MNI: US Treasury Market Needs Restructuring-Jackson Hole Paper

The U.S. Treasury market has grown too large and capital requirements too stringent to depend on dealers for intermediation, and regulators should look at options including all-to-all trading and official purchase programs to improve resilience and backstop market liquidity in times of enormous selling pressures, according to research presented Friday to the Federal Reserve's annual economic symposium in Jackson Hole.

Darrell Duffie, a professor at Stanford University Graduate School of Business, told Fed and other central bank officials that insufficient dealer intermediation capacity impairs the resilience of Treasury market trading, risking "losses of market efficiency, higher costs for financing U.S. deficits, potential losses of financial stability and reduced save-haven services to investors."

The Fed had to step in to offer virtually unlimited Treasury financing to dealers and purchase nearly a trillion dollars of Treasury securities over a three-week period during the Covid-19 pandemic in March 2020 when dealers' customers' daily bond buying surged to over 10 times the normal amount.

"For U.S. Treasuries to maintain the high level of safe-haven services that they have normally provided to global investors, the intermediation capabilities of the underlying market must be sufficiently resilient to crisis-level selling," Duffie said.

MARKET STRUCTURE IMPROVEMENTS

An official liquidity backstop by the Fed or the Treasury could be useful in dealing with Treasury market dysfunction but come with some moral hazard risks and could run counter to monetary policy if interest rates are rising, Duffie said. The programs should be transparent and clear about their objective of supporting financial stability.

Improvements to market structure could also increase the intermediation capacity of the market, Duffie said. These include broader central clearing, all-to-all trade, post-trade transaction reporting and substituting the Supplementary Leverage Ratio rule with higher risk-based capital requirements.

The SEC has proposed new central clearing rules, which would improve market safety but risk concentrating settlement risk in a central counterparty. Central clearing also lowers barriers to all-to-all trading, in which any investor can trade with one another.

(See: MNI: US Treasury Clearing To Limit Contagion, Create New Risks)

Such a system could increase market efficiency and the total intermediation capacity of the market, Duffie said. Dallas Fed President Lorie Logan has urged regulators persist with Treasury market reforms.