In the global financial system, US Treasuries play a special role. They’re basically as close to cash as a financial asset can get and their yields act as the "risk-free" rate against which all other assets are measured. In other words, the US Treasury market is supposed to be the safest and most liquid in the world. But Treasuries have also been at the center of some pretty big financial events in recent years, including the March 2020 sell-off and the collapse of Silicon Valley Bank this year. The Federal Reserve has had to step in to support the market, and now there’s concern over who will buy all these bonds as the US Treasury ramps up its borrowing. So why does the world’s most important market keep experiencing these issues? And what can be done to improve the way Treasuries are bought and sold? In this episode, we speak with Stanford University finance professor Darrell Duffie, who just presented a paper about this very issue to central bankers at the annual Jackson Hole symposium. We talk to him about why the Treasury market keeps experiencing problems, what can be done to fix it, and why the issue is gaining more urgency. This transcript has been lightly edited for clarity.
Key insights from the pod
:
Why volatility is rising in the US Treasury market — 3:48
Why the world’s safest asset can get into trouble — 7:27
How good does the market need to be? — 9:00
How Treasuries are traded currently — 16:13
How post-Lehman regulations impair Treasury market liquidity — 22:12
What's preventing all-to-all Treasury market trading — 28:57
The role of central clearing — 32:01
The risks of central clearing — 38:15
Why the Fed should be concerned with Treasury market liquidity — 40:45
Why the market needs to get fixed — 42:30
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Tracy Alloway: (00:10)
Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe Weisenthal: (00:15)
And I'm Joe Weisenthal.
Tracy: (00:16)
Joe, have you been watching Treasury yields lately?
Joe: (00:19)
Uh, they're up. They've gone up. I am aware.
Tracy: (00:21)
That's it. That's the show.
Joe: (00:22)
I am aware that the line has gone up and to the right lately.
Tracy: (00:25)
Yes. But not just that they've moved quite quickly. I think volatility in the Treasury market has once again become a talking point. And I always get a little bit of a sense of deja vu because whenever things start happening in the market for US government bonds, extreme things, these extreme moves, it feels like everyone says, ‘oh, this shouldn't be happening in the world's most liquid market, the world's safest market, we shouldn't be seeing these types of dramatic shifts.’
Joe: (00:54)
The expectation is this is like a very extremely liquid slow moving market, but it has been a very fast move and people don't really know why. There's a lot of debate. You have people talk about, “Well, look, the economy is proving to be more resilient than people might have guessed six months ago, even a month ago.” And I think there's this expectation, there's this sense that things are moving faster.
There's also a lot of talk about Treasury supply. Supply-demand imbalances and so forth. So things are on the move to say the least. And you see it in mortgage spreads which are very wide. You see in other risk assets not seeming to like this Treasury volatility. So lots going on there.
Tracy: (01:31)
So you mentioned a couple things there, which is yes, the economy seems to be doing relatively well, and yes, the amount of Treasury supply is exploding and has been going up for a very long time. There's another factor here, which is the actual inner workings of the Treasury market. So how Treasuries are actually traded, and whether or not that is potentially contributing to some of the volatility that we've seen.
And again, I feel like this topic keeps coming up. Every year there's some massive move in Treasury markets and everyone starts talking about liquidity issues, and yet you don't really see any big solutions being proposed to it. You see talk about, you know, maybe loosening some of the regulation around the supplementary leverage ratio or something like that. But it feels like we need to talk about this and maybe try to come up with a solution. Let's do it!
Joe: (02:21)
And we're in a good place to talk about it.
Tracy: (02:22)
Yes. We are at Jackson Hole .
Joe: (02:25)
I thought you were going to lead in with that. I like how we eased into it a little bit.
Tracy: (02:30)
Oh, I want this to be an evergreen episode for an evergreen problem.
Joe: (02:35)
But the people here care about this topic.
Tracy: (02:37)
Yes, absolutely. The way US Treasury debt is traded has a lot of implications, particularly for the cost of financing the US deficit. That's an obvious one. And so we should talk about it.
Joe: (02:50)
Let's talk about it.
Tracy: (02:50)
I'm very pleased to say that we have the perfect guest. We are going to be speaking with Darrell Duffie. He is of course a professor of finance at Stanford's Graduate School of Business, and he is presenting a paper at Jackson Hole in front of the world's top central bankers, all about this issue. It's called “Resilience Redux in the US Treasury Market.” So, Darrell, thank you so much for coming on Odd Lots.
Darrell Duffie: (03:14)
Thanks for having me, Tracy, Joe. It's terrific to be here.
Joe: (03:17)
You know it's the perfect guest when it's the guest that the top central bankers around the world want to hear from.
Tracy: (03:30)
When Treasuries are moving, they call up Darrell Duffie. Alright well, professor, thank you again for coming on. Why don't we just start with the basics. You know, we sort of alluded to this in the intro, but it feels like this is a subject that just keeps coming up and never really seems to go away. What's going on here?
Darrell: (03:48)
Well over the past century there have been, as you suggested, many episodes of increased volatility and liquidity problems in the Treasury market. But I do think these are happening more frequently.
Just recently, I think you summarized pretty well some of the stresses in the Treasury market coming from the fiscal side. The US is issuing more than people expected. There was a recent downgrade by Fitch. And the Fed is struggling with what to do about inflation. That additional monetary policy uncertainty also contributes to volatility.
Let me back up a minute. I just spent most of the last year on a sabbatical at the New York Fed and working with some terrific economists there. Michael Fleming, Frank Keane, Claire Nelson, Or Shachar, and Peter Van Tassel. We decided we needed to look into the relationship between the volatility that you two discussed and the liquidity in the market. They're closely intertwined.
So we dug deep and went into a lot of data and yeah, volatility seems to be the main determinant of illiquidity in the market. So when fiscal uncertainty or a debt ceiling debate or a Covid crisis or monetary policy uncertainty start to get volatility higher and higher, the market becomes less and less liquid, it's an extremely regular relationship. About 80% of illiquidity is explained simply by variation in yield volatility.
Joe: (05:19)
So just to press on this relationship between rates volatility or yield volatility and illiquidity, like, which way does the direction run? Because we can come up with these fundamental stories, right? Like, okay, maybe the economy is better than expected. Maybe we're going to have more rate hikes than previously anticipated. In which case you say, okay, “Well that's a fundamental story. Fundamental drivers.”
And then you could look at the nature of the structure, like the size of dealer balance sheets, etc. It's like, okay, well this is something technical that contributes to also could be a contributor to volatility. How do you think about the directions of causality when you look into a problem like this?
Darrell: (05:59)
Yeah, well, both the direct kind of fundamentals, fiscal/monetary fundamentals and the global economy and geopolitics recently all play a direct fundamental role. And then as you alluded, there's also kind of a feedback effect. When volatility rises for fundamental reasons, dealers are going to struggle with providing sufficient liquidity to the market.
And to the extent that dealer balance sheets are not sufficiently flexible to accommodate the provision of liquidity to the market, that in and of itself increases illiquidity, increases volatility, and they kind of feed back on themselves. And you can get an episode like we had when Covid hit in March, 2020, where liquidity becomes even worse than would be suggested by volatility alone. Much worse. And that's just a sign that the market is not capable of intermediating those extreme demands for liquidity.
Tracy: (06:57)
So this seems to be a distinct characteristic of Treasuries in particular, which is when stuff starts to go really wrong, like it did in March of 2020, people often sell the safest stuff first, which means they sell Treasuries. So you get this big wave of selling at precisely the moment that a lot of dealers want to wind down or back away from risk. Is that just a fundamental tension in the market? Is that always going to be the case?
Darrell: (07:27)
As long as US Treasuries are the world's most important safe haven, which is clearly the case by by miles, that's always going to be the result for basically two reasons.
Number one, a whole lot of major investors like foreign exchange reserve managers, firms that are storing safe liquid asset just in case, well, the just in case happened, and they are going to liquidate those positions. The other channel for this is that as the volatility grows and uncertainty grows, a lot of investors are kind of finding it too hot to handle and they have to unload some risk. And Treasuries are the easiest security to unload in the world. The market's got a good reputation for being the deepest and most liquid market in the world.
Joe: (08:14)
So we've talked about this a little bit in the past with a few different guests, including Josh Younger. He made the point in one of the episodes that we did, which is like, if you're thinking about like, what do we want to do to have better Treasury market structure then it doesn't necessarily make sense to optimize for, ‘Well, we never want to have a March, 2020 again,’ because you don't necessarily want to optimize for the one out of every a hundred year pandemic.
But what would you say? Is the goal, like, if you're like, okay, there does seem to be this relationship between volatility and illiquidity, it does seem like some of these bouts of volatility and illiquidity become more frequent. If you think about designing an optimal market structure for Treasuries, what would you say we're trying to achieve?
Darrell: (09:00)
Josh, I've known him since he worked at JP Morgan. And now that he is moved to the Fed, we get to talk a lot more. This is a terrific insight that he has. Do you really want to design a market for the worst day in a thousand? Isn't that very expensive? And maybe overdoing it because 999 days out of a thousand, you didn't really need that kind of a market structure.
I'm going to be a little provocative here. I think you do want to build a market for the worst day in a thousand for the following reason. Let's say, I’m managing the foreign exchange reserves of an emerging market central bank. When do I need to actually take advantage of the depth and liquidity of the US Treasury market? It's that one day in a thousand when all the other safe haven investors are trying to do the same thing.
In the paper that Tracy mentioned that I'm giving here at Jackson Hole, I talk about this wrong way risk from the viewpoint of illiquidity. You don't want the market to be great except on that very singular day on which everybody needs the liquidity.
Why not? Well, because A, this is the linchpin of global financial market stability. You want it to work day in, day out. And B, if you discourage safe haven investors from believing that even though everybody else is liquidating that day, they could also liquidate at at low cost with ease, then they won't use the US Treasury security as much as their safe haven. They'll diversify.
And that's what we've been seeing somewhat over the last couple of decades. A degree of diversification away from the US Treasury. Still by far the dominant, uh, safe haven, something like 59% of foreign exchange reserves are held in US Treasuries. But from the viewpoint of view US taxpayer, you want everyone to believe that on the worst day in a thousand, that market is going to be there for them.
Tracy: (10:50)
Wait, I'm going to be provocative now or try to [be]. Okay, so on this note, we did see in March 2020, the Fed unveiled all these different emergency programs aimed at supporting the US Treasury market. So, you know, we had the new standing repo facility and I think, you know, they were buying US Treasuries in exchange for reserves, and then they exempted all of those from the supplementary leverage ratios for banks. So it seems like the backstop is in place. If something bad were to happen again, I would presume that the Fed would unveil either those exact measures again or something very similar. So is the issue solved?
Darrell: (11:30)
Yeah, Tracy, that is provocative. So I would definitely say...
Tracy: (11:35)
That’s a polite way of saying you're so wrong.
Darrell: (11:37)
No, the Fed came out guns blazing. Unlimited financing in the repo market for anyone that had access to the Fed. A trillion dollars of purchases in the first three weeks. Nearly a trillion of US Treasuries relieving dealer balance sheets of their overloading getting the supplementary leverage ratio dialed back and it was causing problems, took a little longer, and it took, I think, some backroom negotiations with the other bank regulators to come on board. So that got delayed and that was a problem.
But the Fed did a terrific job at crisis management during those weeks. And I say weeks because they didn't solve the problem. They only made it less bad than it otherwise would've been. It took five, six, seven, eight weeks before market liquidity was restored. And again, going back to my wrong way risk point if I am looking for a market that's going to work for me in a crisis, I don't wanna have to wait weeks in order to get liquidity or to pay a low cost for liquidity.
I want it to be working all the time. Now, of course, it's unrealistic that it should work every single day. But if we rely only on central banks, and I speak more broadly to bail out their government securities market when they get into trouble, it's not going to be a hundred percent effective. And it raises moral hazard, it says to the rest of the world, we'll use the central bank balance sheet to bail you out. You don't need to focus on improving market structure, reducing undue leverage. We have your backs. That message, while it needs to be there, is not a substitute for improving the market structure.
Joe: (13:18)
Yeah. You sort of anticipated my next question, but okay. It does seem like in an emergency, the Fed can say, we're going to, you know, do QE at a scale that we've never seen before. And as Tracy mentioned unveil these new facilities kind of on the fly. And it seems like basically since 2008, 2009, the Fed has gotten really good standing up new facilities very quickly. So that's like a skill that they've developed.
But can you talk a little bit more about what you perceive as to be the cost of a stability regime that sort of presumes that, yeah, ‘we know there's some frailties, but our solution is that in that, you know, 7 Sigma or 12 Sigma a day that the Fed is there’ and like why that's not a good system. .
Darrell: (14:05)
Well, just, I want to re-emphasize that the Fed does...
Joe: (14:08)
I don’t know how many sigmas it really is. Is that once every billion year? I don't know, I’m just throwing out numbers.
Darrell: (14:13)
The Fed does need to be there. It's not as though one should say “let's take the Fed's balance sheet out of the equation and try to do without it.”
It needs to be there. It's a backstop. It's the last resort. The Fed is the buyer of last resort. After it's become the lender of last resort. It can't do anything else but bail at the market by buying securities. But relying on that has several problems. I already mentioned it's not a hundred percent of effective on the first day.
And there's also the size of the Fed's balance sheet, that's controversial. I mean, even if you think it's innocuous, it raises political concerns. There are those that say, well, maybe the Fed's balance sheet is too big and we need to curtail the ability of central banks, including the Fed, to expand their balance sheets to the extent that they have been.
And they've been using them very, very liberally over the past couple of decades. The other concern is once the balance sheet is large, that eventually is going to come back down. And those Treasuries are going to be adding to the stock of securities that other investors need to have. And that it means that the central banks, including the Fed, need to do that vary gingerly, there's a lot of volatility in the Treasury market and the Fed is letting its balance sheet come down.
Other investors are having to pick up the load. It's easier to expand the balance than it is to bring it down. So using the Fed's balance sheet, while it's necessary, is not a painless solution. And I would argue it's not the best solution anyway. We can do better by improving market structure, pushing out into the extreme tails the number of events in which the Fed needs to step in and buy.
Tracy: (15:51)
Why don't we talk about the market structure, and maybe before we start talking about improvements that could be made, could you give us the sort of lay of the land when it comes to how Treasuries are traded today? So there's primary dealers for the new issuance, and then there's your sort of run of the mill dealers for secondary market trades. But talk to us how it works right now.
Darrell: (16:13)
Terrific. Well, it's an extremely complex structure, but it can be summarized pretty simply. There's two segments of the market. There's the inter-dealer market in which the dealers trade among themselves, and then there's the customer to dealer market in which investors around the world trade with dealers.
Notably, investors do not trade directly with other investors. There is no all-to-all trade in the US Treasury market. No matter whether you're an insurance company, a hedge fund, or an exchange reserve manager, you are going to be buying and selling with a dealer. If you're a dealer on the other hand, there's a very active inter-dealer market for the on the run securities. Those are the latest issues of the Treasury.
There's an order book market, which is a high frequency trading market run by BrokerTec, which is the subsidiary of the Chicago Mercantile Exchange, where you have the same kinds of high frequency trading that you see in the stock market. The only other participants on the broker tech market are high frequency trading firms, sometimes called principle trading.
Firms like Jump, like DRW, like Citadel [Securities] firms that have a very special purpose of intermediating in the inter-dealer market taking, you know, little bid offer spreads from, from the dealers and from each other. That's the basic structure of the market. Again, the notable feature is if you're an investor, you can trade only with a dealer. If you're a dealer, you have the ability to lay off positions in the inter-dealer market.
Joe: (17:39)
Again, before we get into sort of like optimal structure, I'm actually just curious, you know, you mentioned that you spent the last year at the New York Fed looking into this and sort of getting this, what did you do? How did you like go about your research? How much is it sort of like a sort of statistical based analysis versus how much was it talking to dealers and understanding how they operate? I'd just be curious about the research process.
Darrell: (18:02)
For this particular project was a combination of meeting and discussing what needed to be done with the economists that I mentioned earlier. And those would be weekly meetings, pretty in depth where we'd go through what we've already learned and what we need to do next. And that happened for six months or so. Uh, and at the same time in the background, were collecting volumes of statistical data. The Fed, because it's a member of the official sector, has access not only to its own data, but to exceptionally fine-grained data on at the transactions level.
Lemme give you one example. There is a data set called TRACE, which records every single trade in the Treasury market with a few minor exceptions. Those data are only available to the official sector. They're not available to the public. And by the way, I disagree with that policy, and we could talk about that. I think it actually is contributes to the problem of illiquidity.
But in any case the Fed as a member of that official sector group can go to its sister agencies in the federal government and say, look, we have this project, here's its objectives. We want to use these TRACE data to analyze liquidity in the US Treasury market. And then we get feedback saying, yeah this looks good. The way the data being presented will not reveal proprietary information. Uh, so go ahead and then we can do the same thing with dealer balance sheet data.
We can get exposures of the dealers not only to Treasury securities, but to agency mortgage backed securities, which turned out to be another big load on their balance sheet, particularly during March of 2020. We can go to a wide range of data sets and we wrote a paper that explains the extent to which we access all of these data, bring them together.
We developed 18 different liquidity metrics and many different metrics on how dealer balance sheets are being loaded. And then we would analyze these using reasonably intricate econometric methods like quantile regressions and a number of other statistical approaches. And then we would start to see the patterns emerge very, very clearly that I described two key patterns that came up over and over again in our discussion meetings, which were volatility seems to explain most of the variation in liquidity, but B, when it doesn't, it's dealer balance sheet loading that explains the remaining part of illiquidity.
It's a highly non-linear effect. When dealer balance sheets are normally loaded, they don't contribute to illiquidity, but when they're reaching their extremes where dealers are handling more Treasury trades and more agency MBS trades than they've handled in the past, then you see illiquidity go up well beyond the level predicted by volatility.
So after analyzing all these data and discussing what's driving these, then we turn to writing up our results. And there's a lot of iterative work there, which you can see in the paper that we wrote.
Tracy: (21:14)
So you can see the dealer balance sheets on a daily basis, not just at quarter end?
Darrell: (21:19)
Not quite, we can only see dealer balance sheets on a weekly basis because the Fed has a data set called FR 2004 which collects those data only on a weekly basis. And summary summaries of those data are available publicly on the New York Fed's website.
Tracy: (21:35)
So going back to this dealer balance sheet issue, I mean, this is something that has come up basically ever since the 2008 financial crisis. And there have been a lot of complaints from the dealers about all this new regulation that limits their ability to take risk on their balance sheet. And the argument for doing that has always been one of financial stability. Well, we want the banks to be safer, and if they have to cut back on their intermediation capacity in the market, maybe that's a fair trade. How do you thread the needle between those two issues, especially in a market as important as Treasuries?
Darrell: (22:12)
Okay. It's very tough because those much more demanding capital requirements and other requirements that came in after the financial crisis have clearly reduced liquidity in a broad set of financial markets. It's glaringly obvious, however, we can't afford to return to the pre-Lehman days in which dealers would expand their balance sheets for a few basis points of arbitrage, creating financial instability.
So while those new capital requirements are necessary for protecting the economy from collapse of the financial services sector, we do need to substitute for the liquidity that's missing in other ways.
There is one capital regulation that I think is not necessary, and that's the one you mentioned, Tracy, the supplementary leverage ratio. That rule penalizes the provision of liquidity even for very safe assets. Let me give you an example. When the Fed was buying Treasury securities from mid-March, it bought within three weeks nearly a trillion dollars of Treasuries.
And one might think, thank goodness that's making more space on dealer balance sheets for other positions. However, from the viewpoint of that capital regulation, there was really not much change at all because the Fed paid for those trillion of Treasuries with a trillion of reserve balances. And reserve balances, although perfectly safe and liquid, have the same impact on dealer capital requirements as the Treasury securities that they replaced.
So there wasn't really, from the viewpoint of the supplementary leverage ratio, much benefit of the Treasury purchases. There were benefits in other respects because Treasuries are risky and dealers were relieved of that risk by the fed's trades. But from the viewpoint of that supplementary leverage ratio, it was very unfortunate. And I and others have argued that the SLR ratio rule should be replaced with higher risk-based capital requirements.
Joe: (24:20)
Sorry, can you explain that? When you say replaced with higher risk-based capital requirements...
Tracy: (24:24)
The capital wouldn't be calculated on the basis of the size of your total balance sheet, but on the riskiness, the actual makeup of the balance sheet.
Darrell: (24:33)
That's right. There's been a kind of go-round in the Basel world of capital requirements for banks. Back in the eighties, we went from a world where there were just basically leverage requirements that did not consider risk to a world in which the financial regulators were saying, ‘Hey, wait a minute, we should be weighting these assets by risk because that's what matters for insolvency.’
And then it was discovered leading up to the crisis, uh, and failure of Lehman that banks were playing games with their risk-based measures, or simply the, the measures were not accurate enough. And so as a backstop, or just in case the supplementary leverage ratio rule was introduced to eliminate from the viewpoint of that capital requirement, any consideration of risk saying, you know, “no more games and no more uncertainty about how much risk we're just going to require for every a hundred dollars of assets of any kind, even central bank deposits, you have to have a certain number of dollars of capital that doesn't depend on the risk.”
Well, in my view, that's backfired. And it's led to more illiquidity than necessary. You could still have the same amount of financial stability with less illiquidity if you dial back that rule and dial up risk-based requirements so that system wide, you're just as safe as you were before. But each individual bank is not internalizing the cost of balance sheet space when it makes trades of safe assets.
Tracy: (26:01)
What would that mean for banks? Interest rate risk, and I'm thinking specifically back to a different March, not 2020, but, March of 2023 when we did see a lot of banks hit by mark to market moves on their bonds because interest rates were going up and so the prices were lower. If you removed bonds from the SLR calculations, would you still be able to take into account interest rate risk or would you not really need to anymore?
Darrell: (26:30)
No, you would still need to do that, but you could do that through a couple of measures that have been proposed that came up after the failures of a Silicon Valley Bank and other banks. So one thing you could do, which should be done, is that the very large, but not GSIB banks, like those big regionals should be required to pass their losses due to interest rate risk through to their capital accounts, so that when they lose money on Treasuries, they have to add capital to replace that they were exempted from passing through those losses.
The second thing you can do, which surprisingly the Fed has not done recently, is to include shocks to interest rates as a scenario in their stress tests so that banks would need to demonstrate that even if the yield curve were to jump up a couple of hundred basis points, they would have the capital necessary to weather that storm.
Tracy: (27:25)
Right. This was the crazy thing about the [CCAR] bank stress test. They were always for a recessionary scenario where interest rates would plummet and they never actually modeled interest rates going sharply up.
Joe: (27:36)
I don't think I realized that. I mean, it's like a classic fighting the last war. So it's like, okay, we're going to like protect against this big collapse or recession and credit risk, etc. And then the idea that like the next, I don't know if you'd call it a crisis, I know Tracy and I fight about whether it's a crisis, but the next bout of...
Tracy: (27:53)
We settled on ‘drama.’
Joe: (27:55)
The the next of drama would be in the other direction of the rates going higher. But yeah, it makes sense that that would be part of a stress test. Yeah.
Darrell: (28:02)
Joe, the Fed has already predicted that it's going to make those losses pass through to capital and I predict personally that they will also include, interest rate risk scenarios and their stress tests. I would not be surprised to see both of those in place soon.
Tracy: (28:24)
Just going back to one suggestion for improving liquidity in Treasuries you mentioned all-to-all trading earlier, so the idea that investors could trade with one another. I am most familiar with that model through multi-year efforts to get it going in corporate credit. There is a lot of resistance to that from the dealers who don't want to give up a lot of their pricing power in that market. Is it a similar story in US Treasuries? Like why doesn't all-to-all trading exist already?
Darrell: (28:57)
Okay, well, the most influential market participants from the viewpoint of designing and innovating market structure are the dealers themselves. And if I were, you know, in the executive suite of one of the largest dealers, I don't think I would necessarily campaign to introduce a new set of competitors for my trade, lowering my market share and reducing my profit margin on each trade. So it's kind of understandable that to the extent that the market hasn't evolved, that, you know, dealer dealers haven't been pushing for that.
By the way, I'm not advocating that the Fed should mandate all-to-all trade or other regulators should mandate that. I think it needs to happen organically because if it's a rule requirement that trades in the Treasury market must be all-to-all, well, first you have to define what that means, and that's going to gum up the market design in and of itself.
It's difficult, it's a difficult design process. And secondly, there's a lot of trade in that market that should be done bilaterally with dealers for very large block trades. And dealers need to be involved in the provision of liquidity directly to investors. So in my view, that all-to-all trade needs to happen in a way that the market is guiding, but there can be a nudge from other, rules that would lead that way. An example being central clearing.
Tracy: (30:22)
Right, so this is the other suggestion in your paper. So a shift towards all-to-all trading — I'm still a little unclear on how that would happen organically, given there seems to be a lot of resistance from the dealers. I assume maybe it's one or two big investors, you know, someone like a BlackRock says we're going to do it, and then the dealers just have to come along for the ride. But the other suggestion is central clearing. And on this issue, again, correct me if I'm wrong, my impression was always that the Fed was a little bit resistant to that idea.
Darrell: (30:54)
Well, the Securities and Exchange Commission recently unanimously proposed broad central clearing in the US Treasury market. I don't think there's that much resistance among the other key players in the official sector. In the case of the Treasury market, those key players are the SEC itself, the New York Fed, the Federal Reserve Board, and the Treasury Department. I don't see a significant amount of resistance across those four key players, but it's not easily done.
First, it’s a difficult design process itself. What are the requirements going to be? And secondly, there is going to be industry resistance. And even without singling out any particular regulator, I think industry pushback on the cost side of that is understandable and it's going to have to be overcome. 'cause leadership in the official sector is going to be needed to push that through.
Joe: (31:48)
Sorry, I'm going to play the role of the ignorant listener — AKA me — define central clearing. And what is it about it that, in your view would contribute to sort of like for the resilience or stability in the market?
Darrell: (32:01)
Okay, good. So let's just back up and describe what it is. In the current US Treasury market, the dealers are required when they trade with each other to settle their trades through the Fixed Income Clearing Corporation (FICC), which means that they're not facing each other for settlement risk. If I trade with you, then tomorrow I'll settle my trade with the Fixed Income Clearing Corporation, and so would you.
That lowers our bilateral risk. It also allows me to net down my purchases against my sales, because if I buy from you, Joe, and I sell to Tracy in a bilateral world with no central clearing, I've got two settlements coming up that I have to pay attention to both of them from the viewpoint of settlement risk and settlement failures, meaning the trades are not done. If I can net a hundred billion of purchases from you, Joe, against say $110 billion of sales with Tracy, that $210 billion gets netted down to $10 billion facing fixed income clearing corporation.
So that massive reduction in my settlement risk is really beneficial from the viewpoint of using my balance sheet efficiently. There was a study done at the New York Fed year before last by Michael Fleming and Frank Keane, two of my other collaborators, in which they showed that on the peak days of the March, 2020 Covid stress, the settlement in one day for the US Treasury market facing the dealers was in excess of a trillion dollars.
And had those trades been centrally cleared, it would've been as low as $300 billion, about a 70% reduction. Now that not only relieves some space on dealer balance sheets, which is one of the key problems here, if the central clearing is done effectively in a kind of straight through anonymous way, then investors in the market could say, well, I could trade directly with another investor and I wouldn't be reliant on my dealer to settle my trade for me.
If only a trade platform operator would offer that service, I'd be all in. And then trade platform operators will say, “wow, now that we have central clearing in this market, the barriers to enter into the intermediation of this market are much lower because investors can settle directly at the Fixed Income Clearing Corporation or whatever central counterparty they choose.” So I think it would organically lower the barriers to more all-to-all trade in addition to reducing the amount of space on dealer balance sheets. And by the way, lowering settlement risk in that crucial market. That's why it was introduced in the first case back in the 1980s to lower settlement risk.
Tracy: (34:40)
So dealers get to use their balance sheet more efficiently through central clearing, but there's still an added cost for them, I believe, and there's still a sort of existential threat to their business model if investors can settle with other investors. So how do you, you're sort of asking them to put in higher individualized costs in exchange for more collective safety, which when you're talking to dealer banks, it sounds rational, but a lot of them are very self-interested for obvious reasons. So how do you get them on side? Do you need to get them on side?
Darrell: (35:16)
You do, simply by forcing the issue. But this is the classic, private cost, public interest kind of trade-offs that where you need the official sector to step in and, and make decisions. And by the way, when I said earlier as a dealer firm, I might not favor this, because of the costs and because it's threatening my market share and my profits. I think if you take a really long perspective on this, there's a chance that all-to-all would massively increase the volume of trade in the US Treasury market.
Let me go back to 1973 when none of us were probably aware of what was going on and talk about the equity options market where stock options were being traded before ‘73 bilaterally, uh, through dealers, just as the treasuries are done today.
Then the Chicago Board Options Exchange entered the market in ‘73, and in the very first month of trade, that exchange did more volume that had been done in any prior year in the dealer-intermediated market. And dealers had a fraction of that trade, which was a small fraction, but big volume since 1973.
Volumes in the equity options market, because it was exchange traded, have grown by many orders of magnitude on the order of a million times the volume of trade that was in place in 1973.
So while in a short run, the dealers got a smaller share of the market and faced more competitive margins on each trade, eventually the volume of trade just dominated that effect. And I don't think any dealer would wanna turn back the clock to the days before exchange traded options. I predict the same thing would happen in the US Treasury market as around the world investors would need liquidity in a much higher volume market, and dealers would be providing a lot of that liquidity both on exchange and off exchange.
Joe: (37:21)
Are there any other government bond markets around the world that work kind of in the way that you are envisioning?
Darrell: (37:27)
Terrific question. So, a former Stanford PhD student, Milena Wittwer, collaborated with two economists at the Bank of Israel on what happened in Israel in March of 2020. Israeli government bonds are traded on an exchange. It's not a dealer-intermediated market. And that market came through. Now it's not a comparison to the US Treasury market in terms of size and depth, but it came through without difficulty. Whereas most government securities markets did suffer in terms of liquidity in March 2020.
Tracy: (37:58)
That's super interesting. Just one other devil's advocate question on central clearing, which is a lot of critics will bring up the issue of concentration risk. So you're taking risk from the dealers and sort of moving it into this one central counterparty. What's your response to that critique?
Darrell: (38:15)
Well, it's true. I mean, you have to say, although it’s considered a pejorativ, the Fixed Income Clearing Corporation is too big to fail and it would become even bigger. So even more importantly, could not fail. You couldn't imagine the chaos that would ensue if the central counterparty for the US treasury market were unable to meet its obligations and had to create an enormous crater on the global financial markets.
So you are putting the onus even more on the safety and soundness of that central counterparty. And I think regulators are up to that. The Fixed Income Clearing Corporation has been designated as systemically important. It’s on the list of Financial Stability Oversight Councils infrastructure that must get too big to fail attention.
I also hear sometimes the misunderstanding that what we would be doing with central counterparties like FICC is to take all of the risk in the market and kind of like bulldoze it into one spot at the central counterparty, making this enormous stack of risk all in one failure point.
That is not a correct metaphor because as you take all of these bilateral purchases and sales and bring them into the central counterparty, all the purchases almost get netted against all the sales, and you get a much smaller stack of risk as a result. The amount of risk goes down enormously. I mentioned a study done by the New York Fed that shows about a 70% reduction in settlement risk in the US Treasury market from doing central clearing. So even though it is true, you're concentrating the risk more in one place, the total amount of risk goes way down.
Joe: (40:08)
So you're here at Jackson Hole with the most impressive audience in the world. I don't mean the Odd Lots hosts and listeners, although hopefully we're fairly impressive as well. But beyond that, is there anything else, like, what are the key things that you hope that your research impresses upon this audience in terms of where to go next with some of this stuff?
Darrell: (40:38)
So I think what you're going to see here at Jackson Hole, or what you have seen by the time that your listeners hear this is a lot of attention on fiscal risks. You're going to see the importance of increasing government debt and how that interplays with inflation risk. The work that we've been discussing today on improving the liquidity of the US Treasury market dovetails well with the topic that I think will be the headline topic here of inflation and sovereign debt risk.
By highlighting the importance of making the US Treasury market and other government government securities markets more resilient to the problems that will arise as we get more and more stress coming from inflation volatility, monetary uncertainty, sovereign debt risk uncertainty, not to mention geopolitical uncertainties. It's kind of a constellation of risks and you wanna build a market that's resilient to those risks. And I think those that prepared the agenda for this meeting thought carefully about bringing all of these topics together in the same symposium.
Tracy: (42:00)
Just on that note, there was one more question I wanted to ask you about all-to-all trading. which is, would the Treasury go for it? Because one of the benefits of the primary dealer model right now is that it is very hard to get a failed auction. In fact, I think it's pretty much impossible. So if you didn't have those primary dealers sort of beholden to the Treasury at a time when the US is expected to sell a lot more debt, that would seem to be a risk.
Darrell: (42:30)
It's certainly something that I've heard some at the largest primary dealers say publicly and in conversations be cautious with changing the structure of this market. Because if dealers are not sufficiently profitable in providing intermediation in the secondary market for US Treasuries where they're traded, then maybe the primary dealers will not participate as actively by committing capital to the primary market, which is where they're issued.
And maybe that would cost us taxpayers more because you wouldn't have a reliable committed buyers at those auctions. That is a risk, but it's not convincing to me that you can sit back and try to sustain the current market structure when the Treasury market is growing bigger and bigger while balance sheets are shrinking relative to GDP, the total US government securities market relative to GDP is going to be about 150% or more according to the projection of the Congressional Budget Office. Whereas dealer balance sheets are shrinking relative to GDP over the last 10 years. That's not sustainable.
So simply to say we don't want to disrupt the current market structure because the dealers won't participate as much in the primary market is not going to fix the problem. The dealers are now taking down on the order of 10% plus or minus in those auctions. That number has been coming down over the years. I predict they'll continue to participate in the market even if there is a change in market structure. But that is not, in my mind, an overriding concern to fixing the market structure.
Tracy: (44:09)
Alright. Well, Darrell Duffie, that was a fantastic overview of a sort of persistently stubborn problem in one of the world's most important markets. So thank you so much for coming on Odd Lots and explaining it to us.
Darrell: (44:21)
Thanks. Terrific conversation, Tracy and Joe.
Tracy: (44:32)
So Joe, I really enjoyed that conversation and you're absolutely right. It's a real treat to hear from the guy that the central bankers are calling in to talk about this. It does seem to be this persistent issue in the market. And you see it happen more and more, these like small bouts of volatility, but they're happening more often.
Joe: (44:52)
Well, and I was really glad you asked that last question because that really crystallized something for me, which is that like we are living in a period of like big fiscal, right? For better or worse. And so it's like, well, what is unsustainable about it? How does that become a stress point?
And to Darrell's point, it's like, if you have this explosion of supply at a time when the entities that are tasked with sort of like managing that supply either have constrained or shrinking balance sheets, then setting aside even like fiscal sustainability or inflation, you are going to run into this infrastructure bottleneck. And it feels like that's really like the challenge here.
Tracy: (45:32)
I think that's exactly right. And I mean, you brought up inflation just then, but this seems to be the other important factor which is, well, maybe that model of trading and dealing in Treasuries worked for a period of very low interest rates where we did have very subdued inflation. But in an era where there is monetary policy tightening, maybe you can't count on the central bank to always backstop the Treasury market. Or if it backstops it, it's going to need to sell some of those Treasuries eventually, then that kind of changes the calculus.
Joe: (46:03)
So we're going to have to do an episode on Israeli government bond market structure. It's like the one country that just, that everyone else saw all this distress. Like I had no idea about that.
Tracy: (46:13)
Yeah, we should actually. Yeah, that'd be really interesting. But for now, shall we head back to the lodge at Jackson Hole?
Joe: (46:15)
Let's do it.