The $24 Trillion Treasury Market Needs More Than Just Clearing

The $24 trillion US Treasury market has gotten too big for even the “Masters of the Universe.” As the Federal Reserve reverses its bond purchase program and more government securities flood back into the hands of dealers, banks, investors and traders, the chances of extreme, unhealthy volatility are rising. We’re at the moment that regulators and market participants have been fearing, which is that there will be more episodes like in March 2020 and September 2019 when parts of the market seized up and prices went haywire. This matters because the Treasury market is considered the most important of all as the foundation for financial assets priced in dollars the world over.

The Securities and Exchange Commission just made the first official move to keep the market from breaking. It proposed on Wednesday to force more trading in government bonds through central clearinghouses. Clearing reduces the risk that either party to a trade will fail to deliver their end of the deal. It can also allow multiple parties to net-off exposures against one another at the same time, which should give everyone more capacity to trade.

If enough banks, investors and other dealers can and do use clearing it will help, but it is no panacea. There are many other changes that should be pursued with the longer term goal of encouraging more market players to be able to trade directly with each other rather than rely so heavily on the 25 primary dealer firms that are obligated to bid at Treasury auctions and authorized to trade with the Fed. The giant US bond fund manager, Pacific Investment Management Co., came out in support of so-called all-to-all trading last week.

The capacity of dealers to intermediate Treasury trading is the core problem and it is making episodes of market stress and dysfunction more frequent, according to a report last year from former central bankers, regulators and academics known as the Group of 30. The panic of March 2020 was particularly extreme: It was when the US and Europe woke up to the severity of the Covid-19 pandemic and led investors to sell almost everything and load up on cash. Instead of acting in their usual role as a haven in times of turmoil, Treasury prices unexpectedly collapsed as liquidity dried up, sending yields soaring.