It didn’t attract a lot of mainstream attention at the time, but the world’s biggest financial safe haven came alarmingly close to a meltdown this spring.
As the COVID-19 pandemic grew into a full-fledged crisis, investors around the world sold U.S. Treasury securities so fast that the trading system couldn’t keep up.
It was the opposite of what usually happens in a crisis, when investors swarm to the heralded safety of Treasury bonds. Instead, Treasury sales that month shot up to a new all-time record of roughly $5 trillion. During one two-day period in mid-March, the venerable 30-year Treasury bond lost 10% of its value.
Even more alarming, however, was that the trading system showed signs of buckling. Dealers couldn’t keep up with orders. Prices and yields bounced in crazy ways. Volatility soared. One key indicator of paralysis, the “spread” between bid and ask prices for Treasuries, was 12 times normal.
The situation was so dire that the Federal Reserve had to intervene in a massive way, buying $1 trillion in Treasuries in three weeks. It was the largest market operation ever conducted by a central bank.
To Darrell Duffie, professor of finance at Stanford Graduate School of Business, the episode revealed a major long-term danger: The world’s biggest and supposedly safest financial market is much more rickety than anybody thought, and the current trading system isn’t sustainable without a major upgrade.
“We had a wake-up call,” says Duffie, a leading expert on the financial system. “This is a safe haven for the world’s financial markets, but it didn’t perform like that in March. We saw that, amid severe market news, the Treasury market could become dysfunctional. This will happen more and more frequently, because the size of the Treasury market is growing exponentially fast.”
In a paper that has sparked intense discussion among central bankers and financial scholars, Duffie argues that the current system can be fixed but needs a lot of work.
The underlying problem, Duffie says, is that the Treasury market has ballooned so much that the major banks that serve as primary dealers — and that keep Treasuries so easy to trade — don’t have enough capital to keep pace.
Those dealers need capital to hold inventories of Treasury securities, and they need much more of it to handle the explosive growth in Treasury volumes. Federal borrowing soared after the last financial crisis, and it’s soaring again as a result of the pandemic.
The stock of outstanding Treasury debt has roughly doubled since 2010, when it was already running high, from $10 trillion to $20 trillion. Those totals will keep growing rapidly for many years, as the U.S. government continues to run multi-trillion-dollar shortfalls. The Congressional Budget Office estimates that total U.S. federal debt could hit $120 trillion by 2050.
Leaving aside what that kind of debt means for the economy, it puts an unprecedented burden on the banks that serve as dealers.
A Centralized Solution
To illustrate how much things have changed in the past decade, Duffie points to a remarkable reversal in the relationship between the assets of major U.S. banks and the volume of marketable Treasury debt. In 2008, U.S. big-bank assets were about $4 trillion more than the Treasury debt. In 2020, however, Treasury debt is about $10 trillion more than U.S. big-bank assets.
The solution, Duffie argues, is to create a broad centralized clearing system for processing and guaranteeing the settlement of Treasury securities trades.
In a centralized clearing system, all significant trades would settle through a single “counterparty” rather than bilaterally with a wide range of other dealers. That would reduce the amount of capital that each dealer needs. Instead of needing capital to guarantee each separate trade, a dealer would be able to offset its contracts to deliver Treasuries against its contracts to receive them. It would need only enough capital to guarantee the net difference between those commitments.
U.S. policymakers are listening. Lael Brainard, a Federal Reserve governor who has been mentioned as a possible pick for Treasury Secretary by President-elect Joe Biden, recently endorsed an expansion of centralized clearing. So did the executive vice president of the New York Fed, which manages the Fed’s open-market operations, who specifically cited Duffie’s paper.
To be sure, Duffie says, a centralized clearing system for the Treasury market wouldn’t be easy or cheap. Market participants would have to put up enough capital to make sure that the clearinghouse could in fact cover its obligations. Traders might have to pay more for trading services, but they would also face less risk that those on the other side of a trade would fall through on their commitments.
Similar clearing systems already exist, Duffie notes, and they’ve been successful. All U.S. listed equities, options, and futures contracts are centrally cleared. And after the 2008 financial crisis, Congress required centralized clearing systems for trading all standard financial derivatives, such as interest rate swaps. The result: Swap trading became much more efficient, with much narrower spreads between bid and ask prices.
The broader benefit, says Duffie, is that such a clearing system could enable a more direct form of trading. Right now, investors have to buy and sell through intermediaries — the primary and secondary dealers. With a centralized clearing system, however, it would be possible for institutions — pension funds, hedge funds, insurance companies — to trade directly with each other.
The overarching benefit, however, would be to increase the resilience and stability of a market that is at the foundation of both the U.S. and global economies.
“This is a global safe haven, and we wouldn’t want it to be threatened,” Duffie says. “The Treasury market is also the way the government funds itself, and if the government can’t fund itself at a reasonable price, because the Treasury market isn’t functional, that’s a problem of national economic security.”