Is the world’s most important asset market collapsing?

In 1790 America’s finances were unstable. Debt servicing costs were higher than revenue, and bonds were trading at 20 cents on the dollar. Alexander Hamilton, the nation’s first Secretary of the Treasury, wanted a deep, liquid market for safe government debt. He understood the importance of investor confidence, so he proposed to honor all debts, including those of the state, and exchange old debts for new bonds with lower interest rates at face value. This was controversial. Shouldn’t speculators who pick up cheap debt on the secondary market be compensated less? Still, Hamilton couldn’t budge. He said, “When a country’s credit is in any doubt, it never fails to give one form or another an exorbitant premium for every loan it has occasion to make.”

More than two centuries later, American politicians are busy undermining Hamilton’s principles. Brinkmanship nearing the debt ceiling is pushing America toward technical default. Rising interest rates and spending restraints have ballooned the debt, and the country’s total assets now stand at $26.6 trillion (96% of GDP), up from $12.2 trillion (71% of GDP) in 2013. Service costs account for one-fifth of government spending. As the Fed reduces its holdings of U.S. Treasuries and increases issuance under quantitative tightening, investors are having to gulp down ever-increasing amounts of Treasuries.

All of this is straining a market that has been horribly dysfunctional in the past. U.S. Treasuries are the foundation of global finance. That yield is the “risk-free” interest rate on which all asset pricing is based. However, such yields have become volatile and market liquidity appears thin. Against this backdrop, regulators are concerned about the increase in activity. The U.S. Treasury market, run by leveraged hedge funds rather than low-risk players like foreign central banks, saw a “flash crash” in 2014 and the ability to exchange U.S. Treasuries for cash in 2019. Interest rates in the “repo” market have skyrocketed. In 2020, the U.S. Treasury market was overwhelmed as long-term holders sold en masse for cash before the Fed intervened.

Repairing the repository

Regulators and politicians want to minimize the possibility of further accidents. A new repo market facility was introduced in 2021 that allows the Fed to trade directly with the private sector. Weekly reports for market participants on secondary transactions will be replaced with more detailed daily updates, and the Treasury is considering releasing more data. To the general public. But these problems pale in comparison to the proposed reforms outlined by the Securities and Exchange Commission (SEC), the main U.S. financial regulator, in late 2022. The SEC is requesting comment on these plans. Implementation could begin early next year.

The result is a heated debate over the extent and causes of problems in the U.S. Treasury market and how long regulators should take to fix them. A fundamental overhaul of government bond trading comes with its own risks. Critics argue that the proposed changes would unnecessarily increase costs to the Treasury. Do they have a point?

Almost all financial institutions are involved in the government bond market. Short-term bills and long-term bonds, some of which pay coupons and others indexed to inflation, are issued by the Treasury. These are sold at auction to buyers, including “primary dealers” (banks and broker-dealers), who then sell to customers such as foreign investors, hedge funds, pension funds, corporations, and money market fund providers. Many are raising money to buy U.S. Treasuries. In overnight repo markets, where bonds can be exchanged for cash, high-frequency traders often use algorithms to match buyers and sellers in secondary markets. Participants, especially large asset managers, often prefer to purchase U.S. Treasury futures that can be delivered to the holder. It requires less cash upfront than buying the bond outright, allowing it to be purchased by eligible treasuries at a future date. Each link in the chain has a potential vulnerability.

The most important of the SEC’s proposals is to mandate central clearing, which would route trades in the Treasury and repo markets through a central counterparty, which would be a clearing house for all sellers. Become a buyer and be a seller to all buyers. This would increase transparency of market positions, remove bilateral counterparty risk, introduce an “all-to-all” market structure, and ease pressure on dealers. Nate Warfel of investment bank BNY Mellon writes that central clearing rules will be implemented. Place it relatively quickly.

But the SEC’s most controversial proposal involves “basis trading,” which would link the U.S. Treasury market to the futures market. To purchase a futures contract, investors only need to post an initial margin equal to a portion of the face value of the U.S. Treasury. This is often easier for asset managers than financing bond purchases through the highly regulated repo market. Therefore, arbitrage may exist between the spot and futures markets. Hedge funds go short, selling contracts to deliver government bonds in the futures market and buying those bonds in the spot market. They then often surrender cash to the Treasury and use it as capital to increase basis trading. In some cases, it appears that the fund ends up repeating this with his 50:1 leverage on the initial capital.

Trading is mostly low risk. However, during times of stress, such as in 2020, when U.S. Treasury prices fluctuated widely, exchanges will require additional margin. If funds are not immediately accessible to cash, they may close positions and cause fire sales. The unwinding of trades in 2020 may have exacerbated market volatility. The SEC proposed designating hedge funds that are particularly active in the U.S. Treasury market as broker-dealers and subjecting them to stricter regulations rather than simple disclosure requirements. It is also considering new rules that would limit the leverage that hedge funds can access from banks.

This infuriated those who profited from trade. Ken Griffin, boss of Citadel, the world’s most profitable hedge fund, claimed in October that regulators were simply “looking for trouble.” He noted that basis trading reduces the Treasury’s funding costs by enabling futures market demand. Decrease cash market yields.

Will officials remain resolute? In a sign of disagreement between the SEC and the Treasury Department, Nellie Liang, the department’s undersecretary, recently said that markets may not be performing as badly as commonly thought and that market flaws are due to structural He suggested that it may reflect a difficult situation rather than a problem. . After all, market liquidity and interest rate volatility interact. Low liquidity often results in greater volatility, as even small trades can cause prices to change. High volatility also reduces liquidity because it increases the risk of market formation. “As is often the case, high volatility affects the liquidity situation in the market,” Liang said, but it does not appear that low liquidity is amplifying volatility.

Furthermore, high volatility can be caused by events, such as active events in recent years. It is far from clear that a different market structure could have avoided periods of extreme stress such as in March 2020, or the turmoil caused by the explosion of derivatives bets by pension funds in the UK gold market. I am not totally sure.

In addition to the SEC’s proposals, the Treasury Department is also working on its own measures, including data collection, increased transparency, and stock buybacks. These include the Treasury purchasing older, less liquid issuances (e.g., 10-year bonds issued six months ago) in exchange for newer, more liquid 10-year bonds. , which could start from 2024. The Treasury Department has acknowledged the leverage practice, but it requires investigation because it allows basis trading. However, Liang added that there are positive aspects to trade, such as increased liquidity.

Although Hamilton could not imagine the network of financial institutions that make up the modern government bond market, he strongly valued speculators who stepped in and bought bonds when bondholders lost confidence. He would have been more worried about defaults and politicians rolling the dice on bond stocks than he was about enthusiastic intermediaries. Many of his successors’ ideas enjoy wide support. Still, it’s good to remember his aversion to belittling those keen to make a deal.

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