The market for U.S. Treasury securities is arguably the world’s most important: a haven for investors in turbulent times, and a benchmark for virtually all other assets. Yet it’s facing increasing strains, as the government’s unsustainable borrowing and the Federal Reserve’s quantitative tightening flood it with trillions of dollars of debt.
To ensure the Treasury market doesn’t become a source of instability, U.S. authorities need to make some adjustments. Quickly.
Treasuries are popular in part because they’re typically extremely liquid, meaning they’re easy to buy and sell without causing big price swings. This feature depends, in part, on a small group of big banks, known as primary dealers, standing ready to trade and to hold large quantities of securities on their balance sheets. In recent years, though, the sheer volume of outstanding government debt, together with more stringent capital requirements, has rendered dealers less able to play their traditional role, particularly when there are sudden surges in activity and increased price volatility.
Other participants also now play a bigger role, and that has added to the fragility. Algorithmic trading firms provide illusory liquidity, holding securities for mere microseconds and withdrawing precisely at the volatile moments when their presence is most needed to make markets. Meanwhile, hedge funds employ vast leverage to exploit small discrepancies between Treasury prices in cash and futures markets. This “basis trade” makes the market more efficient, but also entails a big risk that, in volatile times, the funds will have to sell large quantities of Treasuries to meet collateral calls on their borrowings. Such forced selling could be destabilizing, given the size and concentration of the positions.
What to do? I see three ways to mitigate the risks.
First, someone with a highly expandable balance sheet must provide real, reliable liquidity. To that end, the Fed should allow all holders of Treasuries to access its standing repo facility, where it lends money against the collateral of government securities. This would allow hedge funds and others to raise cash quickly without needing to sell en masse. To ensure it would be used only as a backstop, the Fed should charge a slightly higher interest rate than what normally prevails in repo markets. Instead of trying to interact directly with the broader set of market participants, the Fed could employ primary dealers as agents, without burdening their balance sheets.
Second, the government should require that all Treasury transactions be routed through a central clearinghouse, which stands between counterparties and ensures that adequate collateral is collected. This makes it easier for a broader group of participants to trade directly, without worrying about one another’s creditworthiness. It also consolidates a complex web of bilateral obligations into a much smaller net exposure to the central counterparty, reducing the overall risk in the system.
Third, set initial collateral requirements for leveraged Treasury positions high enough so that they needn’t be increased during bouts of volatility. This would limit the potential for excessive hedge fund leverage and reduce the risk of vicious cycles in which rising collateral demands and forced selling compound one another. The right level would depend on how much regulators want to reduce the probability of distress. If my recommendations on standing repo and central clearing were adopted, the requirements presumably could be less stringent.
Ideally, the government would do its part by getting its fiscal policy in order. Unfortunately, Congress appears unlikely to do so anytime soon—unless the bond market vigilantes return in enough force to compel a constructive response. All the more reason to address the market’s vulnerabilities before trouble arises. The Fed’s involvement, together with the other fixes I’ve suggested, should calm nerves and reduce the risk of a market meltdown.
Bill Dudley, a Bloomberg Opinion columnist, served as president of the Federal Reserve Bank of New York from 2009 to 2018. He is the chair of the Bretton Woods Committee, and has been a nonexecutive director at Swiss bank UBS since 2019.