U.S. Treasury Markets - Steps Toward Increased Resilience
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U.S. Treasury Markets Steps Toward Increased Resilience
DISCLAIMER
This report is the product of the Group of Thirty’s Working Group on Treasury Market
Liquidity and reflects broad agreement among its participants. This does not imply
agreement with every specific observation or nuance. Members participated in their
personal capacity, and their participation does not imply the support or agreement of
their respective public or private institutions. The report does not represent the views of
the membership of the Group of Thirty as a whole.
ISBN 1-56708-184-3
How to cite this report:
Group of Thirty Working Group on Treasury Market Liquidity. (2021).
U.S. Treasury Markets: Steps Toward Increased Resilience. Group of Thirty.
https://group30.org/publications/detail/4950.
Copies of this paper are available for US$25 from:
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Twitter: @GroupofThirtyU.S. Treasury Markets
Steps Toward Increased Resilience
Published by
Group of Thirty
Washington, D.C.
July 2021G30 Working Group on
Treasury Market Liquidity
CHAIR
Timothy F. Geithner
President, Warburg Pincus
Former Secretary of the Treasury, United States
PROJECT DIRECTOR
Patrick Parkinson
Senior Fellow, Bank Policy Institute
PROJECT ADVISORS
Darrell Duffie Jeremy Stein
Adams Distinguished Professor of Management and Moise Y. Safra Professor of Economics,
Professor of Finance, Stanford Graduate School of Harvard University
Business
WORKING GROUP MEMBERS
William C. Dudley Masaaki Shirakawa
Senior Research Scholar, Griswold Center for Economic Distinguished Guest Professor, Aoyama-Gakuin University
Policy Studies at Princeton University Former Governor, Bank of Japan
Former President, Federal Reserve Bank of New York
Lawrence H. Summers
Arminio Fraga Charles W. Eliot University Professor, Harvard University
Founding Partner, Gávea Investimentos Former Secretary of the Treasury, United States
Former Governor, Banco Central do Brasil
Kevin Warsh
Mervyn King Distinguished Visiting Fellow, Hoover Institution,
Member of the House of Lords, United Kingdom Stanford University
Former Governor, Bank of England Former Member of the Board of Governors,
Federal Reserve System
Guillermo Ortiz
Partner, BTG Pactual Axel A. Weber
Former Governor, Banco de México Chairman, UBS
Chairman, Institute of International Finance
GROUP OF THIRT Y iiiTable of Contents Foreword. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .................................................................................... vii Acknowledgments.. . . . . . . . . . . . . . . . . . ................................................................................. viii Abbreviations.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..................................................................................... ix Introduction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..................................................................................... 1 Key Issues and Recommendations.................................................................. 7 References.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .................................................................................. 19 Group of Thirty Members 2021.. ..................................................................... 21 Group of Thirty Publications since 2010................................................. 25
Foreword
T
he Group of Thirty (G30) presents its latest publica- under strain. This report identifies and analyzes the weak-
tion, U.S. Treasury Markets: Steps Toward Increased nesses in the market, and makes recommendations that
Resilience. Prepared by the G30 Working Group on should meaningfully strengthen its resilience. The recom-
Treasury Market Liquidity, the report diagnoses the weak- mendations are feasible, and should add a greater degree of
nesses in the U.S. Treasury market that became apparent predictability to the market.
during the period of market stress in March 2020, and On behalf of the G30, we extend our thanks to Timothy
lays out steps that can strengthen its resilience in future Geithner for his astute leadership of the Working Group
stress episodes. behind this important report, and to the members of the
The U.S. Treasury market plays a central role in the Group for their dedication and efforts. We are also grate-
global system, with Treasury rates providing the funda- ful to the Project Advisors, Darrell Duffie and Jeremy
mental benchmark for pricing of most financial assets. Stein, for their commitment and considered advice, and
Continued confidence in the market, and in its ability to to the Project Director, Patrick Parkinson, for bringing
function efficiently in times of stress, is critical to the stabil- his decades of expertise to the task of framing actionable
ity of the global financial system. reforms. We also thank Arminio Fraga for extensively
The emergence of the COVID-19 pandemic shook the sharing his time and insights.
global economy, and also brought the U.S. Treasury market
Jacob A. Frenkel Tharman Shanmugaratnam
Chairman, Board of Trustees Chairman
Group of Thirty Group of Thirty
GROUP OF THIRT Y viiAcknowledgments
O
n behalf of the Group of Thirty (G30), I would forward. Furthermore, we would like to thank the various
like to express great appreciation to those central banks that provided useful data to help us under-
whose time, talent, and energy have driven this stand how central bank policies may be affecting the
project to a successful completion. I would like to thank resilience of market liquidity.
the members of the Working Group on Treasury Market The G30 extends our deep appreciation to the Project
Liquidity, who guided our collective work at every stage, Director, Patrick Parkinson, for his steadfast support and
with special acknowledgement to Arminio Fraga for his careful drafting of the report, and to the Project Advisors,
support. The intellect and experience of this diverse and Darrell Duffie and Jeremy Stein, for their tireless work and
deeply knowledgeable team was essential as we sought to contributions to the analysis and formulation of the report.
craft the report’s findings and recommendations to increase The coordination of this project and many aspects of
the resilience of the bond market and reduce the frequency project management, Working Group logistics, and report
and scale of extraordinary central bank interventions. production were centered at the G30 offices in Washington,
The Working Group must thank the many leaders in the D.C. This project could not have been completed without
financial community who supported this study and agreed the work of the Executive Director, Stuart Mackintosh, and
to be interviewed, highlighting how their institutions are his team, including Desiree Maruca and Emma Prall. We
leading the economic and fiscal response to the COVID-19 are grateful to them all.
pandemic, and what policy responses are needed moving
Timothy F. Geithner
Chair
Working Group on Treasury Market Liquidity
viii U.S. Treasury Markets: Steps Toward Increased ResilienceAbbreviations
ATS Alternative Trading System
CCLF Capped Contingency Liquidity Facility
CCP Central Counterparty
CFTC Commodity Futures Trading Commission
COVID-19 Coronavirus Disease 2019
DTCC Depository Trust & Clearing Corporation
DVP Delivery Versus Payment
ECB European Central Bank
FICC Fixed Income Clearing Corporation
FIMA Foreign and International Monetary Authority
FINRA Financial Industry Regulatory Authority
GCF General Collateral Financing
GSCC Government Securities Clearing Corporation
GSIBS Global Systemically Important Banks
IAWG Interagency Working Group on Treasury Market Surveillance
IDB Interdealer Broker
MBS Mortgage-backed Securities
NSCC National Securities Clearing Corporation
PTFS Principal Trading Firms
SCI Systems Compliance and Integrity
SEC Securities and Exchange Commission
SIFMU Systemically Important Financial Market Utility
SLR Supplementary Leverage Ratio
SRF Standing Repo Facility
TRACE Trade Reporting and Compliance Engine
GROUP OF THIRT Y ixIntroduction
T
he U.S. Treasury market is the single most impor- On those platforms, trades between dealers typically are
tant financial market in the world, as Treasury rates centrally cleared, but trades involving PTFs typically are
are a fundamental benchmark for pricing virtually not centrally cleared but instead are settled bilaterally with
all other financial assets. Consequently, confidence in the the IDB. Trading in the dealer-to-customer segment is in
U.S. Treasury market, and in its ability to function effi- over-the-counter markets intermediated by dealers (pre-
ciently even in times of stress, is critical to the stability of the dominantly broker-dealer units of the largest global banks).
global financial system. In normal market conditions the While there has been increasing use of multidealer trading
market has functioned and continues to function extremely platforms, trades executed using those platforms are still
well. Even under stress, until recently the market had been settled bilaterally between the dealer and the client. There
highly resilient. However, a series of episodes, including is essentially no central clearing of dealer-to-client trades
the “flash rally” of 2014, the Treasury repo market stress of of Treasuries. Finally, the U.S. Treasury and Treasury repo
September 2019, and the COVID-19 shock of March 2020, markets are highly interconnected by arbitrage with the
have created doubts about its continued capacity to absorb highly liquid Treasury futures market, which, unlike the
shocks and focused attention on factors that may be limit- Treasury market itself, is a centralized market that is cen-
ing the resilience of Treasury market liquidity under stress.1 trally cleared and is subject to safeguards, including margin
The U.S. Treasury market is bifurcated into “inter- requirements, that apply to all futures transactions.
dealer” and dealer-to-client markets. The vast majority The root cause of the increasing frequency of episodes
of trades in the interdealer markets are trades in a small of Treasury market dysfunction under stress is that the
number of “on-the-run” issues, while trades in the dealer- aggregate amount of capital allocated to market-making by
to-client markets include large volumes of trades in bank-affiliated dealers has not kept pace with the very rapid
“off-the-run issues.2 In recent years, a large share of trading growth of marketable Treasury debt outstanding,3 in part
in the electronic interdealer markets has been accounted because leverage requirements that were introduced as part
for not by dealers, which are broker-dealers or banks, but of the post-global financial crisis bank regulatory regime
by so-called principal trading firms (PTFs), which are have discouraged bank-affiliated dealers from allocating
not regulated as broker-dealers and not affiliated with capital to relatively low-risk activities like market-making.
banks. Trades in those electronic interdealer markets are In the interdealer market, the PTFs have been provid-
anonymous trades that are intermediated by the operator ing significant liquidity, but they simply do not have the
of the trading platform (the interdealer broker or IDB). balance sheet capacity to replace the supply of liquidity
1 For a description of these episodes and the questions about Treasury market resilience that they have raised, see Ryan and Toomey (2021).
2 On-the-run issues are the securities that have been issued most recently by the Treasury. All other issues are termed off-the-run issues. On-the run-issues are the
most actively traded, accounting for more than half of total trading activity. However, off-the-runs make up more than 95 percent of outstanding marketable
Treasury securities. See Clark, Cameron, and Mann (2016).
3 For evidence that the market intermediation capacity of dealers has been shrinking while the size of the Treasury market has been growing dramatically, see
Duffie (2020) and Liang and Parkinson (2020).
GROUP OF THIRT Y 1that bank-affiliated dealers once provided. Nor have other stabilize market-making capacity in the Treasury markets.
liquidity providers been able to come close to filling the gap The willingness and capacity of firms to make markets is
in the dealer-to-client market, in part because their ability critically dependent on confidence in their ability to fund
to supply liquidity has been handicapped by the design of their holdings of Treasury securities, even during periods
dealer-to-client markets, the lack of post-trade transparency of stress. Thus, a key recommendation is that access to repo
in those markets, and higher costs for repo financing than financing from the Federal Reserve be widened substan-
those faced by the largest bank-affiliated dealers. Finally, tially beyond the small group of “primary dealers.”6 Other
the regulation of the U.S. Treasury markets is balkanized,4 recommendations address the use of central clearing in the
and the need for interagency coordination seems to have Treasury markets, including the need for central clearing
slowed the regulatory response to significant changes in the of all trades on anonymous trading platforms operated by
structure and functioning of the Treasury market. interdealer brokers, the desirability of widespread clearing
To be sure, even if far more capital had been allocated of Treasury repos, and the concomitant need to ensure that
to market-making, the Treasury market could not have existing government authority for oversight of central clear-
functioned effectively in March 2020. (Developments in ing of Treasuries is exercised vigorously.
the U.S. Treasury market in March 2020 are discussed in Even if implementation of these recommendations
box 1.) The underlying economic uncertainty created by the encourages more nonbank firms to expand market-making
pandemic and the associated massive and widespread “dash in the Treasury markets, bank-affiliated dealers are likely
for cash” by holders of Treasury securities was so extreme to remain the predominant suppliers. Consequently, it is
that no market structure could have provided the capac- essential that banking regulations do not unnecessarily dis-
ity to absorb the widespread selling pressures that resulted courage the allocation of bank capital to market-making,
without some dysfunction, and market functioning could which seems to be an unintended consequence of lever-
only be restored by massive purchases of Treasuries by the age requirements and certain other regulations. Given the
Federal Reserve. However, if intermediation capacity is not importance of the U.S. Treasury markets (and of bond
increased, and the U.S. government continues the fiscal pol- and other financial markets, generally), we recommend
icies that have been rapidly increasing the stock of Treasury that banking regulators should comprehensively review
securities outstanding,5 episodes of market dysfunction are the existing body of relevant regulations and amend those
not only likely to continue but to occur with increasing regulations to avoid unnecessary impediments to market-
frequency. If they do, investors in Treasuries could lose con- making. At the same time, the robustness of prudential
fidence in the safety and liquidity of Treasury debt, which safeguards for broker-dealers that are not affiliated with
would both undermine financial stability globally and add banks (independent dealers) should be reviewed.
materially to the debt-servicing burden on future genera- Some important segments of the Treasury market (the
tions of U.S. taxpayers. Alternatively, if market functioning dealer-to-client segment of the cash market and much of
can be sustained only by frequent, large-scale purchases of the Treasury repo market) currently are far less transparent
Treasuries by the Federal Reserve, market participants than many other U.S. financial markets. Greater public
could come to believe that fiscal concerns rather than mac- transparency is needed to better enable investors to assess
roeconomic objectives are motivating the purchases. the quality of trade execution by dealers and trading plat-
This report makes recommendations for enhancing the forms and to enable additional dealers to supply liquidity
liquidity of the Treasury market under stress. A central to the Treasury market. Last, strengthening the underpin-
goal of these recommendations is to increase, diversify, and nings of the U.S. Treasury market and maintaining their
4 For a description and sharp critique of existing regulation of the Treasury market, see Yadov (forthcoming).
5 The stock of marketable Treasury debt outstanding more than tripled between 2008 and 2020 and, as of March 2021, the Congressional Budget Office projected
that it would double again by 2035.
6 The primary dealers are the trading counterparties of the Federal Reserve Bank of New York in its implementation of monetary policy. As of June 2021, there
were 24 primary dealers, including units of domestic and foreign banks and a few independent broker-dealers (dealers not affiliated with banks).
2 U.S. Treasury Markets: Steps Toward Increased ResilienceBOX 1: DEVELOPMENTS IN THE U.S. TREASURY MARKET IN MARCH 2020
On March 11, 2020, the World Health Organiza- Financing for Treasuries suddenly became
tion announced its “assessment that COVID-19 scarce. Treasury repo rates spiked in the inter-
can be characterized as a pandemic.” Over the dealer market, where the difference between
preceding weeks, financial markets had been the General Collateral Financing (GCF)e rate and
showing signs of increased fragility associated the interest rate offered by the Fed on reserves
with COVID-19 news. Around March 11, the reached 76 basis points on March 16 and 54
Treasury market became essentially dysfunc- basis points on March 17.
tional. Heavy investor demands to liquidate In short, U.S. Treasuries did not serve their
Treasury securities overwhelmed the capacity traditional safe-haven role. Instead, dysfunction
of dealers to intermediate the market. Those in the Treasury market exacerbated the crisis.
demanding large amounts of cash in exchange In a massive response, the Fed offered essen-
for Treasuries included relative-value hedge tially unlimited liquidity to primary dealers in the
funds, mutual funds, and foreign central banks. Treasury repo market. While this quelled dys-
Treasury prices became exceptionally vola- function in the Treasury repo market within a
tile. For example, the 10-year yield spiked 64 few days of mid-March, it was not until late May
basis points between March 9 and 18. a The that conditions in the market for trading Treasury
30-year bond lost 10 percent of its market value securities had gradually returned to nearly
over March 16 and 17. Bid-offer spreads quoted normal. To reduce the quantity of Treasuries
by dealers for off-the-run Treasuries increased impinging on dealer balance sheets, the Fed
by over a factor of 10.b In the interdealer market, purchased nearly $1 trillion of Treasuries within
the depth of quoted liquidity for on-the-run the three-week period beginning March 16.
10-year securities dropped from normal levels Then the Fed continued to buy Treasuries and
of about $300 million to about $25 million.c mortgage-backed securities (MBS) at a high rate.
The yields of similar-maturity Treasuries were Among many additional measures,f on April 1,
no longer close to each other.d Primary dealers the Fed exempted Treasuries and reserves held
reported Treasury settlement failures (trades by bank holding companies from the capital
that failed to settle on the contractual settle- requirement associated with the Supplemental
ment date [typically the next business day after Leverage Ratio (SLR). The Fed and other key
the trade]) at roughly triple their normal levels, bank regulators followed suit on May 15 by
totaling approximately $1.5 trillion in fails over extending this exemption to commercial bank
the three-week period beginning March 16. subsidiaries subject to the SLR.
Note: a. See Vissing-Jorgensen (2021) for charts of Treasury yields. b. See Clarida, Duygan-Bump, and Scotti (2021, figure 1).
c. Depth is measured by Fleming (2020) as the total of quantities quoted at the inside five tiers, averaged across the bid and offer
sides of the order book operated by BrokerTec, the largest of the interdealer brokers. d. Duffie (2020, 11). e. GCF repo is a service
that allows FICC netting members to trade repos throughout the day and then, after the netting process at the end of the day,
allocate specific securities to satisfy the net obligations on a triparty basis at the Bank of New York Mellon (https://www.dtcc.
com/clearing-services/ficc-gov/gcf-repo). f. See Clarida, Duygan-Bump, and Scotti (2021).
GROUP OF THIRT Y 3strength as the Treasury market and the broader financial Treasury market to the U.S. and global financial system,
system evolve will require effective government oversight, even modest improvements in market functioning would
which in turn requires clearer accountability and respon- have substantial benefits.
sibility than has been provided to date by the existing Although the focus of this report is on the U.S. Treasury
interagency approach to oversight.7 markets, many of the issues discussed here are potentially
We believe that these recommendations would make a relevant to bond markets more generally, including other
material contribution to improving the functioning of the bond markets in the United States and bond markets in
Treasury market, both in normal times and in periods of other countries.8 (See box 2 for a brief discussion of devel-
crisis, reducing systemic risk in the Treasury market and opments in March 2020 in government bond markets in
reducing the need for certain types of interventions by the other countries and similarities and differences between
Federal Reserve in crisis. Implementation of each recom- those markets and the U.S. Treasury market.) Like the
mendation would help, and, because some are mutually U.S. Treasury markets, many of those markets are over-
reinforcing (for example, those enabling the provision of the-counter markets that are intermediated, largely by
liquidity by entities other than the largest bank-affiliated bank-affiliated dealers, with little or no use of central
dealers), implementation in tandem would magnify their clearing. Consequently, as in the U.S. Treasury market,
contribution. That said, their implementation will not there may be insufficient market-making capacity, owing in
eliminate the potential for stress in these markets. They part to application of a similar post-global financial crisis
will not eliminate the likelihood of large-scale Fed pur- bank regulatory regime. Also, as in the United States, the
chases of Treasury securities or Federal Reserve support resiliency of some of these other bond markets is likely to
for other parts of the U.S. financial system in the most be challenged by the growing role of nonbank financial
extreme circumstances. They do not address the many institutions. Thus, authorities and market participants in
other challenges that come from the extent of leverage and other jurisdictions should consider the applicability of our
maturity mismatches in parts of the nonbank financial recommendations. Notably, greater resilience in other bond
system in the United States. Nor would they reduce the markets may be beneficial not only for those markets them-
risks that come from concerns about the current level of selves but also for the U.S. Treasury markets, because when
U.S. fiscal deficits and the long-term sustainability of the other bond markets are illiquid, investors often meet their
U.S. fiscal position. But the benefits of these recommenda- liquidity needs by selling U.S. Treasury securities.
tions would be material. And given the importance of the
BOX 2: GOVERNMENT BOND MARKETS IN OTHER COUNTRIES
The events of March 2020 also impacted govern- standard structural features of those markets
ment bond markets outside the U.S. To provide were considered.
broader context for this report, the functioning In general, the picture that emerges is that the
of several government bond markets in March dislocations seen in the U.S. were on the extreme
2020, the resulting policy actions taken, and the end of the spectrum. This is consistent with
7 The Government Securities Act of 1986 gave the Treasury Department broad (but not comprehensive) authority to regulate the Treasury market. In practice,
it has delegated much of that authority to other agencies, including the Federal Reserve and the Securities and Exchange Commission (SEC). In recent years,
Treasury market oversight by the Treasury, Federal Reserve, SEC, and Commodity Futures Trading Commission (CFTC) has been coordinated through a
staff-level Interagency Working Group on Treasury Market Surveillance (IAWG).
8 Indeed, while many of the issues are relevant to other types of U.S. government securities, including securities issued by U.S. government agencies and government-
sponsored enterprises, the focus of the analysis and recommendations has been exclusively on the markets for U.S. Treasury securities and Treasury repos.
4 U.S. Treasury Markets: Steps Toward Increased Resiliencethe idea that the “dash for cash” seen in March with peak dysfunction occurring from March
2020 was, to an important extent, an increase 16th–24th. Central bank actions contributed to
in the demand for dollar-denominated reserves, a significant improvement in conditions. Other
which—prior to a massive increase in the supply jurisdictions saw similar, albeit more moderate
of reserves by the Fed—necessitated substantial developments in March 2020. Switzerland, for
increases in the yields on dollar-denominated example, had higher bid-ask spreads, which
Treasury bonds. pointed to lower secondary market liquidity,
Nevertheless, other countries also experi- but higher trading volumes. This was again due
enced qualitatively similar—albeit in some cases to government bondholders reducing their
considerably milder—disruptions to market most liquid positions to rebalance portfolios or
functioning and responded with broadly similar to generate cash. In the Swiss case, the overall
policy measures. Moreover, some of the core period of heightened selling pressure lasted
structural aspects of the U.S. market, such as only a few days before policy measures stabi-
the dominance of dealer-intermediated over- lized the market.
the-counter trading and an absence of central Similar to the United States, some central
clearing of many transactions, are also the norm banks worked to stabilize their government
in other jurisdictions. bond markets with a combination of increased
repo financing of bonds, as well as stepped-up
March 2020 dislocations and policy response. outright purchases. In some cases, the bond pur-
The dislocations resulted in a notable increase chase programs were larger than anything that
in both sovereign bond yields and measures these central banks had engaged in previously. In
of market illiquidity, such as widened bid-ask the U.K. for example, the Bank of England put in
spreads, beginning in early March. However, place the largest single purchase program ever
in many cases, the liquidity disruptions were launched by the central bank.
relatively transient, though this was in part due
to rapid and aggressive central bank interven- Commonalities in market structure. An over-
tion. In the European Union, government bond the-counter market structure is the predominant
liquidity was impaired for approximately a week mode of government bond trading. Although a
in March. The amount of dislocation was smaller few countries (for example, Germany, Japan, and
than seen in other jurisdictions at the same time Switzerland) have exchange listing of govern-
and dissipated quickly. ment bonds, actual trading volume conducted
In the United Kingdom, as in the U.S., inves- on exchanges accounts for a small fraction of
tors rushed to sell assets, including government overall volume. In the European Union, due to
bonds, to acquire cash. Gilt yields rose sharply regulatory requirements, government bonds are
with the 10-year yield increasing from 26 bps listed on public exchanges but volumes exe-
[basis points] to 80 bps in mid-March. Bid/ cuted in these venues are minimal compared to
offer spreads increased to roughly four times the OTC (over-the-counter) market.
their usual levels for approximately one week,
GROUP OF THIRT Y 5As in the United States, relatively little central increase the use of the JSCC, a CCP, have been
clearing of cash transactions in government made. Consequently, the share of the JSCC in
bonds takes place in most jurisdictions. Japan DVP settlements of JGBs has risen to over 80
appears to be an exception, however. In Japan, percent recently, from the level seen during the
the use of CCPs is not mandatory for the sales Global Financial Crisis at just below 50 percent.a
and purchases of JGBs; however, efforts to
Note: a. CCP = central counterparty; DVP = delivery versus payment; JBGs = Japanese government bonds; JSCC = Japan
Securities Clearing Corporation.
6 U.S. Treasury Markets: Steps Toward Increased ResilienceKey Issues and
Recommendations
C
onsistent with the perspective on weaknesses in the Under stress, access to Federal Reserve liquidity has been
structure of the U.S. Treasury market that was set extended on an ad-hoc basis to the small group of primary
out in the introduction, the working group focused dealers. Without direct access, central bank liquidity
its attention on developing recommendations to address support for the U.S. Treasury market, which relies heavily
five key sets of issues: (1) central bank liquidity support for on nonbank financial intermediaries for market liquid-
Treasury market functioning, (2) central clearing of trades ity, has been excessively dependent on the willingness and
of Treasury securities and Treasury repos, (3) prudential reg- ability of the primary dealers to intermediate between the
ulation of dealers, (4) market transparency, and (5) market Federal Reserve and those other nonbank financial inter-
regulation. Interviews that the working group conducted mediaries. In principle, banks and the primary dealers can
with 29 market participants, including bank-affiliated and obtain liquidity from the Fed and on-lend it to others. But
independent dealers, asset managers, central bankers, and in a crisis the willingness of those firms to intermediate has
operators of market infrastructure, confirmed that these tended to be constrained by a combination of regulations
are the key issues, while also revealing diverse views on how and internal limits on the firms’ risk-taking, both of which
those issues should be addressed. Below we discuss the issues have tended to tighten under stress.9
and present the rationales for ten recommendations that we Consequently, the single most important near-term
believe are the most promising. The recommendations are measure that should be taken to enhance market-making
brought together in box 3. capacity in the Treasury markets under stress is the cre-
ation by the Federal Reserve of a Standing Repo Facility
(SRF) that would guarantee to a broad range of market
FEDERAL RESERVE LIQUIDITY participants the availability of repo financing for Treasury
FACILITIES TO SUPPORT TREASURY securities. In addition, an SRF would limit demands
MARKET FUNCTIONING for market liquidity under stress by allowing holders of
The willingness and capacity of firms to make markets is Treasuries that want cash to obtain the cash by tapping the
critically dependent on their confidence in their ability to SRF rather than selling the securities. This would extend
fund inventories of Treasury securities that they may acquire the logic behind the repo facility that the Federal Reserve
as a result of those activities, even during stress. Ultimately, provided to foreign and official monetary institutions at the
complete confidence can come only from direct access to end of March 2020.10
liquidity from the Federal Reserve, which has essentially It should be a standing facility, not a discretionary, emer-
unlimited capacity to provide funding. Currently, only gency facility for two reasons. First, unless it is a standing
banks (and other insured depository institutions) have facility, it cannot create the confidence in the availability
direct access to Fed liquidity in normal market conditions. of repo financing under stress that is needed to broaden
9 As discussed below, increases in bank reserves associated with countercyclical monetary policies produce a procyclical tightening of leverage requirements
applicable to banks. At the same time, increases in market volatility effectively tighten banks’ internal limits on market risk and counterparty credit risk.
10 https://www.federalreserve.gov/newsevents/pressreleases/fima-repo-facility-faqs.htm.
GROUP OF THIRT Y 7BOX 3: RECOMMENDATIONS
Recommendation 1: The Federal Reserve weakening overall resilience of the banking
should create a Standing Repo Facility (SRF) system. In particular, U.S. banking regulators
that provides very broad access to repo financ- should take steps to ensure that risk-insensi-
ing for U.S. Treasury securities on terms that tive leverage ratios function as backstops to
discourage use of the facility in normal market risk-based capital requirements rather than
conditions without stigmatizing its use under constraints that bind frequently.
stress. It should make permanent its Foreign and
Recommendation 7: The SEC, in consulta-
International Monetary Authority repo facility.
tion with the Federal Reserve and the Treasury,
Recommendation 2: All trades of Treasury secu- should review the robustness of the prudential
rities and Treasury repos executed on electronic safeguards at broker-dealers (including inter-
interdealer trading platforms that offer anony- dealer brokers) in U.S. Treasury securities and
mous trading by interposing an interdealer Treasury repos that are not affiliated with banks
broker between buyers and sellers should be (independent dealers).
centrally cleared.
Recommendation 8: The TRACE reporting
Recommendation 3: Treasury repos should be system should be expanded to capture all trans-
centrally cleared. actions in U.S. Treasury securities and Treasury
repos, including those of commercial bank
Recommendation 4: Market participants and
dealers and principal trading firms. Further-
regulators should continue to study how dealer-
more, subject to a cap on the disclosed size of
to-client cash trades of Treasuries might best be
trades, the data should be publicly disclosed in
centrally cleared, including via the sponsored
a manner similar to the way that data on corpo-
clearing model, and assess the private and
rate bond transactions are currently disclosed.
public policy cases for central clearing using
whatever is the optimal model. Recommendation 9: SEC Regulations ATS and
SCI should be applied to all significant trading
Recommendation 5: The Treasury Department,
platforms for Treasury securities, including both
after consultation with the Federal Reserve,
interdealer and multidealer dealer-to-client
should organize and take responsibility for a joint
platforms.
review of the design and operation of the Fixed
Income Clearing Corporation (FICC) by Treasury, Recommendation 10: As a first step toward
the SEC, the CFTC, and the Federal Reserve, with more vigorous oversight of the Treasury market,
a view toward ensuring that the supervision and the Treasury, after consultation with the Federal
regulation of FICC is sufficiently robust. FICC Reserve, should lead an interagency study that
should be granted access to the SRF. identifies all exemptions of Treasury securi-
ties from U.S. securities laws, evaluates their
Recommendation 6: Banking regulators should
rationales, and, where there is no clear and
review how market intermediation is treated
compelling rationale, recommends measures
in existing regulation, with a view to identify-
for applying those laws to Treasury securities.
ing provisions that could be modified to avoid
Thereafter, Treasury should prepare an annual
disincentivizing market intermediation, without
report on Treasury market functioning.
8 U.S. Treasury Markets: Steps Toward Increased Resilienceand diversify the supply of Treasury market liquidity. the use of leverage, and the appropriateness of continued
Second, delays in introducing a discretionary facility and exemption of Treasury securities from the coverage of secu-
uncertainty about its terms and the breadth of access to the rities margin regulations should be reassessed.
facility can permit market dysfunction to develop, which A pragmatic and operationally efficient means by which
tends to feed on itself. the Fed could reach a broad range of counterparties would
The financing should be provided at a rate that is high be by clearing its repos through the Fixed Income Clearing
enough to discourage extensive use of the facility in normal Corporation (FICC), which would provide access to many
market conditions but not so high as to stigmatize use of broker-dealers as well as banks.11 FICC would need to
the facility when Treasury repo markets are under stress. exempt the Federal Reserve from requirements for FICC
Haircuts on securities financed should be set out in advance members to participate in the mutualization of losses from
and should be sufficiently high that the haircuts alone defaults by FICC members. Also, as discussed below,
would provide the Federal Reserve with adequate protec- general concerns about the concentration of risk in FICC
tion against counterparty risk, even in volatile markets. The and specific concerns about FICC’s transparency and gov-
daily marking-to-market of the collateral in a repo agree- ernance need to be addressed, whether or not the Federal
ment is a powerful risk mitigant that, when combined with Reserve uses FICC to implement a broad SRF. The Federal
prudent haircuts on collateral values, can practically, if not Reserve should also make permanent its temporary Foreign
entirely, eliminate counterparty credit risk. and International Monetary Authority (FIMA) repo facil-
An important concern with respect to creation of an ity. Longer term, the Federal Reserve should extend access
SRF is the potential for it to create moral hazard that would to the SRF as broadly as operationally feasible.
increase systemic risk by encouraging entities with access
to the facility to become more highly leveraged. Although RECOMMENDATION 1: The Federal Reserve should
assured access to repo financing may encourage some create an SRF that provides very broad access to repo
market participants to become more highly leveraged and financing for U.S. Treasury securities on terms that
to engage in more maturity transformation, those incen- discourage use of the facility in normal market condi-
tives would be tempered by the pricing of the financing, tions without stigmatizing its use under stress. It should
which would be unattractive in normal market conditions. make permanent its FIMA repo facility.
At the same time, an SRF would forestall potential runs on
repo financing, which are a significant source of systemic
risk in the absence of an SRF. Finally, especially if access to CENTRAL CLEARING OF TRADES
an SRF is wide, its existence may also preempt some sales of OF TREASURY SECURITIES
Treasury securities under stress. In turn, this would reduce AND TREASURY REPOS
the need for the Federal Reserve to purchase Treasuries to A central counterparty for the clearing and settlement of
restore market functioning. Because Fed purchases, unlike trades in U.S. Treasury securities was established in 1986.12
repos, transfer interest rate risk from the private sector to When interdealer electronic trading platforms were first
the Federal Reserve, such purchases entail far greater moral launched in the late 1990s, participation was limited to
hazard than Fed repo lending. Even if creation of an SRF the primary dealers and all of the trades between primary
does not increase moral hazard, the use of leverage by inves- dealers were centrally cleared through that central coun-
tors in the Treasury market needs to be monitored and the terparty (CCP). However, today principal trading firms
policy implications need to be assessed. As discussed below, (PTFs) account for a very large share of trading, and trades
central clearing of Treasury repos would in principle limit between PTFs and the IDBs seldom are centrally cleared
11 FICC currently has about 175 direct members (largely broker-dealers and banks), and thousands more firms have access to FICC indirectly through those
direct members. See Pozmanter and Hraska (2021).
12 It was known as the Government Securities Clearing Corporation (GSCC) until 2003, when it became known as the Government Securities Division of the
Fixed Income Clearing Corporation (FICC). The GSCC extended its services to Treasury repos in 1995. Ingber (2017) discusses the historical development
of central clearing of U.S. Treasury and other U.S. government securities.
GROUP OF THIRT Y 9but instead are cleared and settled bilaterally between the the potential for PTFs and the large incumbent dealers to IDBs and the PTFs. In the dealer-to-client segment of the reduce their supply of liquidity in response to enhanced Treasury market, trades of Treasury securities have never competition and, perhaps most important, costs associ- been centrally cleared and instead are cleared and settled ated with potential risk management failures by the central bilaterally between the dealers and their clients. Overall, counterparty, which would increase with the expansion of only a little more than 20 percent of purchases and sales of central clearing. Under stress CCPs will inevitably be seen Treasuries have been centrally cleared in recent years.13 By as guaranteed by the government. (These benefits and costs contrast, a higher and growing share of Treasury repos are are elaborated in box 4.) centrally cleared, with recent growth in the share principally Counterparty credit risks on trades in U.S. Treasury attributable to the expansion by FICC of its sponsored repo securities are not as large as those in other U.S. financial service, which enables money funds, hedge funds, and other markets, because the contractual settlement cycle for U.S. entities that are not members of FICC to centrally clear Treasury securities is shorter (usually one day) and Treasury their repos through sponsors that are FICC members.14 security prices generally are less volatile than other securi- The small and declining share of centrally cleared trades ties prices. But liquidity risks are relatively large because in Treasuries and the progress in clearing a growing share of large daily settlement volumes for purchases and sales of Treasury repos has spurred a debate about the potential and especially for repos. When markets are under stress, public policy benefits and costs of wider central clearing of the risks can be significant. Furthermore, because the risks Treasuries and Treasury repos.15 Importantly, the benefits seem to be underappreciated by some market participants, and costs differ for different market segments and trans- risk management practices may be suboptimal.16 action types, so the analysis of, and recommendations The management of counterparty risk on trades that regarding, wider central clearing must take those differ- are cleared and settled bilaterally with IDBs (largely trades ences into account. with PTFs and some trades with hedge funds) is not trans- In general, the benefits of wider central clearing include parent. While such trades are settled on a delivery versus greater transparency of counterparty risks and counter- payment (DVP) basis and the IDBs apparently bilaterally party risk management, reduction of counterparty credit net their trades with platform users, in volatile markets and liquidity risks through netting of counterparty expo- counterparty credit and liquidity risks and operational sures and application of margin requirements and other risks can still be substantial.17 In effect, an IDB in an risk mitigants, the creation of additional market-making anonymous electronic trading platform acts as a central capacity at all dealers as a result of recognition of the reduc- counterparty, in that it is the buyer to every seller and a tion of exposures achieved though multilateral netting, seller to every buyer. Consequently, as in the case of any the enhancement of the competitive position of smaller CCP, a financial or operational problem at an IDB could bank-affiliated and independent dealers, and the facilita- disrupt trading in the interdealer markets and the fallout tion of all-to-all trading, which can improve the quality of would extend to the dealer-to-client markets. However, trade execution in normal market conditions and broaden under existing U.S. law and regulation, an IDB is not regu- and stabilize the supply of market liquidity under stress. lated as a CCP. Central clearing of all trades with IDBs The costs of wider central clearing include higher costs in through FICC would make those risks and the associated normal market conditions, including clearing fees and the risk management practices more transparent and subject costs of meeting generally higher margin requirements, to enhanced regulation. 13 Derived from Treasury Market Practices Group (2018, 11). According to the TPMG report, for about 12.7 percent of U.S. Treasury transactions both coun- terparties clear the trade. For another 19.4 percent of transactions, one side is centrally cleared but the other side is cleared bilaterally between an IDB and the original trade counterparty. 14 See https://www.dtcc.com/clearing-services/ficc-gov/sponsored-membership. 15 See Duffie (2020), Fleming and Keane (2021), and Pozmanter and Hraska (2021), among others. 16 Treasury Market Practices Group (2018, 2). 17 Treasury Market Practices Group (2018, 3). 10 U.S. Treasury Markets: Steps Toward Increased Resilience
BOX 4: CENTRAL CLEARING
Central clearing is clearing through a central contracts. Central clearing is less common in
counterparty (CCP) that interposes itself bond markets, which typically are decentral-
between the original counterparties to a trade. ized, over-the-counter markets intermediated
In the United States, this is accomplished by by banks.
novation, a process through which the origi- The Fixed Income Clearing Corporation
nal contract between the buyer and seller is (FICC), a division of the Depository Trust &
replaced with two contracts, one between the Clearing Corporation (DTCC), is a CCP for
buyer and the CCP and the other between the Treasury repos and government securities trades
seller and the CCP, with the economic terms of between its member dealers, as depicted in
the new contracts identical to those in the origi- figure 1. Primary dealers are required to centrally
nal contract. The primary purpose of central clear the cash trades of Treasury securities. But
clearing is the reduction of counterparty risk, many other broker-dealers and banks volun-
which is accomplished primarily by: tarily participate in FICC to share in the benefits
of central clearing.
1. Netting all transactions between the CCP
and each of its members. For example,
if clearing member A buys 120 units of a c1 d1 c2
financial instrument from member B and
sells 100 units to member C, central clear-
ing reduces the commitments of A to a
purchase of 20 units from the CCP. c3 FICC c4
2. The CCP imposing a standard set of risk
d2 d3
mitigants with respect to its exposures
to its members, including financial and
operational standards for membership, c5
margin requirements, the mutualization
of risk from counterparty defaults through
Figure 1. A schematic of central clearing in
requirements that the CCP’s members the U.S. Treasury market
help cover losses and liquidity pressures
Note: Dotted lines indicate trades that are centrally cleared. As illus-
resulting from such defaults, and the cen- trated, trades between major dealers are centrally cleared at FICC,
tralized monitoring of counterparty risks as are some (but by no means all) other interdealer trades. Trades
between dealers and their customers are not centrally cleared,
and management of the liquidation of with the exception that some dealer-to-customer Treasury repos
defaulting members’ positions.a are centrally cleared via a sponsoring clearing member of FICC, as
will be discussed below.
Central clearing is ubiquitous in exchange-
traded markets for derivatives and equities. The Roughly 20 percent of commitments to settle
Dodd-Frank Act included a regulatory require- Treasury security trades are cleared through
ment to centrally clear many standardized swap FICC.b Daily volumes of FICC-cleared Treasury
GROUP OF THIRT Y 11trades, including cash trades and repos, are One of the disadvantages of broader central
typically about $4.2 trillion. Daily volumes of clearing is that this increases the systemic nature
cleared sponsored Treasury repos in May 2021 of the CCP, increasing the importance of strong
were between $200 billion and $300 billion. regulatory oversight. It may contribute to a per-
Total daily volumes of cleared repos of gov- ception that the CCP is too big to fail, which
ernment securities, including Treasuries and in the absence of effective government over-
mortgage-backed securities (MBS), have been sight, could increase systemic risk. For those
about $3.7 trillion. market participants that are not margining their
In addition to reducing counterparty risk, uncleared trades, a shift to central clearing also
clearing improves market transparency by increases the cost of financing margins.
giving market participants and regulators more Broad central clearing could encourage
information about counterparty exposures and trade-platform operators to open their venues
greater common knowledge of practices for to a wider set of market participants, or even
trade settlement and margin. Central clearing all-to-all trade. This would improve competi-
also reduces settlement failures that propagate tion and reduce the amount of dealer balance
via “daisy chains,” by which A fails to deliver sheet space needed to intermediate the market.
securities to B, who consequently fails to deliver But with reduced market shares and bid-offer
to C, and so on.c The margin requirements of a spreads, dealers might lower their commitments
CCP also impose a uniform cap on the leverage of capital to the market. It is not a sure thing that
of centrally cleared positions. other investors would step in to absorb large
trade flows to the extent that dealers would.
Note: a. For a thorough discussion of risk management by CCPs, see Committee on Payments and Market Infrastructures and
Board of the International Organization of Securities Commissions (2017). b. See footnote 14, above. c. See Fleming and Keane
(2021, 23–27).
To be sure, central clearing of their trades with IDBs clearing of their trades does not seem to be fundamentally
would impose additional costs on PTFs, which could incompatible with their business model. FICC has adjusted
induce some of them to pull back from providing liquid- its fee structure to try to make central clearing more attrac-
ity in markets for on-the-run Treasuries, where they are a tive to PTFs, but further adjustments to those fees may be
significant source of liquidity in normal market conditions. needed to ensure that they are not an unnecessary impedi-
But most PTFs already have broker-dealer affiliates that ment to clearing PTF trades. As discussed below, legitimate
are clearing members of the National Securities Clearing concerns about further concentration of risk in FICC can
Corporation (NSCC) and some have broker-dealer affili- and should be addressed by robust government regulation
ates that are FICC members. It is not clear why they could of FICC, for which ample authority exists under U.S. law.
not clear through their affiliates and, if it is possible for them
to clear through their affiliates, why the marginal costs of RECOMMENDATION 2: All trades of Treasury
clearing would be so large as to prompt a significant decline securities and Treasury repos executed on electronic
in their liquidity provision. PTFs are major participants in interdealer trading platforms that offer anonymous
other markets where central clearing is required, including trading by interposing an interdealer broker between
the exchange-traded futures and options markets, so central buyers and sellers should be centrally cleared.
12 U.S. Treasury Markets: Steps Toward Increased ResilienceWider central clearing of Treasury repos to include dealers for liquidity in both the secondary and primary
dealers’ trades with buyside firms, including money funds markets is undesirable.
and hedge funds, greatly expands the capacity of dealers In principle, if all repos were centrally cleared, the
to intermediate under existing accounting and regulatory minimum margin requirements established by FICC would
capital rules by achieving netting of repos and reverse repos apply marketwide, which would stop competitive pressures
that currently bloat dealers’ balance sheets. Buyside firms from driving haircuts down (sometimes to zero), which
benefit because dealers are willing to intermediate cleared reportedly has been the case in recent years. However, in its
repos at narrower spreads, which are reflected in part in sponsored repo service, FICC does not require sponsors to
higher rates paid to buyside repo investors on cleared repos collect margin from the participants they sponsor. Regulators
than on uncleared repos and in part in lower rates charged should critically examine the implications of this policy to
to repo borrowers (including hedge funds and smaller ensure that central clearing of repos through the sponsored
broker-dealers) on cleared repos. Those benefits may be repo service actually achieves the benefits envisioned.
enough to provide adequate incentives for continued expan-
sion of repo clearing. Indeed, buyside clearing had been RECOMMENDATION 3: Treasury repos should be
increasing very rapidly through expanded use of FICC’s centrally cleared.
sponsored repo service until early 2020,18 and many market
participants expect that growth to resume, especially if, The public policy case for central clearing of dealer-to-
as proposed by FICC,19 FICC’s sponsored repo service is client cash trades is not as strong as the case for central
broadened to include triparty repos as well as DVP repos. clearing of IDB trades or Treasury repos. The risks of
The combination of an SRF and wider repo clearing bilateral settlements of such trades are not as large or as
would expand and make access to repo financing cheaper concentrated as the risks of uncleared IDB trades. And
and more stable for a broad range of potential liquidity central clearing of cash trades would not free up nearly as
providers to the Treasury markets. It might even lead to much dealer balance sheet as central clearing of repos. 20
all-to-all trading of repos, which would allow a wider group But, as demonstrated by a recent Federal Reserve Bank of
of liquidity providers to obtain funding directly from the New York study, it would substantially reduce dealers’ daily
money funds and other highly risk-averse repo investors settlement obligations,21 which would reduce liquidity risks
that are the ultimate source of repo financing, rather than associated with those settlements and counterparty credit
relying on the largest bank-affiliated dealers for repo financ- risks associated with failures to deliver on the contractual
ing, which likely would increase the reliability of access settlement date, not only for the dealers but also for FICC.
to funding under stress for alternative liquidity providers. It likely also would enable smaller dealers to compete more
As a result, the overall supply of liquidity to the Treasury effectively with larger dealers. Finally, it would facilitate
markets would likely increase and would become better all-to-all trading, which would have benefits for market
diversified and more stable. However, most of the largest efficiency and enable the provision of market liquidity by
bank-affiliated dealers are primary dealers and these mea- investors. But all-to-all trading can also occur without
sures may erode some of the benefit of being a primary central clearing, as demonstrated by the success of some all-
dealer. But it is not clear that the erosion would be so large to-all trading platforms for corporate bonds. By contrast,
as to cause the costs to exceed the benefits. In any event, the success of central clearing of repos via the sponsored
continued heavy reliance on the small number of primary clearing model suggests that the costs of dealer-to-client
central clearing are not an insurmountable barrier, at least
18 https://www.dtcc.com/charts/membership.
19 https://www.sec.gov/rules/sro/ficc/2021/34-92014.pdf.
20 In effect, accounting rules allow purchases and sales of the same security to be netted but do not allow reverse repos and repos of the same security to be netted,
unless the repo and reverse repo are with the same counterparty and the trades have been documented under a master netting agreement.
21 Fleming and Keane (2021) estimated that wider central clearing would have lowered dealers’ daily settlement obligations by 60 percent in the weeks before
and after the market disruptions of March 2020, and 70 percent during the market disruptions, when trading was at its highest.
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