The $25.8 trillion market for US Treasury debt is like the circulatory system for the world’s financial markets — everything else relies on it. In recent years blockages have occasionally formed, and central banks have had to step in to restore the money flow. Now, as Treasury prices adjust to a surge in federal borrowing and a changing outlook for long-term interest rates, it’s essential that policymakers keep the market healthy.
The diagnosis is relatively simple. For decades the market has depended on a group of so-called primary dealers (today there are 24) to maintain order during times of stress. But the size of the market has exploded in the past decade, at the same time as new rules have set limits on banks’ leverage, curbing their capacity to take on assets. Meanwhile, as primary dealers’ holdings have shrunk, principal trading firms, hedge funds and other nonbanks have stepped in to play a bigger role.
Unlike the primary dealers, these firms and funds have no obligation to help make markets and their activities are less visible to regulators. That leaves policymakers scrambling for emergency solutions — as when a shock from the Covid-19 pandemic drove investors, including highly leveraged hedge funds, to sell Treasuries in a “dash for cash” in 2020. Regulators are considering ways to discourage such risks from building, including pressing banks to gather data and curb lending to hedge funds.
Sustainable cures are overdue. Policymakers should act on four fronts to help keep the market functioning smoothly.
As a start, the Securities and Exchange Commission should focus on central clearing for Treasuries. By acting as a trusted middleman, clearinghouses mitigate the risk of counterparties failing to make good on trades. Yet less than a quarter of Treasury trades are centrally cleared, compared with nearly all trades in markets such as exchange-traded derivatives and equities.