a high demand for Treasuries, lowering the cost to taxpayers of financing U.S. deficits. Treasuries are still the most important safe haven in global financial markets. Nothing else even comes close.

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