On the eve of the biggest boom in U.S. bond sales since World War II, cracks are appearing in the exclusive Wall Street club responsible for ensuring the market functions smoothly.

For decades, the firms, known as primary dealers, have sat at the nexus of the Treasuries market, buying newly issued bonds to disseminate throughout financial markets and trading directly with the Federal Reserve. This relationship has helped the Fed implement its policy goals, yet the implosions of recent months suggest that the group is under duress.

Dominated by big banks like JPMorgan Chase & Co. and Goldman Sachs Group Inc., the 24 primary dealers struggled to keep money moving within the core of global finance during the coronavirus panic in March. The Fed deployed a series of unprecedented interventions in response, including trillions of dollars worth of emergency funds -- and inadvertently fueled debate on the need for reform.

One proposed solution: end Wall Street’s near-monopoly on club membership. Bond giant Pacific Investment Management Co. argues that asset managers should be included in the group. That could benefit the Newport Beach, California-based firm and would add trillions of dollars to the collective firepower of primary dealers, further boosting the influence of these investing behemoths.

“Certainly increasing the number of primary dealers would be useful. Instead of increasing it to smaller dealer financial institutions, widening it out to larger asset managers seems a better bang for your buck,” Pimco economist Tiffany Wilding said in an interview. “The Fed’s programs and policies will be more efficiently transmitted throughout the financial system if it opens up its operations to a broader set of counterparties.”

Record Supply
Because primary dealers are obliged to buy new Treasuries when they’re auctioned, they’ll be critical to helping absorb the record supply of debt the U.S is selling to rescue the economy from the ruin of the pandemic. On Monday, the federal government said its debt load will rise by a record $3 trillion between the end of March and June.

It doesn’t look like money is getting where it’s needed in times of stress -- or not without massive intervention by the central bank. In March, Treasuries market makers -- traditionally banks, which can no longer trade as freely given post-financial crisis regulations -- were overwhelmed as volatility spiked to levels last seen in 2009, siphoning liquidity from the longest-dated bonds. That seizure came barely six months after convulsions in the repo market, where much of the trading in Treasuries is financed.

Treasury-market volatility spiked to a post-2009 high last month
The solution for the Treasury market could lie in loosening roles that the New York Fed has cultivated over the decade of recovery from the last recession. That’s how the central bank in 2013 tackled the excess funds sloshing around the system after three rounds of quantitative easing, bringing money managers into the fold as counterparties for reverse-repo operations to help drain some of that cash.

Looking ahead, it might allow asset managers to qualify for operations in which it adds credit to the banking system by borrowing Treasuries and mortgages from primary dealers. Wilding’s among those who say asset managers would be particularly well situated to participate in this, given they have the capacity both to offer securities in bulk to the New York Fed and to distribute the funds.

But for the Fed to expand its trading counterparties, it’d have to be confident in the safety and soundness of that institution. Any asset manager would need sufficient scale, and safeguards against any conflicts across their businesses.

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