How safe is global finance?
By Praveen Kumar
When Mark Carney stepped down as governor of the Bank of England on March 15 2020, financial markets were in free fall brought by the Covid-19 crisis. Mark Carney, the chief architect in making global financial institutions much more resilient to shocks after the financial crisis when he chaired the Basel-based Financial Stability Board. He should be a happy man seeing that during the Covid crisis, no major global financial institution failed and was able to absorb shock rather than amplify the health crisis into a financial meltdown. So, is it safe to assume that the global financial system is secure and resilient?
In March 2020, as the world grappled with the gravity of the Covid crisis, something bizarre happened in the US Treasury market. Typically, investors dump risky investments during the crisis and put money into safe havens like US government bonds. In response, the yield on US government bonds typically goes down during turmoil. Instead, there was a large sell-off of Treasuries, causing the bond yields to shoot up in March 2020, rattling the investors. Bond yields move inverse to the bond price, if the price goes up, the yield falls and vice-versa. After hitting an all-time low of 0.32% on March 9, 10-year Treasury yields jumped almost a percentage point, hitting 1.27% on March 19. The yield spike is due to the massive dumping of Treasuries at a time of high risk, precisely when the investors are expected to buy Treasuries.
Treasury market volatility spiked massively as the banks and dealers had lesser capacity to absorb the relentless Treasury selling due to the post-financial crisis regulatory constraints levied on them. The higher volatility caused the bid-ask spread for the Treasuries to widen. According to New York Fed, the bid-ask spread widened by six times the post-crisis average for 30-year Treasuries and doubled for 10-year Treasuries. As a result, the world's most liquid financial market came under severe strain, suffered from a bout of illiquidity and looked broken.
This happened in the backdrop of the repo market turmoil in September 2019. Repo rate unusually spiked to as high as 10% during the day, more than four times the Fed funds rate of 2-2.25% at the time. The repo rate spike was unusual as the repo rate generally ranges within the Fed funds rate.
The $21 Trillion US Treasury market is the bedrock of the global financial system. US Treasury market is the world's largest, safest, most liquid and most important bond market. US government bonds act as a safe haven for investors during the market turmoil. It serves as a benchmark for the interest rates that consumers, businesses, and governments across the globe pay for the borrowings. For the stability of the global financial system, the smooth functioning of the US Treasury market is paramount.
Only the Federal Reserve's aggressive intervention saved the accident from turning into a full-blown financial crisis. As the severe dislocation is evident during March 2020, the Fed effectively cut the interest rate to zero, pledged to purchase at least $700 billion assets as part of a new round of Quantitative Easing, relaxation of SLR capital requirement for banks and unlimited repo financing for dealers Treasury position. These measures by the Fed helped in smoothening the market functioning. In response, Fed's total assets expanded from $4.2 trillion at the starting of March 2020 to $8.0 trillion in June 2021.
What caused the bond market breakdown?
The supply-demand mismatch explains what went wrong in the world's largest financial market. In March 2020, due to uncertainty about the virus and the future economic outlook, investor's dash for cash resulted in the massive selling of Treasuries. The dealers could not intermediate the market safely, as the sale of Treasuries exceeded dealers' capacity to intermediate, overwhelming the bond market.
The Fed noted in May 2020 Financial Stability Report, "As investors sold less-liquid Treasury securities to obtain cash, dealers absorbed large amounts of these Treasury securities onto their balance sheets. It is possible that some dealers reached their capacity to absorb these sales, leading to a deterioration in Treasury market functioning."
Unlike stocks, bonds do not trade much through exchanges. Instead, bonds trade majorly over-the-counter (OTC) through the large broker-dealers, making bond trading highly susceptible to the dealer's regulatory changes. The financial crisis of 2008-09 gave rise to banking regulatory reforms to improve financial stability and avoid taxpayers funded bailouts of financial institutions. However, regulatory reforms constrained the banks' ability to use their balance sheet to intermediate the market safely. The banks' balance sheet growth failed to keep pace with outstanding marketable Treasuries growth. The ratio of total outstanding marketable Treasuries to positions financed by primary dealers stood around 2.5 times before Financial Crisis 2008-09, in 2018 it peaked nearly 10 times.
Things could turn for worse ahead, as the total outstanding Treasuries are projected to grow at an even higher rate. According to Congressional Budget Office, the projected US budget deficit between 2021-2031 totalled $14.6 trillion. As a result, the Treasury market will be more prone to March 2020 like events with higher frequency and magnitude.
The Fed had successfully rescued the Treasury market in March 2020. However, rather than reforming the Treasury market structure, expecting the Fed to rescue the market during the next crisis would result in moral hazard and impair the Treasury status as a safe haven. The health crisis has shown that the world's most important financial market's health is in crisis and needs to be upgraded.
Need for reforming Treasury market
Rather than extending the SLR relief, the Fed allowed temporary SLR relief to expire in March 2021. Relaxing the post-financial crisis banking regulations to improve the functioning of the Treasury market looks unlikely under the Biden administration.
Expanding the role of central clearing in Treasuries would result in better inter-mediation of Treasury trading. Central Clearing Party (CCP) is a financial market utility, acts as an intermediary between buyers and sellers of financial instruments. Only 22.4% of Treasury transactions go through the CCP, compared to 100% of exchange-traded derivatives and equities, and a majority of standard interest rate derivatives are cleared centrally.
A recent report published by the New York Fed finds that central clearing of US Treasuries could have avoided much of the strain on the system during the March 2020 turmoil.
Netting of trades in central clearing reduces the dealer settlement obligations. The report finds that central clearing of all the trades would lower dealers daily gross settlement obligations by $332 billion (60% reduction) in the weeks preceding and following the market disruption in March and by $791 billion (69% reduction) on March 30 when the trading was at its highest.
CCP reduces the settlement failures, and counter party risk as the CCP becomes the counter party to every trade, increases market transparency, improves financial stability, and reduces dealers' balance sheet dependence. 2008-09 Financial crisis had shown such upgrades of market structures could be successful without impacting the market's liquidity.
The dollar remains the world's reserve currency and the most used currency for international trade. The dollar's strength is partly derived from the safe-haven status of US government debt. The creaking structure of the US bond market would have far-reaching consequences outside the US. US Treasuries remain the bedrock of global finance. The world needs the US Treasury market to function smoothly, at least till the dollar hegemony in global finance remains.
The author is currently pursuing PGP in Public Policy from the Takshashila Institution. Views are personal and do not represent Takshashila’s policy recommendations