Can the Fed Fix the Treasury Market by Tweaking Repo?

By Liz Capo McCormick | Bloomberg,

The $21.7 trillion Treasuries market is the bedrock of the global financial system. It’s not good when bedrock shivers, let alone shakes! But bouts of Treasuries turmoil have been happening more frequently and at times triggering large-scale interventions from the U.S. Federal Reserve. Pandemic-sparked volatility in March 2020 caused liquidity in the world’s biggest bond market to plunge, pushing the Fed to pour in more than $100 billion a day through debt purchases. More than a year later, the Fed announced the creation of what’s known as a standing repo facility, a step meant to head off future turmoil. A few hours earlier, a panel of former top global policy makers had called for the creation of such a facility, along with other measures to shore up the Treasuries market.

1. Why is the Treasuries market so important?

There are lots of reasons. One, because it’s estimated that the value of more than $50 trillion in assets around the globe are priced off Treasuries. So turmoil in government debt markets can have ripple effects on other asset classes, creating volatility that may push investors to run to the safety of cash. Beyond that, the U.S. government has had to ramp up sales of debt, which has surged by about 50% since late 2017, to finance a growing budget deficit that then ballooned to fund coronavirus-relief spending.

2. What caused those market backflips?

It’s complicated. In 2020 the catalyst for the disruption was of course a once-in-a-century event, as the Covid-19 outbreak wreaked havoc on equities and commodities and caused wild gyrations in Treasuries. Asset managers said dealers pulled back from market making as things unraveled, and a blowout of hedge funds in leveraged Treasury trades exacerbated the sharp movement in yields. But pinning down causes of sharp market movements can be hard, as with the September 2019 blowup in the “repo” (repurchase agreement) market, which provides the funding for many Treasuries trades.

3. Are there any common themes?

Most agree that all of these issues have transpired against a backdrop of regulations adopted after the 2008 financial crisis. While financial stability was their goal, some argue that the rules have crimped banks’ ability to make markets, which has opened the door for more frequent bouts of liquidity troubles. And Federal Reserve Vice Chair for Supervision Randal Quarles in 2020 warned that the sheer size of the Treasury market itself was hampering dealers’ market-making capacity.

4. What did the Fed do?

At its July 2021 Federal Open Market Committee meeting, it said it would create a standing repo facility (SRF) — actually, two of them, one domestic and one foreign. When people say Treasuries are highly liquid, the proof is in the repo market, where banks and other big investors swap Treasuries for cash in short-term deals that amount to collateralized loans. Repo makes the wheels of finance turn a little more easily — except when it doesn’t. In September 2019, the Fed had to flood the repo market with hundreds of billions after interest rates spiked in a sign of distress. Afterward, Fed officials postulated the idea of setting up a SRF that would give the Fed a permanent presence in the market, allowing eligible counterparties to convert certain debt securities into cash daily, as an ever-ready backstop. The turmoil of March 2020 brought the idea back to the fore.

5. Is this related to any current market trouble?

No. The creation of the SRF is a preventive measure for a crisis that’s not happening at the moment. Right now, in fact, money-market funds and other investors flush with cash are tapping the Fed to offload it through record amounts of what’s called reverse repos, in which the Fed loans out securities it owns. That’s the opposite of what happened in times of market stress like March 2020, when the Fed supplied cash in exchange for securities.

6. How will the SRF work?

Under the domestic facility, the Fed will conduct daily overnight repo operations swapping cash for Treasuries, agency debt securities and agency mortgage-backed securities, with a maximum operation size of $500 billion. Under the foreign repo facility, the Fed will enter into overnight repos as needed with foreign official institutions against their holdings of Treasury securities maintained in custody at the Federal Reserve Bank of New York. The minimum bid for repos under the facilities will be set initially at 25 basis points. Counterparties for domestic operations will include primary dealers and will be expanded over time to include additional depository institutions. The foreign facility will have an initial per counterparty limit of $60 billion.

7. What did the G30 report say?

The Group of Thirty, an independent global council of economic and financial leaders, on July 28 published an array of recommendation for ensuring the soundness of the Treasury market. Former U.S. Treasury Secretary Tim Geithner, who heads the G30’s Working Group on Treasury Market Liquidity, included the SRF as its top recommendation. The G30 report attributed the “root cause” of recent Treasuries disruptions to a surge in federal U.S. debt accompanied by a tighter regulatory regime for bank capital in the aftermath of the 2007-09 financial crisis.

8. What other fixes to the Treasuries market have been proposed?

It’s not only the G30 — former president of the New York Fed Bill Dudley wrote in a Bloomberg Opinion column on July 29 that while the SRF is a big step forward, much more needs to be done to guarantee its smooth functioning. Here are some key ideas that experts have put forward.

Central Clearing

To prevent another flareup, Fed officials — including Chairman Jerome Powell — have raised the possibility of fortifying the market’s foundation with a broad-based central counterparty (CCP) clearinghouse to back up trades and handle surges in activity in times of stress. A CCP that handles many if not all Treasuries trades, supported by capital supplied by its members, could limit the need for Fed interventions. Presently, only about a fifth of the market goes through the Depository Trust & Clearing Corp.’s Fixed Income Clearing Corp. (FICC) unit, the only central clearinghouse in Treasuries. Shifting trades there would mirror what regulators did after derivative losses almost crashed the global economy in 2008, when they pushed most interest-rate swap activity onto CCPs. But some see such action as raising costs. Others argue that a clearinghouse could make matters worse by concentrating risks. To ensure the soundness of the clearing house itself, the G30 advised that the Treasury Department lead a review of the design and operation of the FICC.

All-to-All Trading

As with a standing repo facility, the idea is to create alternative ways for traders to find counterparties for the times when the Wall Street dealers who normally handle large volumes are hunkered down. Enhancing the ability of investors to trade more directly with each other, known as all-to-all trading, is seen by some as a way to reduce dependence on the Fed’s primary dealers, a group of 24 that is dominated by big banks such as JPMorgan Chase & Co. and Bank of America Corp. One idea floated is to allow investment managers into the primary dealer fold. Bond giant Pacific Investment Management Co. has argued that asset managers should be included in the group. Showing that many recommendations connect to each other, the G30 reported noted that “broad central clearing could encourage trade-platform operators to open their venues to a wider set of market participants, or even all-to-all trade.”

Transparency

Many say the Treasury market is still too opaque, a situation that can contribute to market nervousness. After years of reviewing the hotly debated issue of the public release of trading data, former Treasury Secretary Steven Mnuchin’s team decided in September 2019 to only allow weekly aggregate statistics gathering through its price-reporting system for bonds known as TRACE. That fell short of what many had desired, given that prices of stocks and corporate bonds are reported instantly or with a small lag throughout the day. “The TRACE reporting system should be expanded to capture all transactions in Treasury securities and Treasury repos,” the G30 advised.

Regulatory relief

Nellie Liang, a former Fed economist who is now Treasury’s deputy undersecretary for domestic finance, last December proposed targeted changes to bank regulations “to improve liquidity provision by bank-affiliated dealers without reducing their overall safety and soundness.” She suggested that reserves at the central bank be permanently excluded from banks’ supplementary leverage ratio (SLR) calculations given they are riskless (Treasuries should not be exempt, they say, because they have interest-rate risk). In response to the pandemic the Fed in 2020 let lenders exclude Treasuries and deposits from SLR calculations, in effect allowing them to lend more. But that waiver lapsed in March, despite many in the markets calling for it to remain. The Fed did say it is considering some type of permanent adjustment to the SLR in the future. The G30 called for modifying capital requirement that discourage market intermediation.

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