Escalating federal borrowing needs may worsen structural deficiencies in the market for US Treasuries that were already on stark display during the 2020 Covid crisis, according to a paper presented to the Federal Reserve’s annual Jackson Hole symposium.
(Bloomberg) — Escalating federal borrowing needs may worsen structural deficiencies in the market for US Treasuries that were already on stark display during the 2020 Covid crisis, according to a paper presented to the Federal Reserve’s annual Jackson Hole symposium.
Darrell Duffie, a Stanford University professor who’s been closely involved for years in efforts to address liquidity concerns in the world’s largest debt market, warned in the paper of risks including financial instability if current weaknesses aren’t resolved.
The main challenge is that the capacity of the primary dealers in US Treasuries to serve as intermediaries between buyers and sellers hasn’t grown in step with the size of the overall market. In times of extreme stress, such as in March 2020, that leaves the market in danger of freezing up.
With the US government’s debt burden on track to hit all-time records in a decade’s time, dealers will be faced with a steady increase in supply. Rising issuance has been an increasing focus of investors in recent weeks, sending yields on longer-dated notes to 16-year highs.
Duffie reprised recommendations that he and others have made to address structural issues, including greater use of a central clearinghouse for Treasuries trades and regulatory changes that would encourage dealers to engage more in intermediation.
“The quantity of Treasury securities that investors may wish to liquidate in a crisis is growing far more rapidly than the size of dealer balance sheets,” Duffie warned. Risks stemming from dealers’ limited intermediation capacity include “losses of market efficiency, higher costs for financing US deficits, potential losses of financial stability, and reduced save-haven services to investors,” he wrote.
As it had done historically, the Fed served as a buyer of last resort during early weeks of the pandemic to avert a meltdown in the Treasuries market, going on to buy close to $1 trillion in Treasury securities and additional mortgage-backed securities — a move meant to clear up space on dealer balance sheets to keep trades flowing.
One continuing constraint on dealers, which include the nation’s largest banks, is the so-called supplementary leverage ratio rule — which compels financial institutions to hold capital against their portfolios, including inventories of Treasuries.
Substituting the rule with higher risk-based capital requirements could help to improve Treasury market intermediation, Duffie wrote.
“The resilience of the US Treasury market is limited by dealer balance sheets that are not sufficiently large and flexible to effectively intermediate this market in a ‘dash for cash,’ as when Covid” hit in spring 2020, he wrote. “The total amount of Treasuries outstanding will continue to grow significantly relative to the intermediation capacity of the market because of large US fiscal deficits and limited dealer balance-sheet flexibility” unless changes are made, Duffie said.
Having more Treasury trades centrally cleared would ensure buyers and sellers would no longer be “exposed” to each other, a change that could improve financial stability. The approach also helps dealers use their balance sheets more efficiently, Duffie wrote.
Other improvements he suggested include:
- All-to-all trading, which would allow any market participant to trade directly with any other, providing better matching efficiency for some transactions and allowing some trades that don’t necessarily require dealer intermediation.
- Better post-trade price transparency with the real-time publication of Treasuries transactions.
- Broader access to official-sector market-function purchase programs such as the Fed’s standing repo facility. This could lower the likelihood of stressing the Treasury market’s intermediation capacity by making it easier for investors that need cash, but don’t necessarily have to sell their securities, to obtain financing from the Fed.
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