How Can Policymakers Improve the Functioning of the U.S. Treasury Market?
The U.S. Treasury market, while considered the deepest and most liquid in the world, has proved vulnerable to serious disruptions in recent years, epitomized by the turmoil in March 2020, when intense selling pressure overwhelmed securities dealers’ balance sheets, causing volatility to spike, spreads to gape, and liquidity to evaporate. At times it was easier to sell investment grade corporate bonds than older, “off-the-run” Treasury bonds. While policymakers have focused on the Treasury market’s problems since March 2020, few substantive changes have been made. Here, we discuss what we believe are the most and least effective measures that policymakers can pursue to help the functioning of this important market.
What are we solving for?
First, it is important to define what policymakers should be solving for. As one of the largest participants in the Treasury market, PIMCO views market liquidity – the ability to buy and sell bonds efficiently, continuously, and economically – as that market’s biggest challenge. While there is ample liquidity when market conditions are good, that liquidity is fickle and disappears quickly under stressed conditions.
In short, the Treasury market functions spectacularly well – until it does not.
Remember that most Treasuries – and other bonds – are not traded on an exchange like shares of stock. Treasuries mostly trade “over the counter,” a transaction negotiated between dealers (i.e., large banks) and end-users (such as asset managers, sovereign wealth funds, or pension funds) – either electronically or, for some segments of the bond market, like off-the-run Treasuries, over the phone. Practically, this means that end-users largely depend on dealers to make markets in Treasury bonds. Usually, dealers are eager to make markets – to buy and sell Treasury bonds to end-users. But in times of stress, such as in March 2020, their willingness and ability often disappear. Put differently, the dealer community still controls the risk-transfer mechanism, particularly in off-the-run Treasury bonds.
Assuming policymakers’ primary goal is to avoid another market seizure, we believe they should focus on reforms that can improve liquidity and evolve the existing Treasury market structure. In that spirit, we advocate policymakers consider 1) broadening access to Federal Reserve (Fed) sponsored programs, such as the standing repurchase (repo) facility and bond buying programs, to inject liquidity into the market more directly and efficiently in times of crisis; 2) increasing dealer balance sheet capacity by tweaking existing bank regulations to allow dealers to make markets in Treasury bonds more readily; and 3) while seemingly quixotic, using the convening authority of policymakers (e.g., the Financial Stability Oversight Council, or FSOC) to help advance “all-to-all” trading – a system in which all market participants are able to trade with each other, bypassing the dealers in some cases. We also discuss efforts that policymakers are considering that we do not believe will bolster liquidity, including: 1) requiring cash clearing of Treasuries, and 2) instituting real-time reporting of Treasury transactions.