This is the first post in my series of reviews of academic papers written in the last year about the market structure of the US Treasury market. As the most important fixed income market it is great to see so much discussion around the topic of market structure. This post is a review and commentary on “Still the World’s Safe Haven?” by Darrell Duffie

Still the world’s safe haven? Redesigning the U.S. Treasury market after the COVID-19 crisis

DISCLAIMER: The opinions expressed here are mine and mine alone. They are not associated with any employer of mine or organization I am associated with.

Summary

The author of this paper lays out an argument that the problems that occurred in the US Treasury market in March 2020 could have been alleviated if central clearing was uniformly mandated and utilized in the US Treasury market as it is in most all other markets including equities, futures and derivatives.

My View

The argument laid out in the paper is correct along the two most important dimensions

1. This paper starts by rightfully pointing out that the market for US Treasuries is too large, and too vital to the U.S.’s interests and the entre functioning of the financial system to be required to squeeze through the balance sheet of a small number of select banks. The growth of the amount of outstanding debt has vastly outpaced the size of bank dealer balance sheets. The lack of universal central clearing is a main reason that the end buyers and sellers cannot transact with each other in an open and fair market.
2. The market for Interest Rate Swaps and other derivatives were transitioned to central clearing successfully under the Dodd-Frank mandate after 2008 and show that a market can make that transition and doing so can increase investor confidence in the market.

March 2020 & The Fed Bailout

The paper does an excellent job reviewing the events of March 2020 and highlighting that the problem was a funding problem for off-the-run securities. As leveraged players, primarily hedge funds, were suffering losses in the rest of their investment portfolio they liquidated what was the easiest to raise cash, and that is US Treasuries. So a market event that normally leads to positive price performance of Treasury bonds was met with massive selling from leveraged players of off-the-run bonds. See Explainer: Classic one-way levered Treasury bond trades for description of these trades and why they cause these issues.

The paper does a good job showing the numerical data that are like the Geiger counter that displays the tremors from the unwinding of the classic one-way leveraged Treasury bond trades. The effect of the forced unwind of off-the-run treasury positions in the current market structure required all trades to go through bank-dealer balance sheets which were unable to cope with the volume.

The author details the ways in which the Fed intervened in the market to bailout the leveraged players and the banks to make sure that the market did not continue to deteriorate and impact the ability for the Treasury to fund the country’s debt.

The author points out that while the Fed has intervened in the past to rescue banks and dealers, given the growth of the market the frequency of this will only likely increase and it is not a sustainable solution or good public policy.

Clearing

The paper’s main point is that central clearing is something that is a good for the market because:

1. It removes the counterparty risk on trades that exist between the time a trade is done and settlement
2. Would allow natural buyers and sellers to transact with each other without requiring the trades be done through banks and their limited balance sheet which would lessen the shocks to the market when large volume of risk is to be transferred from one end participant to another.

There are three markets for hedging interest rate risk: cash treasuries, bond futures, and interest rate swaps. All except cash treasuries are centrally cleared. The question is: if all three including cash treasuries were centrally cleared today, what would be the argument for removing the clearing mandate for cash treasuries?

Public interest is better served by removing these select banks as chokepoints in the market for our nation’s debt.

Any change would certainly incur costs on individual market participants, and remove of the advantageous position that some players hold in the current market structure, but the overall benefits to the market and investor confidence could well outweigh these costs.

This is similar to the equity markets prior to Reg NMS, where willing buyers and sellers could not transact with each other because of the fact that trades had to go through a dealer. It took a regulatory act to remove that impediment and since then the market has flourished.

The paper properly points out that for central clearing to be effective it must be mandated by the regulators and must cover all trades and all market participants. Because there are no participants that would singularly benefit from central clearing, it is a good to the market overall, only a regulatory mandate will create change.