That brings us back to the key problem haunting the Fed: can this adjustment occur without another 2020-style freeze? There is good and bad news on this front. To start with the good: 20 long months after that COVID-19 market shock, financial authorities now understand the source.
The essential problem might be likened to somebody rebuilding a house after a bad storm, but only shoring up half the foundations. More specifically, a decade ago, in the aftermath of the 2008 financial crisis, regulators tightened capital rules for banks in a way that made it too costly to hold vast quantities of Treasuries on their books.
This move strengthened half the financial system’s foundations — it made the banks safer — but had the unintended consequence of prompting them to withdraw from traditional market-making roles.
This has coincided with a rise in “principal trading firms” (or high-frequency trading funds), which have moved into the Treasuries sector with their computerised models and now account for 50-60 per cent of activity, as Gary Gensler, Securities and Exchange Commission chair, noted last week.
When market conditions are calm, the PTFs create strong, liquid foundations for trading. But in a crisis, they have no incentive to act as market makers, are more likely to flee and, as the IAWG paper notes, when some big holders of Treasury bonds — notably foreign investors — trimmed exposures in March 2020, nothing could absorb the selling shock.
What made the situation doubly pernicious was that some hedge funds had built huge, hidden derivatives positions. The lightly-regulated foundations of the system, in other words, created big cracks, although the banks were safe.
The bad news is that there is no easy or swift fix for these problems — even though authorities understand them. Last week the Fed convened a conference which floated ideas to protect the market from future shocks. Gensler, for example, called for those pesky PTPs to be placed inside the SEC’s regulatory net. He also suggested that Treasuries be cleared on a central platform.
Meanwhile, Fed officials called for more transparency and Wall Street bankers — unsurprisingly — demanded a rollback of the capital rules.
Some of these ideas are sensible. Personally, I would be wary of any widespread relaxation of the post-crisis reforms. But it would be useful if the rules were tweaked to help brokers to act as market makers in the Treasuries sector.
Indeed, this is precisely what the Fed did temporarily in 2020. It would make even more sense to introduce more oversight of PTPs, via a clearing house or regulatory scrutiny (or both).
However, as so often in Washington, it would be wildly naive to expect that an entirely sensible set of solutions will be implemented fast. It has been clear that structural cracks were emerging in the Treasuries market ever since a so-called flash crash — or freeze — hit the sector, briefly, in 2015, presaging 2020.
The Fed has since tinkered with…
Read More: The US Treasuries market is a dangerous place to dream