1 00:00:11,000 --> 00:00:14,160 Speaker 1: Hello, and welcome to another episode of the Odd Lots Podcast. 2 00:00:14,240 --> 00:00:16,440 Speaker 2: I'm Tracy Alloway and I'm Joe Wisenthal. 3 00:00:16,720 --> 00:00:18,920 Speaker 1: Joe, have you been watching treasury yield s lately? 4 00:00:19,200 --> 00:00:19,320 Speaker 3: Uh? 5 00:00:19,480 --> 00:00:22,080 Speaker 2: They're up, They've I'm that's it. 6 00:00:22,120 --> 00:00:23,239 Speaker 1: That's the show where. 7 00:00:23,079 --> 00:00:25,160 Speaker 2: That the line has gone up into the right lance. 8 00:00:25,239 --> 00:00:28,960 Speaker 1: Yes, but not just that, they've moved quite quickly up. 9 00:00:29,040 --> 00:00:32,200 Speaker 1: And I think volatility in the treasury market has once 10 00:00:32,280 --> 00:00:35,479 Speaker 1: again become a talking point. And I always get a 11 00:00:35,520 --> 00:00:38,519 Speaker 1: little bit of a sense of deja vu because whenever 12 00:00:38,560 --> 00:00:42,800 Speaker 1: things start happening in the market for US government bonds, 13 00:00:42,840 --> 00:00:46,800 Speaker 1: extreme things, these extreme moves, it feels like everyone says, Oh, 14 00:00:46,800 --> 00:00:49,240 Speaker 1: they shouldn't be happening in the world's most liquid market, 15 00:00:49,320 --> 00:00:52,320 Speaker 1: the world's safest market. We shouldn't be seeing these types 16 00:00:52,479 --> 00:00:54,240 Speaker 1: of dramatic shifts, right. 17 00:00:54,440 --> 00:00:58,000 Speaker 2: The expectation is this is like a very extremely liquid, 18 00:00:58,240 --> 00:01:00,320 Speaker 2: slow moving market. But it has been a very fast 19 00:01:00,360 --> 00:01:02,440 Speaker 2: move and people don't really know why. There's a lot 20 00:01:02,480 --> 00:01:04,840 Speaker 2: of debate. You have people talk about, well, look, the 21 00:01:04,880 --> 00:01:07,759 Speaker 2: economy is proving to be more resilient than people might 22 00:01:07,800 --> 00:01:11,240 Speaker 2: have guessed six months ago, even a month ago. And 23 00:01:11,319 --> 00:01:13,920 Speaker 2: I think there's this expectation. There's this sense that things 24 00:01:13,959 --> 00:01:16,520 Speaker 2: are moving faster. There's also a lot of talk about 25 00:01:16,640 --> 00:01:21,320 Speaker 2: treasury supply, supplied demand imbalances and so forth. So things 26 00:01:21,360 --> 00:01:23,360 Speaker 2: are on the move, to say the least, and you 27 00:01:23,400 --> 00:01:26,200 Speaker 2: see it in mortgage spreads are very wide. You see 28 00:01:26,240 --> 00:01:30,000 Speaker 2: it another risk assets not seeming to like this treasury volatility. 29 00:01:30,080 --> 00:01:31,560 Speaker 2: So lots going on there. 30 00:01:31,600 --> 00:01:34,199 Speaker 1: So you mentioned a couple of things there, which is, yes, 31 00:01:34,240 --> 00:01:37,880 Speaker 1: the economy seems to be doing relatively well, and yes, 32 00:01:38,160 --> 00:01:41,800 Speaker 1: the amount of treasury supply is exploding and has been 33 00:01:41,880 --> 00:01:45,039 Speaker 1: going up for a very long time. There's another factor here, 34 00:01:45,160 --> 00:01:49,000 Speaker 1: which is the actual inner workings of the treasury market, 35 00:01:49,080 --> 00:01:52,280 Speaker 1: so how treasuries are actually traded and whether or not 36 00:01:52,400 --> 00:01:56,120 Speaker 1: that is potentially contributing to some of the volatility that 37 00:01:56,160 --> 00:01:59,200 Speaker 1: we've seen. And again, I feel like this topic keeps 38 00:01:59,360 --> 00:02:02,440 Speaker 1: coming up every year there's some massive move in treasury 39 00:02:02,480 --> 00:02:06,120 Speaker 1: markets and everyone starts talking about liquidity issues, and yet 40 00:02:06,240 --> 00:02:10,440 Speaker 1: you don't really see any big solutions being proposed to it. 41 00:02:10,560 --> 00:02:13,160 Speaker 1: You see talk about, you know, maybe loosening some of 42 00:02:13,200 --> 00:02:16,600 Speaker 1: the regulation around supplementary leverage ratio or something like that, 43 00:02:16,680 --> 00:02:18,680 Speaker 1: But it feels like we need to talk about this 44 00:02:18,800 --> 00:02:20,600 Speaker 1: and maybe try to come up with a solution. 45 00:02:20,680 --> 00:02:22,440 Speaker 2: Let's do it, and we're in a good place to 46 00:02:22,440 --> 00:02:23,000 Speaker 2: talk about it. 47 00:02:23,080 --> 00:02:24,640 Speaker 1: Yes, we're at Jackson Hole. 48 00:02:25,320 --> 00:02:26,639 Speaker 2: I thought you were. I thought that was going to 49 00:02:26,680 --> 00:02:29,120 Speaker 2: be the first is like Jackson I like how you 50 00:02:29,200 --> 00:02:30,720 Speaker 2: like we eat it into it a little bit. 51 00:02:30,840 --> 00:02:33,280 Speaker 1: Oh, I want this to be an evergreen episode for 52 00:02:33,320 --> 00:02:35,680 Speaker 1: an evergreen problem. It feels like, but. 53 00:02:35,760 --> 00:02:37,280 Speaker 2: The people here care about this topic. 54 00:02:37,440 --> 00:02:42,280 Speaker 1: Yes, absolutely. The way US treasury debt is traded has 55 00:02:42,440 --> 00:02:46,440 Speaker 1: a lot of implications, particularly for the cost of financing 56 00:02:47,080 --> 00:02:49,600 Speaker 1: the US deficit. That's an obvious one, and so we 57 00:02:49,639 --> 00:02:50,360 Speaker 1: should talk about it. 58 00:02:50,440 --> 00:02:51,160 Speaker 2: Let's talk about it. 59 00:02:51,280 --> 00:02:54,080 Speaker 1: I'm very pleased to say that we have the perfect guest. 60 00:02:54,280 --> 00:02:56,560 Speaker 1: We are going to be speaking with Darryl Duffy. He is, 61 00:02:56,600 --> 00:03:00,000 Speaker 1: of course, a professor of finance at Stanford's Graduate School 62 00:03:00,240 --> 00:03:03,800 Speaker 1: of Business, and he is presenting a paper at Jackson 63 00:03:03,840 --> 00:03:07,399 Speaker 1: Hole in front of the world's top central bankers all 64 00:03:07,440 --> 00:03:11,000 Speaker 1: about this issue. It's called Resilience reducs in the US 65 00:03:11,040 --> 00:03:13,960 Speaker 1: Treasury market. So, Darryl, thank you so much for coming on. 66 00:03:14,000 --> 00:03:17,600 Speaker 3: All thoughts, thanks for having me, Tracy, Joe, It's terrific. 67 00:03:17,240 --> 00:03:19,359 Speaker 2: To be here, you know, it's the perfect guest when 68 00:03:19,400 --> 00:03:21,280 Speaker 2: it's the guest, and it's like not just it, like 69 00:03:21,320 --> 00:03:22,880 Speaker 2: we want to have him on odd laws that the 70 00:03:22,960 --> 00:03:26,000 Speaker 2: central the top central banker is around the world want 71 00:03:26,040 --> 00:03:29,080 Speaker 2: to hear from a Professor Duffy. So yes on this issue. 72 00:03:29,160 --> 00:03:30,840 Speaker 2: I'm very excited about this episode. 73 00:03:30,919 --> 00:03:34,760 Speaker 1: When treasuries are moving, they call up Daryl Duffy. All right, well, professor, 74 00:03:35,240 --> 00:03:37,720 Speaker 1: thank you again for coming on. Why don't we just 75 00:03:38,080 --> 00:03:40,800 Speaker 1: start with the basics. You know, we sort of alluded 76 00:03:40,840 --> 00:03:43,200 Speaker 1: to this in the intro, but it feels like this 77 00:03:43,240 --> 00:03:46,360 Speaker 1: is a subject that just keeps coming up and never 78 00:03:46,440 --> 00:03:48,640 Speaker 1: really seems to go away. What's going on here? 79 00:03:49,000 --> 00:03:53,120 Speaker 3: Well, over the past century, there have been, as you suggested, 80 00:03:53,160 --> 00:03:57,000 Speaker 3: many episodes of increased volatility and liquidity problems in the 81 00:03:57,040 --> 00:03:59,800 Speaker 3: treasury market, but I do think these are happening more frequently. 82 00:04:00,160 --> 00:04:02,600 Speaker 3: Just recently. I think you summarized pretty well some of 83 00:04:02,640 --> 00:04:06,320 Speaker 3: the stresses in the treasury market coming from the fiscal side. 84 00:04:06,360 --> 00:04:10,240 Speaker 3: The US is issuing more than people expected, there was 85 00:04:10,280 --> 00:04:14,320 Speaker 3: a recent downgrade by Fitch, and the Fed is struggling 86 00:04:14,440 --> 00:04:18,039 Speaker 3: with what to do about inflation. That additional monetary policy 87 00:04:18,080 --> 00:04:22,839 Speaker 3: uncertainty also contributes to volatility. Let me back up a minute. 88 00:04:22,920 --> 00:04:25,080 Speaker 3: I just spent most of the last year on a 89 00:04:25,080 --> 00:04:29,120 Speaker 3: sabbatical at the New York FED and working with some 90 00:04:29,240 --> 00:04:36,039 Speaker 3: terrific economists there, Michael Fleming, Frank Keene or Shekhar, Peter 91 00:04:36,160 --> 00:04:39,760 Speaker 3: von tassl Claire Nelson. We decided we needed to look 92 00:04:39,800 --> 00:04:44,279 Speaker 3: into the relationship between the volatility that you two discussed 93 00:04:44,600 --> 00:04:48,560 Speaker 3: and the liquidity in the market. They're closely intertwined. So 94 00:04:48,839 --> 00:04:51,279 Speaker 3: we dug deep and went into a lot of data, 95 00:04:51,279 --> 00:04:55,000 Speaker 3: and yeah, volatility seems to be the main determinant of 96 00:04:55,040 --> 00:04:58,599 Speaker 3: lil liquidity in the market. So when fiscal uncertainty or 97 00:04:58,720 --> 00:05:03,360 Speaker 3: debt ceiling debate, or a COVID crisis or monetary policy 98 00:05:03,440 --> 00:05:09,320 Speaker 3: uncertainty start to get a volatility higher and higher, market 99 00:05:09,360 --> 00:05:13,000 Speaker 3: becomes less and less liquid. It's an extremely regular relationship. 100 00:05:13,000 --> 00:05:17,839 Speaker 3: About eighty percent of illiquidity is explained simply by variation 101 00:05:18,000 --> 00:05:19,520 Speaker 3: and yield volatility. 102 00:05:19,720 --> 00:05:24,600 Speaker 2: So just to press on this relationship between rates volatility 103 00:05:24,640 --> 00:05:29,039 Speaker 2: or yield volatility and illiquidity, like which way does the 104 00:05:29,080 --> 00:05:31,520 Speaker 2: direction run? Or because we can come up with these 105 00:05:31,640 --> 00:05:34,680 Speaker 2: fundamental stories right, like Okay, maybe the economy is better 106 00:05:34,720 --> 00:05:37,839 Speaker 2: than expected. Maybe we're going to have more rate hikes 107 00:05:37,880 --> 00:05:40,599 Speaker 2: than previously anticipated, in which case you say, okay, well 108 00:05:40,600 --> 00:05:43,880 Speaker 2: that's sort of like that's a fundamental story of fundamental driver. 109 00:05:44,240 --> 00:05:46,880 Speaker 2: And then you could look at certain nature of the structure, 110 00:05:46,960 --> 00:05:49,680 Speaker 2: like the size of dealer balance sheets, et cetera. It's like, okay, well, 111 00:05:49,720 --> 00:05:53,680 Speaker 2: this is something technical that contributes to also could be 112 00:05:53,680 --> 00:05:56,560 Speaker 2: a contributor to volatility. How do you think about like 113 00:05:56,800 --> 00:05:59,800 Speaker 2: the directions of causality when you look into a problem. 114 00:05:59,440 --> 00:06:04,240 Speaker 3: Like this, Yeah, well, both the direct fundamentals, fiscal monetary 115 00:06:04,279 --> 00:06:08,640 Speaker 3: fundamentals and global the global economy and geopolitics recently all 116 00:06:08,640 --> 00:06:11,800 Speaker 3: play a direct fundamental role. And then, as you alluded, 117 00:06:12,240 --> 00:06:15,800 Speaker 3: there's also kind of a feedback effect. When volatility rises 118 00:06:15,800 --> 00:06:20,200 Speaker 3: for fundamental reasons, dealers are going to struggle with providing 119 00:06:20,200 --> 00:06:24,320 Speaker 3: sufficient liquidity to the market, and to the extent that 120 00:06:24,400 --> 00:06:28,600 Speaker 3: dealer balance sheets are not sufficiently flexible to accommodate the 121 00:06:28,640 --> 00:06:31,279 Speaker 3: provision of liquidity to the market, that in and of 122 00:06:31,320 --> 00:06:36,440 Speaker 3: itself increases illiquidity, increases volatility, and they kind of feedback 123 00:06:36,480 --> 00:06:39,080 Speaker 3: on themselves, and you can get an episode like we 124 00:06:39,279 --> 00:06:43,839 Speaker 3: had when COVID hit in March twenty twenty, where liquidity 125 00:06:43,880 --> 00:06:48,360 Speaker 3: becomes even worse than would be suggested by volatility alone, 126 00:06:48,480 --> 00:06:51,000 Speaker 3: much worse. And that's just a sign that the market 127 00:06:51,040 --> 00:06:56,720 Speaker 3: is not capable of intermediating those extreme demands for liquidity. 128 00:06:56,960 --> 00:07:01,200 Speaker 1: Right. So, this seems to be a distinct characteristic of 129 00:07:01,360 --> 00:07:05,280 Speaker 1: treasuries in particular, which is when stuff starts to go 130 00:07:05,440 --> 00:07:08,599 Speaker 1: really wrong like it did in March of twenty twenty, 131 00:07:09,000 --> 00:07:13,200 Speaker 1: people often sell the safest stuff first, which means they 132 00:07:13,320 --> 00:07:16,280 Speaker 1: sell treasury. So you get this big wave of selling 133 00:07:16,480 --> 00:07:19,240 Speaker 1: at precisely the moment that a lot of dealers want 134 00:07:19,280 --> 00:07:23,120 Speaker 1: to wind down or back away from risk. Is that 135 00:07:23,280 --> 00:07:26,520 Speaker 1: just a fundamental tension in the market. Is that always 136 00:07:26,560 --> 00:07:27,360 Speaker 1: going to be the case? 137 00:07:27,720 --> 00:07:30,960 Speaker 3: As long as US treasuries are the world's most important 138 00:07:31,000 --> 00:07:35,080 Speaker 3: safe haven, which is clearly the case by Miles, that's 139 00:07:35,120 --> 00:07:39,160 Speaker 3: always going to be the result for basically two reasons. 140 00:07:39,240 --> 00:07:42,760 Speaker 3: Number One, a whole lot of major investors like foreign 141 00:07:42,800 --> 00:07:48,080 Speaker 3: exchange reserve managers firms that are storing a safe liquid 142 00:07:48,160 --> 00:07:51,320 Speaker 3: asset just in case, Well, the just in case happened, 143 00:07:51,800 --> 00:07:54,760 Speaker 3: and they are going to liquidate those positions. The other 144 00:07:55,120 --> 00:07:59,239 Speaker 3: channel for this is as the volatility grows and uncertainty grows, 145 00:08:00,120 --> 00:08:02,640 Speaker 3: of investors are you know, kind of finding it too 146 00:08:02,720 --> 00:08:05,240 Speaker 3: hot to handle and they have to unload some risk, 147 00:08:05,320 --> 00:08:08,960 Speaker 3: and treasuries are the easiest security to unload in the world. 148 00:08:08,960 --> 00:08:12,120 Speaker 3: The market's got a good reputation for being the deepest 149 00:08:12,120 --> 00:08:14,400 Speaker 3: and most liquid market in the world. 150 00:08:14,240 --> 00:08:16,560 Speaker 2: So I know, we we've talked about this a little 151 00:08:16,560 --> 00:08:19,320 Speaker 2: bit in the past with a few different guests, including 152 00:08:19,520 --> 00:08:21,920 Speaker 2: Josh Younger. He made the point on one of the 153 00:08:21,920 --> 00:08:24,160 Speaker 2: episodes that we did, which is like, if you're thinking about, 154 00:08:24,200 --> 00:08:26,520 Speaker 2: like what do we want to do to have better 155 00:08:26,600 --> 00:08:30,800 Speaker 2: treasury market structure, that it doesn't necessarily make sense to 156 00:08:30,920 --> 00:08:33,440 Speaker 2: optimize for well, we never want to have a March 157 00:08:33,480 --> 00:08:36,680 Speaker 2: twenty twenty again, because you don't necessarily want to have, 158 00:08:37,160 --> 00:08:39,440 Speaker 2: you know, optimized for the one out of every one 159 00:08:39,559 --> 00:08:42,600 Speaker 2: hundred year pandemic. But what would you say, like is 160 00:08:42,640 --> 00:08:45,040 Speaker 2: the goal, Like if you're like, okay, there does seem 161 00:08:45,040 --> 00:08:49,040 Speaker 2: to be this relationship between volatility and illiquidity. It does 162 00:08:49,080 --> 00:08:52,120 Speaker 2: seem like some of these bouts of volatility and illiquidity 163 00:08:52,280 --> 00:08:55,439 Speaker 2: become more frequent. If you think about designing sort of 164 00:08:55,520 --> 00:08:59,199 Speaker 2: an optimal market structure for treasuries, what would you say 165 00:08:59,200 --> 00:08:59,880 Speaker 2: we're trying. 166 00:08:59,640 --> 00:09:02,640 Speaker 3: To each Josh I've known him since you worked at 167 00:09:02,720 --> 00:09:05,120 Speaker 3: JP Morgan, and now that he's moved to the FED, 168 00:09:05,160 --> 00:09:07,280 Speaker 3: we get to talk a lot more. This is a 169 00:09:07,400 --> 00:09:10,400 Speaker 3: terrific insight that he has, the kind of do you 170 00:09:10,600 --> 00:09:12,679 Speaker 3: really want to design a market for the worst day 171 00:09:12,679 --> 00:09:15,760 Speaker 3: in a thousand? Isn't that very expensive? And maybe overdoing 172 00:09:15,760 --> 00:09:18,840 Speaker 3: it because nine ninety nine days out of a thousand 173 00:09:18,880 --> 00:09:21,720 Speaker 3: you didn't really need that kind of a market structure. 174 00:09:21,840 --> 00:09:24,760 Speaker 3: I'm going to be a little provocative here. I think 175 00:09:24,800 --> 00:09:26,680 Speaker 3: you do want to build a market for the worst 176 00:09:26,760 --> 00:09:29,920 Speaker 3: day in a thousand for the following reason. If I'm 177 00:09:30,280 --> 00:09:33,800 Speaker 3: let's say, managing the foreign exchange reserves of an emerging 178 00:09:33,840 --> 00:09:36,800 Speaker 3: market central bank, when do I need to actually take 179 00:09:36,840 --> 00:09:39,760 Speaker 3: advantage of the depth and liquidity of the US Treasury market. 180 00:09:40,080 --> 00:09:42,640 Speaker 3: It's that one day in a thousand when all the 181 00:09:42,720 --> 00:09:46,400 Speaker 3: other safe haven investors are trying to do the same thing. 182 00:09:47,400 --> 00:09:50,280 Speaker 3: In the paper on that Tracy mentioned I'm giving here 183 00:09:50,280 --> 00:09:53,800 Speaker 3: at Jackson Hole, I talk about this wrong way risk 184 00:09:54,000 --> 00:09:57,439 Speaker 3: from the viewpoint of illiquidity. You don't want the market 185 00:09:57,559 --> 00:10:00,720 Speaker 3: to be great except on that very same regular day 186 00:10:01,360 --> 00:10:05,800 Speaker 3: on which everybody needs the liquidity. Why not? Well, because 187 00:10:06,080 --> 00:10:09,640 Speaker 3: a this is the lynchpin of global financial market stability. 188 00:10:09,679 --> 00:10:12,840 Speaker 3: You wanted to work day in, day out, and b 189 00:10:13,280 --> 00:10:17,640 Speaker 3: If you discourage safe haven investors from believing that even 190 00:10:17,679 --> 00:10:20,720 Speaker 3: though everybody else is liquidating that day, they could also 191 00:10:20,800 --> 00:10:24,000 Speaker 3: liquidate at low cost with ease, then they won't use 192 00:10:24,040 --> 00:10:27,240 Speaker 3: the US Treasury security as much as they're safe haven. 193 00:10:28,200 --> 00:10:31,080 Speaker 3: They'll diversify. And that's what we've been seeing somewhat over 194 00:10:31,080 --> 00:10:34,320 Speaker 3: the last couple of decades, a degree of diversification away 195 00:10:34,360 --> 00:10:38,839 Speaker 3: from the US Treasury, still by far the dominant safe haven. 196 00:10:39,600 --> 00:10:42,360 Speaker 3: Something like fifty nine percent of foreign exchange reserves are 197 00:10:42,360 --> 00:10:44,319 Speaker 3: held in US treasuries. But from the viewpoint of the 198 00:10:44,440 --> 00:10:47,480 Speaker 3: US taxpayer, you want everyone to believe that on the 199 00:10:47,520 --> 00:10:49,480 Speaker 3: worst day NF thousand, that market is going to be 200 00:10:49,520 --> 00:10:50,520 Speaker 3: there for them. 201 00:10:50,840 --> 00:10:53,880 Speaker 1: Wait, I'm going to be provocative now or try to. Okay, 202 00:10:54,120 --> 00:10:57,480 Speaker 1: So on this note, we did see in March twenty twenty, 203 00:10:57,559 --> 00:11:02,200 Speaker 1: the FED unveiled all these different emergency programs aimed at 204 00:11:02,240 --> 00:11:04,199 Speaker 1: supporting the US treasury market. So you know, we have 205 00:11:04,320 --> 00:11:07,680 Speaker 1: the new standing repo facility, and I think you know 206 00:11:07,720 --> 00:11:10,520 Speaker 1: they were buying US treasuries in exchange for reserves, and 207 00:11:10,520 --> 00:11:13,560 Speaker 1: then they exempted all of those from the supplementary leverage 208 00:11:13,640 --> 00:11:19,280 Speaker 1: ratios for banks. So it seems like the backstop is 209 00:11:20,000 --> 00:11:23,120 Speaker 1: in place. If something bad were to happen again, I 210 00:11:23,160 --> 00:11:26,120 Speaker 1: would presume that the FED would unveil either those exact 211 00:11:26,120 --> 00:11:30,559 Speaker 1: measures again or something very similar. So is the issue solved? 212 00:11:31,080 --> 00:11:35,360 Speaker 3: Yeah, you're tracy. That is provocative, So I would definitely. 213 00:11:35,120 --> 00:11:36,880 Speaker 1: Say it's a polite way of saying you're so wrong. 214 00:11:37,480 --> 00:11:42,240 Speaker 3: No, the FED. The FED came out guns blazing unlimited 215 00:11:42,400 --> 00:11:46,680 Speaker 3: financing and the rebound market for anyone that had access 216 00:11:46,840 --> 00:11:49,880 Speaker 3: to the FED a trillion dollars of purchases in the 217 00:11:49,880 --> 00:11:54,120 Speaker 3: first three weeks, nearly a trillion of US treasuries, relieving 218 00:11:54,120 --> 00:11:57,800 Speaker 3: the other dealer balance sheets of their overloading. Getting the 219 00:11:57,800 --> 00:12:02,000 Speaker 3: supplementary leverage ratio back and it was causing problems took 220 00:12:02,040 --> 00:12:05,240 Speaker 3: a little longer, and it took I think some backroom 221 00:12:05,360 --> 00:12:08,480 Speaker 3: negotiations with the other bank regulators to come on board, 222 00:12:08,840 --> 00:12:11,040 Speaker 3: so that got delayed, and that was a problem. But 223 00:12:11,080 --> 00:12:14,839 Speaker 3: the FED did a terrific job at crisis management during 224 00:12:14,880 --> 00:12:19,320 Speaker 3: those weeks, and I say weeks because they didn't solve 225 00:12:19,400 --> 00:12:23,120 Speaker 3: the problem. They only made it less bad than it 226 00:12:23,200 --> 00:12:26,720 Speaker 3: otherwise would have been. It took five, six, seven, eight 227 00:12:26,760 --> 00:12:31,040 Speaker 3: weeks before market liquidity was restored. And again going back 228 00:12:31,040 --> 00:12:35,280 Speaker 3: to my wrong way risk point, if I'm looking for 229 00:12:35,800 --> 00:12:38,280 Speaker 3: a market that's going to work for me in a crisis, 230 00:12:38,800 --> 00:12:40,839 Speaker 3: I don't want to have to wait weeks in order 231 00:12:40,960 --> 00:12:43,600 Speaker 3: to get liquidity or to pay a low cost for liquidity. 232 00:12:43,640 --> 00:12:46,000 Speaker 3: I wanted to be working all the time. Now, of 233 00:12:46,000 --> 00:12:49,320 Speaker 3: course it's unrealistic that it should work every single day. 234 00:12:49,520 --> 00:12:52,040 Speaker 3: But if we rely only on central banks and I 235 00:12:52,080 --> 00:12:56,319 Speaker 3: speak more broadly, to bail out their government securities market 236 00:12:56,760 --> 00:12:58,920 Speaker 3: when they get into trouble, it's not going to be 237 00:12:58,920 --> 00:13:01,920 Speaker 3: one hundred percent effective and it raises moral hazard. It 238 00:13:02,000 --> 00:13:04,600 Speaker 3: says to the rest of the world, we'll use the 239 00:13:04,640 --> 00:13:06,880 Speaker 3: central bank balance sheet to bail you out. You don't 240 00:13:06,880 --> 00:13:11,160 Speaker 3: need to focus on improving market structure reducing undue leverage. 241 00:13:11,840 --> 00:13:14,840 Speaker 3: We have your backs that message. While it needs to be, 242 00:13:14,960 --> 00:13:18,600 Speaker 3: there is not a substitute for improving the market structure. 243 00:13:18,840 --> 00:13:23,080 Speaker 2: Yeah, you sort of anticipated my next question, but okay, 244 00:13:23,160 --> 00:13:26,600 Speaker 2: it does seem like in an emergency the FED can 245 00:13:26,640 --> 00:13:29,200 Speaker 2: say we're going to know by do QUI at a 246 00:13:29,240 --> 00:13:32,120 Speaker 2: scale that we've never seen before, and as Tracy mentioned, 247 00:13:32,679 --> 00:13:35,880 Speaker 2: unveil these unveil these new facilities kind of on the fly, 248 00:13:36,200 --> 00:13:38,679 Speaker 2: and it seems like basically since two thousand and eight 249 00:13:38,679 --> 00:13:41,240 Speaker 2: two thousand and nine, the FED has gotten really good 250 00:13:41,280 --> 00:13:44,200 Speaker 2: at standing up new facilities very quickly. So that's like 251 00:13:44,240 --> 00:13:46,400 Speaker 2: a skill that they've developed. But can you talk a 252 00:13:46,440 --> 00:13:48,640 Speaker 2: little bit more about what you perceive is to be 253 00:13:48,800 --> 00:13:52,320 Speaker 2: the cost of a sort of stability regime that sort 254 00:13:52,360 --> 00:13:56,520 Speaker 2: of presumpt presumes that, yeah, we know there's some frailties, 255 00:13:56,800 --> 00:13:59,760 Speaker 2: but our solution is that in that you know, seven 256 00:14:00,160 --> 00:14:03,280 Speaker 2: more twelve sigma day that the FED is there, and like, well, 257 00:14:03,280 --> 00:14:05,200 Speaker 2: talk about more about why that's not a good system. 258 00:14:05,320 --> 00:14:08,280 Speaker 3: Okay, Well, just I want to re emphasize that the FED, I. 259 00:14:08,240 --> 00:14:10,839 Speaker 2: Don't know how many sigmas it really is that billion, 260 00:14:11,080 --> 00:14:13,280 Speaker 2: I don't know. I just put throughout a number. 261 00:14:13,480 --> 00:14:15,959 Speaker 3: The FED does need to be there. It's not as 262 00:14:16,000 --> 00:14:20,120 Speaker 3: though one should say, let's take the fed's balance sheet 263 00:14:20,120 --> 00:14:21,960 Speaker 3: out of the equation and try to do without it. 264 00:14:21,960 --> 00:14:24,960 Speaker 3: It needs to be there. It's a backstop. It's the 265 00:14:25,040 --> 00:14:27,840 Speaker 3: last resort. The FED is the buyer of last resort. 266 00:14:27,880 --> 00:14:30,040 Speaker 3: After it's become the lender of last resort. It can't 267 00:14:30,080 --> 00:14:33,560 Speaker 3: do anything else. But bail at the market by buying securities. 268 00:14:33,880 --> 00:14:37,480 Speaker 3: But relying on that has several problems. I already mentioned 269 00:14:37,720 --> 00:14:40,000 Speaker 3: it's not one hundred percent of effective on the first day. 270 00:14:40,920 --> 00:14:43,280 Speaker 3: And there's also the size of the Fed's balance sheet 271 00:14:43,480 --> 00:14:46,760 Speaker 3: that's controversial. I mean, even if you think it's innocuous, 272 00:14:47,120 --> 00:14:50,600 Speaker 3: it raises political concerns. There are those that say, well, 273 00:14:50,640 --> 00:14:53,040 Speaker 3: maybe the Fed's balance sheet is too big, and we 274 00:14:53,080 --> 00:14:57,760 Speaker 3: need to curtail the ability of central banks, including the FED, 275 00:14:57,840 --> 00:15:00,280 Speaker 3: to expand their balance sheets to the extent that they 276 00:15:00,280 --> 00:15:02,840 Speaker 3: have been and they've been using them very, very liberally 277 00:15:02,880 --> 00:15:06,120 Speaker 3: over the past couple of decades. The other concern is 278 00:15:06,120 --> 00:15:08,920 Speaker 3: once the balance sheet is large, it eventually is going 279 00:15:08,960 --> 00:15:11,560 Speaker 3: to come back down and those treasuries are going to 280 00:15:11,600 --> 00:15:15,720 Speaker 3: be adding to the stock of securities that other investors 281 00:15:16,040 --> 00:15:18,400 Speaker 3: need to have, and that it means that the central banks, 282 00:15:18,440 --> 00:15:21,240 Speaker 3: including the FED, need to do that very gingerly. There's 283 00:15:21,280 --> 00:15:23,160 Speaker 3: a lot of volatility in the treasury market, and the 284 00:15:23,160 --> 00:15:26,320 Speaker 3: FED is letting its balance sheet come down. Other investors 285 00:15:26,360 --> 00:15:29,160 Speaker 3: are having to pick up the load. It's easier to 286 00:15:29,240 --> 00:15:31,360 Speaker 3: expand the balance sheet than it is to bring it down. 287 00:15:31,560 --> 00:15:34,360 Speaker 3: So using the Fed's balance sheet while it's necessary, is 288 00:15:34,520 --> 00:15:38,000 Speaker 3: not a painless solution, and I would argue it's not 289 00:15:38,040 --> 00:15:41,080 Speaker 3: the best solution anyway. We can do better by improving 290 00:15:41,120 --> 00:15:45,400 Speaker 3: market structure. Pushing out into the extreme tails the number 291 00:15:45,440 --> 00:15:47,640 Speaker 3: of events in which the FED needs to step in 292 00:15:47,680 --> 00:15:48,120 Speaker 3: and linch. 293 00:15:51,040 --> 00:15:54,480 Speaker 1: Why don't we talk about the market structure and maybe 294 00:15:54,520 --> 00:15:57,360 Speaker 1: before we start talking about improvements that could be made, 295 00:15:57,440 --> 00:15:59,280 Speaker 1: could you give us the sort of lay of the 296 00:15:59,400 --> 00:16:03,040 Speaker 1: land when it comes to how treasuries are traded today. 297 00:16:03,120 --> 00:16:05,960 Speaker 1: So there's primary dealers for the new issuance, and then 298 00:16:06,000 --> 00:16:08,600 Speaker 1: there's your sort of run of the mill dealers for 299 00:16:09,000 --> 00:16:12,280 Speaker 1: secondary market trades. But talk to us how it works 300 00:16:12,360 --> 00:16:12,840 Speaker 1: right now? 301 00:16:12,920 --> 00:16:16,040 Speaker 3: Terrific. Well, it's an extremely complex structure, but it can 302 00:16:16,040 --> 00:16:19,320 Speaker 3: be summarized pretty simply. There's two segments of the market. 303 00:16:19,400 --> 00:16:23,520 Speaker 3: There's the interdealer market, in which the dealers trade among themselves, 304 00:16:23,840 --> 00:16:26,120 Speaker 3: and then there's the customer to dealer market, in which 305 00:16:26,520 --> 00:16:31,360 Speaker 3: investors around the world trade with dealers. Notably, investors do 306 00:16:31,440 --> 00:16:34,720 Speaker 3: not trade directly with other investors. There is no alto 307 00:16:34,760 --> 00:16:37,520 Speaker 3: all trade in the US treasure market, no matter whether 308 00:16:37,520 --> 00:16:40,840 Speaker 3: you're an insurance company, a hedge fund, a foreign exchange reserve, manager. 309 00:16:41,600 --> 00:16:44,000 Speaker 3: You are going to be buying and selling with a 310 00:16:44,040 --> 00:16:46,960 Speaker 3: dealer if you're a dealer. On the other hand, there 311 00:16:47,000 --> 00:16:50,320 Speaker 3: is a very active interdealer market for the on the 312 00:16:50,400 --> 00:16:53,120 Speaker 3: run securities. Those are the latest issues of the Treasury. 313 00:16:53,640 --> 00:16:55,960 Speaker 3: There's an order book market, which is a high frequency 314 00:16:55,960 --> 00:16:59,440 Speaker 3: trading market run by Brokertech, which is a subsidiary of 315 00:16:59,440 --> 00:17:02,960 Speaker 3: the Chicago Mercantile Exchange, where you have the same kinds 316 00:17:03,000 --> 00:17:05,919 Speaker 3: of high frequency trading that you see in the stock market. 317 00:17:06,080 --> 00:17:09,280 Speaker 3: The only other participants on the broker Tech market are 318 00:17:09,359 --> 00:17:14,399 Speaker 3: high frequency trading firms sometimes called principal trading firms like Jump, 319 00:17:14,680 --> 00:17:18,960 Speaker 3: like DRW, like Citadel, firms that have a very special 320 00:17:19,000 --> 00:17:23,840 Speaker 3: purpose of intermediating in the interdealer market, taking you know, 321 00:17:24,320 --> 00:17:27,560 Speaker 3: little bit offer spreads from the dealers and from each other. 322 00:17:27,840 --> 00:17:30,840 Speaker 3: That's the basic structure of the market. Again, the notable 323 00:17:30,880 --> 00:17:33,840 Speaker 3: feature is if you're an investor, you can trade only 324 00:17:33,880 --> 00:17:36,480 Speaker 3: with a dealer. If you're a dealer, you have the 325 00:17:36,560 --> 00:17:39,760 Speaker 3: ability to lay off positions in the interdealer market. 326 00:17:39,920 --> 00:17:43,360 Speaker 2: Again, before we get into sort of like optimal structure, 327 00:17:43,400 --> 00:17:45,399 Speaker 2: I'm actually just curious. You know, you mentioned that you 328 00:17:45,440 --> 00:17:48,040 Speaker 2: spent the last year at the New York FED looking 329 00:17:48,080 --> 00:17:50,439 Speaker 2: into this and sort of getting this. What did you do? 330 00:17:50,640 --> 00:17:52,399 Speaker 2: How did you let go about your research? Like, how 331 00:17:52,480 --> 00:17:54,720 Speaker 2: much is it sort of like a sort of statistical 332 00:17:54,760 --> 00:17:58,760 Speaker 2: base analysis versus how much was it talking to dealers 333 00:17:58,800 --> 00:18:01,680 Speaker 2: and understanding how they are. I'd just be curious about. 334 00:18:01,680 --> 00:18:05,400 Speaker 3: The research process for this particular project was a combination 335 00:18:05,560 --> 00:18:08,399 Speaker 3: of meeting and discussing what needed to be done with 336 00:18:08,520 --> 00:18:11,600 Speaker 3: the economists that I mentioned earlier, and those would be 337 00:18:11,640 --> 00:18:14,720 Speaker 3: weekly meetings pretty in depth where we would go through 338 00:18:15,320 --> 00:18:17,480 Speaker 3: what we've already learned and what we need to do next. 339 00:18:17,920 --> 00:18:22,120 Speaker 3: And that happened for six months or so. And at 340 00:18:22,119 --> 00:18:26,000 Speaker 3: the same time, in the background, we're collecting volumes of 341 00:18:26,119 --> 00:18:30,040 Speaker 3: statistical data to FED, because it's a member of the 342 00:18:30,040 --> 00:18:33,080 Speaker 3: official sector, has access not only to its own data, 343 00:18:33,480 --> 00:18:38,800 Speaker 3: but to exceptionally fine grained data on at the transactions level. 344 00:18:38,880 --> 00:18:41,440 Speaker 3: Let me give you one example. There is a data 345 00:18:41,480 --> 00:18:45,919 Speaker 3: set called trace which records every single trade in the 346 00:18:45,960 --> 00:18:50,120 Speaker 3: treasure market with a few minor exceptions. Those data are 347 00:18:50,160 --> 00:18:54,080 Speaker 3: only available to the official sector. They're not available to 348 00:18:54,119 --> 00:18:56,520 Speaker 3: the public. And by the way, I disagree with that policy, 349 00:18:56,960 --> 00:18:58,920 Speaker 3: and we could talk about that. I think it actually 350 00:18:59,000 --> 00:19:02,600 Speaker 3: is contributes to the problem of illiquidity. But in any case, 351 00:19:03,119 --> 00:19:05,720 Speaker 3: the FED, as a member of that official sector group, 352 00:19:06,160 --> 00:19:11,080 Speaker 3: can go to its sister agencies in the federal government 353 00:19:11,280 --> 00:19:14,320 Speaker 3: and say, look, we have this project, here's its objectives. 354 00:19:14,320 --> 00:19:17,000 Speaker 3: We want to use these trace data to analyze liquidity 355 00:19:17,000 --> 00:19:21,280 Speaker 3: in the US treasury market. And then we get feedback saying, yeah, 356 00:19:21,320 --> 00:19:23,119 Speaker 3: this looks good. The way that pre zata are being 357 00:19:23,200 --> 00:19:28,159 Speaker 3: presented will not reveal proprietary information, so go ahead. And 358 00:19:28,200 --> 00:19:31,080 Speaker 3: then we can do the same thing with dealer balance 359 00:19:31,080 --> 00:19:34,600 Speaker 3: sheet data. We can get exposures of the dealers not 360 00:19:34,640 --> 00:19:38,399 Speaker 3: only to treasury securities, but to agency mortgage backed securities, 361 00:19:38,400 --> 00:19:41,520 Speaker 3: which turned out to be another big load on their 362 00:19:41,560 --> 00:19:45,720 Speaker 3: balance sheet, particularly during March of twenty twenty. We can 363 00:19:45,800 --> 00:19:50,119 Speaker 3: go to a wide range of data sets, and we 364 00:19:50,160 --> 00:19:53,680 Speaker 3: wrote a paper it explains the extent to which we 365 00:19:54,640 --> 00:19:58,320 Speaker 3: access all of these data bring them together. We developed 366 00:19:58,359 --> 00:20:02,720 Speaker 3: eighteen different liquidity tricks and many different metrics on how 367 00:20:02,760 --> 00:20:05,680 Speaker 3: dealer balance sheets are being loaded. And then we would 368 00:20:05,720 --> 00:20:13,600 Speaker 3: analyze these using reasonably intricate econometric methods like quantile regressions 369 00:20:13,640 --> 00:20:17,800 Speaker 3: and a number of other statistical approaches, and then we 370 00:20:17,840 --> 00:20:20,680 Speaker 3: would start to see the patterns emerge very very clearly. 371 00:20:21,080 --> 00:20:24,680 Speaker 3: That I describe two key patterns that came up over 372 00:20:24,760 --> 00:20:29,480 Speaker 3: and over again in our discussion meetings. Where A volatility 373 00:20:29,480 --> 00:20:32,960 Speaker 3: seems to explain most of the variation in liquidity, but 374 00:20:33,400 --> 00:20:37,280 Speaker 3: b when it doesn't, it's dealer balance sheet loading that 375 00:20:37,440 --> 00:20:41,920 Speaker 3: explains the remaining part of illiquidity. It's a highly nonlinear effect. 376 00:20:42,520 --> 00:20:46,720 Speaker 3: When dealer balance sheets are normally loaded, they don't contribute 377 00:20:46,720 --> 00:20:50,160 Speaker 3: to ill liquidity. But when they're reaching their extremes, where 378 00:20:50,200 --> 00:20:54,359 Speaker 3: dealers are handling more treasury trades and more agency MBS 379 00:20:54,440 --> 00:20:57,400 Speaker 3: trades and they've handled in the past, then you see 380 00:20:57,480 --> 00:21:01,760 Speaker 3: illiquidity go up well beyond the level predicted by volatility. 381 00:21:02,320 --> 00:21:06,880 Speaker 3: So after analyzing all these data and discussing what's driving these, 382 00:21:07,320 --> 00:21:10,440 Speaker 3: then we turn to writing up our results and there's 383 00:21:10,480 --> 00:21:12,960 Speaker 3: a lot of iterative work there which you can see 384 00:21:13,200 --> 00:21:14,200 Speaker 3: in the paper that we wrote. 385 00:21:14,440 --> 00:21:16,960 Speaker 1: So you can see the dealer balance sheets on a 386 00:21:17,040 --> 00:21:18,800 Speaker 1: daily basis, not just at quarter. 387 00:21:18,720 --> 00:21:19,919 Speaker 2: End, not quite. 388 00:21:20,040 --> 00:21:23,120 Speaker 3: We can only see dealer balance sheets on a weekly 389 00:21:23,160 --> 00:21:26,480 Speaker 3: basis because the FED has a data set called FR 390 00:21:26,520 --> 00:21:30,520 Speaker 3: two thousand and four which collects those data only on 391 00:21:30,560 --> 00:21:33,720 Speaker 3: a weekly basis and summaries of those data are available 392 00:21:33,720 --> 00:21:35,560 Speaker 3: publicly on the New York Fed's website. 393 00:21:35,800 --> 00:21:39,480 Speaker 1: So going back to this dealer balance sheet issue, I mean, 394 00:21:39,520 --> 00:21:41,960 Speaker 1: this is something that has come up basically ever since 395 00:21:42,000 --> 00:21:45,240 Speaker 1: the two thousand and eight financial crisis, and there have 396 00:21:45,320 --> 00:21:48,040 Speaker 1: been a lot of complaints from the dealers about all 397 00:21:48,080 --> 00:21:51,560 Speaker 1: this new regulation that limits their ability to take risk 398 00:21:51,720 --> 00:21:54,880 Speaker 1: on their balance sheet. And the argument for doing that 399 00:21:54,920 --> 00:21:58,040 Speaker 1: has always been one of financial stability. Well, we want 400 00:21:58,080 --> 00:22:00,520 Speaker 1: the banks to be safer, and if they have to 401 00:22:00,560 --> 00:22:04,440 Speaker 1: cut back on their intermediation capacity in the market, maybe 402 00:22:04,600 --> 00:22:07,840 Speaker 1: that's a fair trade. How do you thread the needle 403 00:22:08,080 --> 00:22:11,800 Speaker 1: between those two issues, especially in a market as important 404 00:22:11,840 --> 00:22:12,560 Speaker 1: as treasuries. 405 00:22:13,000 --> 00:22:18,200 Speaker 3: Okay, it's very tough because those much more demanding capital 406 00:22:18,240 --> 00:22:21,200 Speaker 3: requirements and other requirements that came in after the financial 407 00:22:21,200 --> 00:22:25,679 Speaker 3: crisis have clearly reduced liquidity and a broad set of 408 00:22:25,680 --> 00:22:30,800 Speaker 3: financial markets. It's glaringly obvious. However, we can't afford to 409 00:22:31,080 --> 00:22:36,240 Speaker 3: return to the pre Lehman days in which dealers would 410 00:22:36,280 --> 00:22:39,520 Speaker 3: expand their balance sheets for a few basis points of arbitrage, 411 00:22:39,920 --> 00:22:45,200 Speaker 3: creating financial instability. So while those new capital requirements are 412 00:22:45,280 --> 00:22:50,720 Speaker 3: necessary for protecting the economy from collapse of the financial 413 00:22:50,760 --> 00:22:55,760 Speaker 3: services sector. We do need to substitute for the liquidity 414 00:22:55,800 --> 00:22:59,920 Speaker 3: that's missing in other ways. There is one capital regulation 415 00:23:00,119 --> 00:23:03,960 Speaker 3: that I think is not necessary, and that's the one 416 00:23:04,000 --> 00:23:08,760 Speaker 3: you mentioned, Tracy, the supplementary leverage ratio. That rule penalizes 417 00:23:09,440 --> 00:23:13,600 Speaker 3: the provision of liquidity, even for very safe assets. Let 418 00:23:13,600 --> 00:23:16,680 Speaker 3: me give you an example. When the FED was buying 419 00:23:16,760 --> 00:23:21,440 Speaker 3: treasury securities from mid March. It bought within three weeks 420 00:23:21,480 --> 00:23:24,960 Speaker 3: nearly a trillion dollars of treasuries, and one might think, oh, 421 00:23:25,000 --> 00:23:29,480 Speaker 3: thank goodness, that's lowering the making more space on dealer 422 00:23:29,520 --> 00:23:33,040 Speaker 3: balance sheets for other positions. However, from the viewpoint of 423 00:23:33,080 --> 00:23:36,720 Speaker 3: that capital regulation, there was really not much change at all, 424 00:23:36,760 --> 00:23:40,159 Speaker 3: because the FED paid for those trillion of treasuries with 425 00:23:40,280 --> 00:23:44,440 Speaker 3: a trillion of reserve balances, and reserve balances, although perfectly 426 00:23:44,480 --> 00:23:48,520 Speaker 3: safe and liquid, have the same impact on dealer capital 427 00:23:48,560 --> 00:23:52,800 Speaker 3: requirements as the treasury securities that they replaced, so there 428 00:23:52,880 --> 00:23:55,920 Speaker 3: wasn't really, from the viewpoint of the supplementary leverage ratio, 429 00:23:56,320 --> 00:23:59,840 Speaker 3: much benefit of the Treasury's purchases. There were benefits in 430 00:23:59,840 --> 00:24:03,880 Speaker 3: other respects because treasuries are risky and dealers were relieved 431 00:24:03,920 --> 00:24:06,040 Speaker 3: of that risk by the fed's trades. But from the 432 00:24:06,080 --> 00:24:10,359 Speaker 3: viewpoint of that supplementary leverage ratio, it was very unfortunate. 433 00:24:10,480 --> 00:24:14,919 Speaker 3: And I and others have argued that the SLR supplementary 434 00:24:14,960 --> 00:24:18,640 Speaker 3: leverage ratio rule should be replaced with higher risk based 435 00:24:18,640 --> 00:24:19,600 Speaker 3: capital requirements. 436 00:24:20,000 --> 00:24:22,040 Speaker 2: So can you explain that when you say replaced with 437 00:24:22,119 --> 00:24:24,440 Speaker 2: higher risk based capital requirements, So. 438 00:24:24,800 --> 00:24:28,400 Speaker 1: The capital wouldn't be calculated on the basis of the 439 00:24:28,440 --> 00:24:31,919 Speaker 1: size of your total balance sheet, but on the riskiness 440 00:24:31,920 --> 00:24:33,919 Speaker 1: the actual makeup of the balance sheet. 441 00:24:34,080 --> 00:24:36,840 Speaker 3: That's right. There's been a kind of go around in 442 00:24:36,880 --> 00:24:39,600 Speaker 3: the world of in the basle world of capital requirements 443 00:24:39,600 --> 00:24:42,439 Speaker 3: for banks. Back in the eighties, we went from a 444 00:24:42,480 --> 00:24:46,360 Speaker 3: world where there were just basically leverage requirements that did 445 00:24:46,359 --> 00:24:50,240 Speaker 3: not consider risk to a world in which the financial 446 00:24:50,240 --> 00:24:52,199 Speaker 3: regulators were saying, hey, wait a minute, we should be 447 00:24:52,240 --> 00:24:56,680 Speaker 3: weighting these assets by risk because that's what matters for insolvency. 448 00:24:57,000 --> 00:24:59,840 Speaker 3: And then it was discovered leading up to the ChRI 449 00:25:00,960 --> 00:25:04,560 Speaker 3: and failure of Lehman, that banks were playing games with 450 00:25:04,640 --> 00:25:08,040 Speaker 3: their risk based measures, or simply the measures were not 451 00:25:08,119 --> 00:25:12,240 Speaker 3: accurate enough, and so as a backstop or just in case, 452 00:25:12,760 --> 00:25:17,800 Speaker 3: the supplementary leverage racial rule was introduced to eliminate, from 453 00:25:17,800 --> 00:25:21,959 Speaker 3: the viewpoint of that capital requirement any consideration of risk, saying, 454 00:25:22,160 --> 00:25:24,720 Speaker 3: you know, no more games and no more uncertainty about 455 00:25:24,720 --> 00:25:27,080 Speaker 3: how much risk. We're just going to require for every 456 00:25:27,080 --> 00:25:29,639 Speaker 3: one hundred dollars of assets of any kind, even central 457 00:25:29,680 --> 00:25:32,359 Speaker 3: bank deposits, you have to have a certain number of 458 00:25:32,359 --> 00:25:35,280 Speaker 3: dollars of capital that doesn't depend on the risk. Well, 459 00:25:35,320 --> 00:25:38,800 Speaker 3: in my view, that's backfired and it's led to more 460 00:25:38,840 --> 00:25:42,119 Speaker 3: illiquidity than necessary. You could still have the same amount 461 00:25:42,200 --> 00:25:46,320 Speaker 3: of financial stability with less illiquidity if you dial back 462 00:25:46,359 --> 00:25:50,800 Speaker 3: that rule and dial up risk based requirements so that 463 00:25:51,040 --> 00:25:53,720 Speaker 3: the system wide you're just as safe as you were before. 464 00:25:54,240 --> 00:25:57,639 Speaker 3: But each individual bank is not internalizing the cost of 465 00:25:57,680 --> 00:26:00,840 Speaker 3: balance sheet space when it makes trades safe assets. 466 00:26:01,160 --> 00:26:05,679 Speaker 1: What would that mean for bank's interest rate risk? And 467 00:26:05,720 --> 00:26:09,720 Speaker 1: I'm thinking specifically back to a different March, not twenty twenty, 468 00:26:09,760 --> 00:26:12,920 Speaker 1: but March of twenty twenty three, when we did see 469 00:26:13,040 --> 00:26:16,359 Speaker 1: a lot of banks hit by mark to market moves 470 00:26:16,359 --> 00:26:18,720 Speaker 1: on their bonds because interest rates were going up and 471 00:26:18,760 --> 00:26:22,400 Speaker 1: so the prices were lower. If you removed bonds from 472 00:26:22,440 --> 00:26:26,560 Speaker 1: the SLR calculations, would you still be able to take 473 00:26:26,600 --> 00:26:28,960 Speaker 1: into account interest rate risk or would you not really 474 00:26:29,000 --> 00:26:29,840 Speaker 1: need to anymore? 475 00:26:30,240 --> 00:26:32,080 Speaker 3: No, you would still need to do that, but you 476 00:26:32,119 --> 00:26:34,320 Speaker 3: could do that through a couple of measures that have 477 00:26:34,440 --> 00:26:37,399 Speaker 3: been proposed that came up after the failures of a 478 00:26:37,440 --> 00:26:40,040 Speaker 3: Silicon Valley bank and other banks. So one thing you 479 00:26:40,040 --> 00:26:43,320 Speaker 3: could do, which should be done, is that the very 480 00:26:43,440 --> 00:26:47,960 Speaker 3: large but not jes banks like those big regionals, should 481 00:26:48,040 --> 00:26:51,760 Speaker 3: be required to pass their losses due to interest rate 482 00:26:51,840 --> 00:26:56,480 Speaker 3: risk through to their capital accounts, so that when they 483 00:26:56,760 --> 00:26:59,439 Speaker 3: lose money on treasuries they have to add capital to 484 00:26:59,480 --> 00:27:03,000 Speaker 3: replace them. They were exempted from passing through those losses. 485 00:27:03,680 --> 00:27:06,800 Speaker 3: The second thing you can do, which surprisingly the FED 486 00:27:06,880 --> 00:27:11,640 Speaker 3: has not done recently, is to include shocks to interest 487 00:27:11,720 --> 00:27:15,560 Speaker 3: rates as a scenario in their stress tests, so that 488 00:27:15,720 --> 00:27:18,920 Speaker 3: banks would need to demonstrate that even if the Yuel 489 00:27:19,000 --> 00:27:21,920 Speaker 3: curve were to jump up a couple of hundred basis points, 490 00:27:22,200 --> 00:27:24,880 Speaker 3: they would have the capital necessary to weather that storm. 491 00:27:25,359 --> 00:27:28,320 Speaker 1: Right. This was the crazy thing about the bank stress test. 492 00:27:28,359 --> 00:27:31,800 Speaker 1: They were always for a recessionary scenario where interest rates 493 00:27:31,800 --> 00:27:35,000 Speaker 1: would plummet, and they never actually modeled interest rates going 494 00:27:35,040 --> 00:27:35,720 Speaker 1: sharply up. 495 00:27:36,119 --> 00:27:38,040 Speaker 2: I don't think I realized that. I mean, it's like 496 00:27:38,080 --> 00:27:40,399 Speaker 2: a classic like what fight. It always is right to 497 00:27:40,480 --> 00:27:42,440 Speaker 2: fight the last war. So it's like, Okay, we're gonna 498 00:27:42,520 --> 00:27:46,520 Speaker 2: like protect against this big collapse or recession and credit risk, 499 00:27:46,560 --> 00:27:49,159 Speaker 2: et cetera. And then the idea that like the next 500 00:27:49,520 --> 00:27:51,560 Speaker 2: I don't know if you'd call it a tracy and 501 00:27:51,560 --> 00:27:53,560 Speaker 2: I fight about whether it's a crisis, but the next. 502 00:27:53,440 --> 00:27:54,800 Speaker 1: Bar settled on drama. 503 00:27:55,119 --> 00:27:58,600 Speaker 2: The drama would be in the other direction of the 504 00:27:58,680 --> 00:28:01,240 Speaker 2: rates going higher. But yeah, sense that that would be 505 00:28:01,320 --> 00:28:02,240 Speaker 2: part of a stress test. 506 00:28:02,359 --> 00:28:05,320 Speaker 3: Yeah, Joe, I mean, the FED is already predicted that 507 00:28:05,359 --> 00:28:10,000 Speaker 3: it's going to make those losses pass through to capital, 508 00:28:11,280 --> 00:28:14,800 Speaker 3: and I predict personally that they will also include interest 509 00:28:14,880 --> 00:28:17,960 Speaker 3: rate risk scenarios in their stress text. I would not 510 00:28:18,000 --> 00:28:19,840 Speaker 3: be surprised to see both of those in place soon. 511 00:28:24,359 --> 00:28:28,840 Speaker 1: Just going back to one suggestion for improving liquidity and treasuries, 512 00:28:29,119 --> 00:28:32,080 Speaker 1: you mentioned all to all trading earlier, So the idea 513 00:28:32,119 --> 00:28:36,640 Speaker 1: that investors could trade with one another. I am most 514 00:28:36,760 --> 00:28:41,560 Speaker 1: familiar with that model through multi year efforts to get 515 00:28:41,560 --> 00:28:44,680 Speaker 1: it going. In corporate credit. There is a lot of 516 00:28:44,720 --> 00:28:47,840 Speaker 1: resistance to that from the dealers who don't want to 517 00:28:47,880 --> 00:28:51,000 Speaker 1: give up a lot of their pricing power. In that market. 518 00:28:51,440 --> 00:28:54,600 Speaker 1: Is it a similar story in US treasuries? Like, why 519 00:28:54,800 --> 00:28:57,160 Speaker 1: doesn't all to all trading exist already? 520 00:28:57,600 --> 00:29:02,160 Speaker 3: Okay, Well, the most influential market participants from the viewpoint 521 00:29:02,240 --> 00:29:07,080 Speaker 3: of designing and innovating market structure are the dealers themselves. 522 00:29:07,840 --> 00:29:11,160 Speaker 3: And if I were, you know, in the executive suite 523 00:29:11,200 --> 00:29:13,040 Speaker 3: of one of the largest dealers, I don't think I 524 00:29:13,040 --> 00:29:18,640 Speaker 3: would necessarily campaign to introduce a new set of competitors 525 00:29:19,360 --> 00:29:23,680 Speaker 3: for my trade, lowering my market share and reducing my 526 00:29:23,680 --> 00:29:26,959 Speaker 3: profit margin on each trade. So it's kind of understandable 527 00:29:27,000 --> 00:29:29,760 Speaker 3: that to the extent that the market hasn't evolved, that 528 00:29:30,680 --> 00:29:33,920 Speaker 3: you know, dealer dealers haven't been pushing for that. By 529 00:29:33,960 --> 00:29:37,200 Speaker 3: the way, I'm not advocating that the FED shouldn't mandate 530 00:29:37,280 --> 00:29:39,800 Speaker 3: all to all trade or other regulators should mandate that. 531 00:29:40,080 --> 00:29:43,280 Speaker 3: I think it needs to happen organically, because if it's 532 00:29:43,600 --> 00:29:47,160 Speaker 3: a rule requirement that trades in the treasury market must 533 00:29:47,160 --> 00:29:50,360 Speaker 3: be all to all, well, first you have to define 534 00:29:50,400 --> 00:29:52,479 Speaker 3: what that means, and that's going to gum up the 535 00:29:52,520 --> 00:29:55,000 Speaker 3: market design in and of itself. It's difficult. It's a 536 00:29:55,040 --> 00:29:58,240 Speaker 3: difficult design process. And secondly, there's a lot of trade 537 00:29:58,280 --> 00:30:00,920 Speaker 3: in that market that should be done by with dealers 538 00:30:01,040 --> 00:30:05,080 Speaker 3: for very large block trades, and dealers need to be 539 00:30:05,160 --> 00:30:08,680 Speaker 3: involved in the provision of liquidity directly to investors. So 540 00:30:08,920 --> 00:30:11,400 Speaker 3: in my view that all to all trade needs to 541 00:30:11,480 --> 00:30:14,640 Speaker 3: happen in a way that the market is guiding, but 542 00:30:15,040 --> 00:30:19,760 Speaker 3: there can be a nudge from other rules that would 543 00:30:19,840 --> 00:30:22,040 Speaker 3: lead that way, an example being central clearing. 544 00:30:22,560 --> 00:30:26,320 Speaker 1: Right, So this is the other suggestion in your paper, 545 00:30:26,440 --> 00:30:29,280 Speaker 1: So a shift towards all to all trading. I'm still 546 00:30:29,320 --> 00:30:32,520 Speaker 1: a little unclear on how that would happen organically, given 547 00:30:32,560 --> 00:30:34,800 Speaker 1: there seems to be a lot of resistance from the dealers. 548 00:30:34,840 --> 00:30:38,640 Speaker 1: I assume maybe it's one or two big investors, you know, 549 00:30:38,720 --> 00:30:40,640 Speaker 1: someone like a black Rock says we're going to do it, 550 00:30:40,680 --> 00:30:42,720 Speaker 1: and then the dealers just have to come along for 551 00:30:42,800 --> 00:30:46,560 Speaker 1: the ride. But the other suggestion is central clearing. And 552 00:30:46,640 --> 00:30:49,880 Speaker 1: on this issue, again, correct me if I'm wrong. My 553 00:30:49,920 --> 00:30:53,000 Speaker 1: impression was always that the FED was a little bit 554 00:30:53,200 --> 00:30:54,600 Speaker 1: resistant to that idea. 555 00:30:55,160 --> 00:30:59,960 Speaker 3: Well, the Security Is and Exchange Commission recently unanimously proposed 556 00:31:00,200 --> 00:31:03,520 Speaker 3: broad central clearing in the US treasury market. I don't 557 00:31:03,560 --> 00:31:08,440 Speaker 3: think there's that much resistance among the other key players 558 00:31:08,520 --> 00:31:11,480 Speaker 3: in the official sector in the case of the treasury market, 559 00:31:11,480 --> 00:31:15,280 Speaker 3: those key players are the SEC itself, the New York Fed, 560 00:31:15,640 --> 00:31:18,680 Speaker 3: the Federal Reserve Board, and the Treasury Department. I don't 561 00:31:18,720 --> 00:31:22,960 Speaker 3: see a significant amount of resistance across those four key players, 562 00:31:23,520 --> 00:31:28,240 Speaker 3: but it's not easily done. First, it's a difficult design 563 00:31:28,320 --> 00:31:31,960 Speaker 3: process itself. What is exactly are the requirements going to be? 564 00:31:32,040 --> 00:31:35,280 Speaker 3: And secondly, there is going to be industry resistance. And 565 00:31:36,000 --> 00:31:40,680 Speaker 3: even without singling out any particular regulator, I think industry 566 00:31:40,680 --> 00:31:44,000 Speaker 3: pushback on the cost side of that is understandable and 567 00:31:44,040 --> 00:31:46,160 Speaker 3: it's going to have to be overcome because leadership in 568 00:31:46,200 --> 00:31:48,320 Speaker 3: the official sector is going to be needed to push 569 00:31:48,360 --> 00:31:48,840 Speaker 3: that through. 570 00:31:49,120 --> 00:31:51,400 Speaker 2: Sorry, I'm going to play the role of the ignorant 571 00:31:51,480 --> 00:31:55,720 Speaker 2: listener AKA may define central clearing and what is it 572 00:31:55,800 --> 00:31:59,360 Speaker 2: about it that, in your view would contribute to sort 573 00:31:59,360 --> 00:32:01,640 Speaker 2: of like for the rest stability in the market. 574 00:32:01,840 --> 00:32:04,560 Speaker 3: Okay, good, So let's just back up and describe what 575 00:32:04,640 --> 00:32:08,120 Speaker 3: it is. In the current US treasury market, the dealers 576 00:32:08,120 --> 00:32:11,920 Speaker 3: are required when they trade with each other to settle 577 00:32:11,960 --> 00:32:15,920 Speaker 3: their trades through the Fixed Income Clearing Corporation, which means 578 00:32:15,920 --> 00:32:18,160 Speaker 3: that they're not facing each other for settlement risk. If 579 00:32:18,160 --> 00:32:21,920 Speaker 3: I trade with you, then tomorrow, I'll settle my trade 580 00:32:21,920 --> 00:32:24,320 Speaker 3: with the Fixed Income Clearing Corporation, and so would you. 581 00:32:24,960 --> 00:32:28,160 Speaker 3: That lowers our bilateral risk. It also allows me to 582 00:32:28,360 --> 00:32:32,440 Speaker 3: net down my purchases against my sales, because if I 583 00:32:32,480 --> 00:32:35,400 Speaker 3: buy from U Joe and I sell to Tracy in 584 00:32:35,440 --> 00:32:38,720 Speaker 3: a bilateral world with no central clearing, I've got two 585 00:32:39,280 --> 00:32:42,480 Speaker 3: settlements coming up that I have to pay attention to, 586 00:32:42,600 --> 00:32:45,560 Speaker 3: both of them from the viewpoint of settlement risk and 587 00:32:45,640 --> 00:32:50,080 Speaker 3: settlement failures, meaning the trades are not done. If I 588 00:32:50,160 --> 00:32:52,920 Speaker 3: can net one hundred billion of purchases from you Joe 589 00:32:53,360 --> 00:32:57,960 Speaker 3: against say one hundred and ten of sales with Tracy, 590 00:32:58,360 --> 00:33:01,440 Speaker 3: that two hundred and ten billion gets netted down to 591 00:33:01,600 --> 00:33:05,600 Speaker 3: ten billion facing fixed Income Clearing Corporation. So that massive 592 00:33:05,640 --> 00:33:09,560 Speaker 3: reduction in my settlement risk is really beneficial from the 593 00:33:09,640 --> 00:33:12,760 Speaker 3: viewpoint of using my balance sheet efficiently. There was a 594 00:33:12,800 --> 00:33:16,080 Speaker 3: study done at the New York Fed year before last 595 00:33:16,120 --> 00:33:19,400 Speaker 3: by Michael Fleming and Frank Keen, two of my other collaborators, 596 00:33:19,640 --> 00:33:22,680 Speaker 3: in which they showed that on the peak days of 597 00:33:23,160 --> 00:33:27,080 Speaker 3: the March twenty twenty COVID stress, the settlement in one 598 00:33:27,200 --> 00:33:30,440 Speaker 3: day for the US Treasury market facing the dealers was 599 00:33:30,480 --> 00:33:34,040 Speaker 3: in excess of a trillion dollars, and had those trades 600 00:33:34,080 --> 00:33:37,080 Speaker 3: been centrally cleared, it would have been as low as 601 00:33:37,160 --> 00:33:40,360 Speaker 3: three hundred billion, about a seventy percent reduction. Now that 602 00:33:40,680 --> 00:33:43,560 Speaker 3: not only relieve some space on dealer balance sheets, which 603 00:33:43,600 --> 00:33:46,520 Speaker 3: is one of the key problems here. If the central 604 00:33:46,560 --> 00:33:49,680 Speaker 3: clearing is done effectively and a kind of straight through 605 00:33:50,040 --> 00:33:54,080 Speaker 3: anonymous way, then investors in the market could say, well, 606 00:33:54,400 --> 00:33:56,760 Speaker 3: I could trade directly with another investor and I wouldn't 607 00:33:56,760 --> 00:33:59,760 Speaker 3: be reliant on my dealer to settle my trade for me. 608 00:34:00,400 --> 00:34:03,200 Speaker 3: If only a trade platform operator would offer that service, 609 00:34:03,280 --> 00:34:06,920 Speaker 3: I'd be all in. And then trade platform operators will say, wow, 610 00:34:07,000 --> 00:34:10,759 Speaker 3: now that we have central clearing in this market, the 611 00:34:10,800 --> 00:34:14,399 Speaker 3: barriers to enter into the intermediation of this market are 612 00:34:14,440 --> 00:34:17,800 Speaker 3: much lower because investors can settle directly at the fixing 613 00:34:17,840 --> 00:34:21,879 Speaker 3: come clearing corporation, or whatever central counterparty they choose. So 614 00:34:22,160 --> 00:34:26,640 Speaker 3: I think it would organically lower the barriers to more 615 00:34:26,680 --> 00:34:30,160 Speaker 3: all to all trade in addition to reducing the amount 616 00:34:30,200 --> 00:34:32,759 Speaker 3: of space on dealer balance sheets and by the way, 617 00:34:32,880 --> 00:34:35,319 Speaker 3: lowering settlement risk in that crucial market. That's why it 618 00:34:35,400 --> 00:34:38,240 Speaker 3: was introduced in the first case back in the nineteen 619 00:34:38,320 --> 00:34:40,000 Speaker 3: eighties to lower settlement risk. 620 00:34:40,280 --> 00:34:43,680 Speaker 1: So dealers get to use their balance sheet more efficiently 621 00:34:44,040 --> 00:34:48,040 Speaker 1: through central clearing. But there's still an added cost for them, 622 00:34:48,360 --> 00:34:50,920 Speaker 1: I believe, and there's still a sort of existential threat 623 00:34:50,920 --> 00:34:54,640 Speaker 1: to their business model if investors can settle with other investors. 624 00:34:55,400 --> 00:34:58,440 Speaker 1: So how do you You're sort of asking them to 625 00:34:59,080 --> 00:35:04,520 Speaker 1: put in high or individualized costs in exchange for more 626 00:35:04,520 --> 00:35:08,960 Speaker 1: collective safety, which when you're talking to dealer banks it 627 00:35:09,040 --> 00:35:12,000 Speaker 1: sounds rational, but a lot of them are very self 628 00:35:12,000 --> 00:35:14,120 Speaker 1: interested for obvious reasons. So how do you get them 629 00:35:14,160 --> 00:35:16,040 Speaker 1: on side? Do you need to get them on side? 630 00:35:16,760 --> 00:35:19,640 Speaker 3: You do simply by forcing the issue. But this is 631 00:35:19,640 --> 00:35:24,280 Speaker 3: the classic private cost public interest kind of trade offs 632 00:35:24,320 --> 00:35:27,759 Speaker 3: that where you need the official sector to step in 633 00:35:28,440 --> 00:35:31,240 Speaker 3: and make decisions. And by the way, when I said earlier, 634 00:35:31,520 --> 00:35:35,280 Speaker 3: as a dealer firm, I might not favor this because 635 00:35:35,320 --> 00:35:38,600 Speaker 3: of the costs and because it's threatening my market share 636 00:35:38,680 --> 00:35:41,840 Speaker 3: and my profits. I think if you take a really 637 00:35:41,880 --> 00:35:45,520 Speaker 3: long perspective on this, there's a chance that also all 638 00:35:45,560 --> 00:35:49,759 Speaker 3: trade would massively increase the volume of trade in the 639 00:35:49,840 --> 00:35:54,040 Speaker 3: US treasury market. Let me go back to nineteen seventy three, 640 00:35:55,120 --> 00:35:57,640 Speaker 3: when none of us were probably aware of what was 641 00:35:57,680 --> 00:36:02,880 Speaker 3: going on and talk about the the equity options market, 642 00:36:02,960 --> 00:36:07,000 Speaker 3: where stock options were being traded before seventy three by 643 00:36:07,120 --> 00:36:11,160 Speaker 3: laterally through dealers, just as the treasuries are done today. 644 00:36:11,440 --> 00:36:14,920 Speaker 3: Then the Chicago Board Options Exchange entered the market in 645 00:36:15,000 --> 00:36:18,520 Speaker 3: seventy three, and in the very first month of trade 646 00:36:18,640 --> 00:36:21,759 Speaker 3: that exchange did more volume that had been done in 647 00:36:21,840 --> 00:36:26,280 Speaker 3: any prior year in the dealer intermediated market, and dealers 648 00:36:26,360 --> 00:36:30,280 Speaker 3: had a fraction of that trade, which was small fraction 649 00:36:30,440 --> 00:36:34,400 Speaker 3: but big volume. Since nineteen seventy three, volumes in the 650 00:36:34,440 --> 00:36:39,400 Speaker 3: equity options market, because it was exchange traded, have grown 651 00:36:39,520 --> 00:36:43,560 Speaker 3: by many orders of magnitude, on the order of a 652 00:36:43,680 --> 00:36:47,040 Speaker 3: million times the volume of trade that was in place 653 00:36:47,040 --> 00:36:49,600 Speaker 3: in nineteen seventy three. So while in a short run 654 00:36:49,640 --> 00:36:53,000 Speaker 3: the dealers got a smaller share of the market and 655 00:36:53,080 --> 00:36:59,080 Speaker 3: faced more competitive margins on each trade, eventually the volume 656 00:36:59,120 --> 00:37:01,480 Speaker 3: of trade just dumbedminated that effect. And I don't think 657 00:37:01,560 --> 00:37:04,680 Speaker 3: any dealer would want to turn back the clock to 658 00:37:04,800 --> 00:37:08,640 Speaker 3: the days before exchange traded options. I predict the same 659 00:37:08,640 --> 00:37:11,600 Speaker 3: thing would happen in the US treasury market, as around 660 00:37:11,640 --> 00:37:15,120 Speaker 3: the world, investors would need liquidity in a much higher 661 00:37:15,160 --> 00:37:18,520 Speaker 3: volume market and dealers would be providing a lot about 662 00:37:18,680 --> 00:37:21,520 Speaker 3: liquidity both on exchange and off exchange. 663 00:37:21,800 --> 00:37:24,360 Speaker 2: Are there any other government bond markets around the world 664 00:37:24,360 --> 00:37:26,960 Speaker 2: that work kind of in the way that you are envisioning? 665 00:37:27,200 --> 00:37:31,040 Speaker 3: Terrific question. So, a former stand for PhD student, Malna Whitwer, 666 00:37:31,480 --> 00:37:35,120 Speaker 3: collaborated with two economists at the Bank of Israel on 667 00:37:35,400 --> 00:37:39,919 Speaker 3: what happened in Israel in March of twenty twenty. Israeli 668 00:37:40,040 --> 00:37:42,640 Speaker 3: government bonds are traded on an exchange. It's not a 669 00:37:42,640 --> 00:37:46,120 Speaker 3: dealer intermediated market, and that market came through. Now it's 670 00:37:46,160 --> 00:37:48,839 Speaker 3: not a comparison to the US treasury market in terms 671 00:37:48,840 --> 00:37:52,160 Speaker 3: of size and depth, but it came through without difficulty, 672 00:37:52,200 --> 00:37:56,600 Speaker 3: whereas most government securities markets did suffer in terms of 673 00:37:56,600 --> 00:37:58,080 Speaker 3: liquidity in March twenty twenty. 674 00:37:58,320 --> 00:38:01,360 Speaker 1: That's super interesting. Just one other Devil's Advocate question on 675 00:38:01,400 --> 00:38:04,080 Speaker 1: central clearing, which is a lot of critics will bring 676 00:38:04,160 --> 00:38:07,600 Speaker 1: up the issue of concentration risk, So you're taking risk 677 00:38:07,719 --> 00:38:10,359 Speaker 1: from the dealers and sort of moving it into this 678 00:38:10,400 --> 00:38:15,480 Speaker 1: one central counter party. What's your response to that critique. 679 00:38:15,719 --> 00:38:18,360 Speaker 3: Well, it's true, I mean you have to say, although 680 00:38:18,400 --> 00:38:22,760 Speaker 3: that it's considered a pejorative that the Fixed Income Clearing 681 00:38:22,800 --> 00:38:25,800 Speaker 3: Corporation is too big to fail, and it would become 682 00:38:26,480 --> 00:38:30,239 Speaker 3: even bigger, So even more importantly, could not fail. You 683 00:38:30,280 --> 00:38:34,279 Speaker 3: couldn't You couldn't imagine the chaos that would ensue if 684 00:38:34,320 --> 00:38:37,480 Speaker 3: the central counterparty for the US treasure market were unable 685 00:38:37,520 --> 00:38:41,440 Speaker 3: to meet its obligations and had to create an enormous 686 00:38:41,520 --> 00:38:46,360 Speaker 3: crater on the global financial markets. So you are putting 687 00:38:46,440 --> 00:38:50,640 Speaker 3: the onus even more on the safety and soundness of 688 00:38:50,680 --> 00:38:54,560 Speaker 3: that central counterparty now, and I think regulators are up 689 00:38:54,600 --> 00:38:57,520 Speaker 3: to that. It's the Fixed Income Clearing Corporation has been 690 00:38:57,560 --> 00:39:02,480 Speaker 3: designated as systemically important. It is on the list of 691 00:39:02,719 --> 00:39:08,560 Speaker 3: financial stability Oversight Councils infrastructure that must get too big 692 00:39:08,600 --> 00:39:14,239 Speaker 3: to fail. Attention. I also hear sometimes the misunderstanding that 693 00:39:14,280 --> 00:39:18,200 Speaker 3: what we would be doing with central counterparties like FICK 694 00:39:19,040 --> 00:39:21,200 Speaker 3: is to take all of the risk in the market 695 00:39:21,800 --> 00:39:24,839 Speaker 3: and kind of like bulldoze it into one spot at 696 00:39:24,840 --> 00:39:28,600 Speaker 3: the central counterparty, making this enormous stack of risk all 697 00:39:28,640 --> 00:39:33,600 Speaker 3: in one failure point. That is not a correct metaphor, 698 00:39:33,920 --> 00:39:37,520 Speaker 3: because as you take all of these bilateral purchases and 699 00:39:37,640 --> 00:39:42,319 Speaker 3: sales and bring them into the central counterparty, all the 700 00:39:42,360 --> 00:39:46,799 Speaker 3: purchases almost get netted against all the sales, and you 701 00:39:46,880 --> 00:39:50,360 Speaker 3: get a much smaller stack of risk. As a result, 702 00:39:50,719 --> 00:39:53,640 Speaker 3: the amount of risk goes down enormously. I mentioned the 703 00:39:54,040 --> 00:39:56,040 Speaker 3: study done by the New York Fed that shows about 704 00:39:56,040 --> 00:39:59,640 Speaker 3: a seventy percent reduction and settlement risk in the US 705 00:39:59,719 --> 00:40:03,400 Speaker 3: chrudgure market from doing central clearing. So even though it 706 00:40:03,520 --> 00:40:06,000 Speaker 3: is true you're concentrating the risk more in one place, 707 00:40:06,200 --> 00:40:07,919 Speaker 3: the total amount of risk goes way down. 708 00:40:08,239 --> 00:40:11,919 Speaker 2: So you're here at Jackson Hall with the most impressive 709 00:40:12,440 --> 00:40:14,839 Speaker 2: audience in the world. I don't mean the odd lat 710 00:40:14,960 --> 00:40:19,479 Speaker 2: to host listeners, although hopefully we're fairly impressive as well. 711 00:40:19,640 --> 00:40:22,040 Speaker 2: But beyond that, is there anything else, like you know, 712 00:40:22,600 --> 00:40:24,439 Speaker 2: like what are you trying to what are the key 713 00:40:24,520 --> 00:40:28,080 Speaker 2: things that you're like, hope that your research impresses upon 714 00:40:28,360 --> 00:40:31,359 Speaker 2: this audience in terms of next steps and things that 715 00:40:31,840 --> 00:40:35,719 Speaker 2: beyond beyond say even what you've described in terms of 716 00:40:35,719 --> 00:40:37,720 Speaker 2: like where to go next with some of this stuff. 717 00:40:38,360 --> 00:40:40,200 Speaker 3: So I think what you're going to see here at 718 00:40:40,239 --> 00:40:42,919 Speaker 3: Jackson Hole, or what you have seen by the time 719 00:40:43,280 --> 00:40:47,480 Speaker 3: that you people are listening, that your listeners hear this 720 00:40:48,160 --> 00:40:53,560 Speaker 3: is a lot of attention on fiscal risks you're going 721 00:40:53,600 --> 00:40:58,680 Speaker 3: to see the importance of increasing government debt and how 722 00:40:58,719 --> 00:41:03,160 Speaker 3: that interplays with inflation risk. The work that we've been 723 00:41:03,200 --> 00:41:07,400 Speaker 3: discussing today on improving the liquidity of the US Treasury 724 00:41:07,440 --> 00:41:11,120 Speaker 3: market details well with the topic that I think will 725 00:41:11,120 --> 00:41:16,879 Speaker 3: be the headline topic here of inflation and sovereign debt risk, 726 00:41:18,080 --> 00:41:23,640 Speaker 3: by highlighting the importance of making the US Treasury market 727 00:41:23,920 --> 00:41:29,200 Speaker 3: and other government securities markets more resilient to the problems 728 00:41:29,200 --> 00:41:33,080 Speaker 3: that will arise as we get more and more stress 729 00:41:33,719 --> 00:41:40,359 Speaker 3: coming from inflation volatility, monetary uncertainty, sovereign debt risk, uncertainty, 730 00:41:40,719 --> 00:41:46,000 Speaker 3: not to mention political uncertainties. It's kind of a constellation 731 00:41:46,080 --> 00:41:49,280 Speaker 3: of risks, and you want to build a market that's 732 00:41:49,520 --> 00:41:52,440 Speaker 3: resilient to those risks. And I think those that prepared 733 00:41:52,440 --> 00:41:56,799 Speaker 3: the agenda for this meeting thought carefully about bringing all 734 00:41:56,840 --> 00:42:00,520 Speaker 3: of these topics together in the same symposium. 735 00:42:00,600 --> 00:42:02,640 Speaker 1: Just on that note, there was one more question I 736 00:42:02,640 --> 00:42:05,160 Speaker 1: wanted to ask you about all to all trading, which 737 00:42:05,239 --> 00:42:09,160 Speaker 1: is would the Treasury go for it? Because one of 738 00:42:09,200 --> 00:42:12,719 Speaker 1: the benefits of the primary dealer model right now is 739 00:42:12,760 --> 00:42:16,200 Speaker 1: that it is very hard to get a failed auction. 740 00:42:16,320 --> 00:42:19,080 Speaker 1: In fact, I think it's pretty much impossible. So if 741 00:42:19,120 --> 00:42:23,400 Speaker 1: you didn't have those primary dealers sort of beholden to 742 00:42:23,480 --> 00:42:26,760 Speaker 1: the treasury at a time when the US is expected 743 00:42:26,800 --> 00:42:29,680 Speaker 1: to sell a lot more debt, that would seem to 744 00:42:29,680 --> 00:42:30,200 Speaker 1: be a risk. 745 00:42:31,000 --> 00:42:34,280 Speaker 3: It's certainly something that I've heard some at the largest 746 00:42:34,560 --> 00:42:40,879 Speaker 3: primary dealers say publicly and in conversations be cautious with 747 00:42:40,960 --> 00:42:44,040 Speaker 3: changing the structure of this market, because if dealers are 748 00:42:44,080 --> 00:42:49,880 Speaker 3: not sufficiently profitable in providing intermediation and the secondary market 749 00:42:49,880 --> 00:42:54,160 Speaker 3: for US treasuries where they're traded, then maybe the primary 750 00:42:54,200 --> 00:42:58,200 Speaker 3: dealers will not participate as actively by committing capital to 751 00:42:58,400 --> 00:43:02,200 Speaker 3: the primary market, which is where they're issued, and maybe 752 00:43:02,239 --> 00:43:04,880 Speaker 3: that would cost US taxpayers more because you wouldn't have 753 00:43:04,880 --> 00:43:08,919 Speaker 3: a reliable, committed buyers at those auctions. That is a risk, 754 00:43:09,400 --> 00:43:13,799 Speaker 3: but it's not convincing to me that you can sit 755 00:43:13,920 --> 00:43:18,800 Speaker 3: back and try to sustain the current market structure when 756 00:43:19,160 --> 00:43:22,440 Speaker 3: the treasure market is growing bigger and bigger while balance 757 00:43:22,480 --> 00:43:26,600 Speaker 3: sheets are shrinking relative to GDP. The total US government 758 00:43:26,600 --> 00:43:29,960 Speaker 3: securities market relative to GDP is going to be about 759 00:43:29,960 --> 00:43:33,080 Speaker 3: one hundred and fifty percent or more according to the 760 00:43:33,120 --> 00:43:36,800 Speaker 3: projection of the Congressional Budget Office, Whereas dealer balance sheets 761 00:43:36,840 --> 00:43:40,280 Speaker 3: are shrinking relative to GDP over the last ten years. 762 00:43:40,600 --> 00:43:44,080 Speaker 3: That's not sustainable. So simply to say we don't want 763 00:43:44,080 --> 00:43:47,319 Speaker 3: to disrupt the current market structure because the dealers won't 764 00:43:47,360 --> 00:43:51,120 Speaker 3: participate as much in the primary market is not going 765 00:43:51,120 --> 00:43:54,360 Speaker 3: to fix the problem. The dealers are now taking down 766 00:43:54,480 --> 00:43:57,560 Speaker 3: on the order of ten percent plus or minus, and 767 00:43:57,640 --> 00:43:59,960 Speaker 3: those auctions, that number has been coming down over the year. 768 00:44:00,320 --> 00:44:02,840 Speaker 3: I predict they will continue to participate in the market 769 00:44:02,880 --> 00:44:05,000 Speaker 3: even if there is a change in market structure. But 770 00:44:05,160 --> 00:44:08,600 Speaker 3: that is not, in my mind, an overriding a concern 771 00:44:08,640 --> 00:44:09,920 Speaker 3: to fixing the market structure. 772 00:44:10,000 --> 00:44:13,319 Speaker 1: All right, Well, Daryl Duffy, that was a fantastic overview 773 00:44:13,480 --> 00:44:17,759 Speaker 1: of a sort of persistently stubborn problem in one of 774 00:44:17,800 --> 00:44:20,040 Speaker 1: the world's most important markets. So thank you so much 775 00:44:20,040 --> 00:44:21,920 Speaker 1: for coming on all thoughts and explaining it to us. 776 00:44:21,960 --> 00:44:23,759 Speaker 3: Thanks terrific conversation. 777 00:44:23,880 --> 00:44:25,239 Speaker 2: Tracing, Joe, thank you so much. 778 00:44:25,320 --> 00:44:34,960 Speaker 1: Yeah, that was fantastic, So, Joe, I really enjoyed that conversation. 779 00:44:35,040 --> 00:44:38,000 Speaker 1: And you're absolutely right. It's a real treat to hear 780 00:44:38,160 --> 00:44:40,800 Speaker 1: from the guy that the central bankers are calling in 781 00:44:41,320 --> 00:44:44,160 Speaker 1: to talk about this. It does seem to be this 782 00:44:44,320 --> 00:44:47,520 Speaker 1: persistent issue in the market, and you see it happen 783 00:44:47,600 --> 00:44:51,279 Speaker 1: more and more, these like small bouts of volatility, but 784 00:44:51,320 --> 00:44:52,560 Speaker 1: they're happening more often. 785 00:44:52,640 --> 00:44:54,960 Speaker 2: Well, and I was really glad you asked that last 786 00:44:55,000 --> 00:44:57,440 Speaker 2: question because that really crystallized something for me, which is 787 00:44:57,480 --> 00:45:01,600 Speaker 2: that we are living in a period of like big 788 00:45:01,640 --> 00:45:05,120 Speaker 2: fiscal right for better or worse. And so it's like, well, 789 00:45:05,120 --> 00:45:08,200 Speaker 2: what is like unsustainable about it or where did the 790 00:45:08,360 --> 00:45:11,800 Speaker 2: how does that become a stress point? And to Daryl's point, 791 00:45:11,960 --> 00:45:15,560 Speaker 2: it's like, if you have this explosion of supply at 792 00:45:15,640 --> 00:45:18,920 Speaker 2: a time when the entities that are like tasked with 793 00:45:19,080 --> 00:45:21,840 Speaker 2: sort of like managing that supply either have constrained or 794 00:45:21,880 --> 00:45:25,040 Speaker 2: shrinking balance sheets, then setting aside you of a like 795 00:45:25,080 --> 00:45:28,600 Speaker 2: fiscal sustainability or inflation, you are going to run into 796 00:45:28,600 --> 00:45:31,560 Speaker 2: this basically like infrastructure bottleneck. And it feels like that's 797 00:45:31,600 --> 00:45:33,200 Speaker 2: really like the challenge here. 798 00:45:33,320 --> 00:45:35,480 Speaker 1: I think that's exactly right, and I mean you brought 799 00:45:35,520 --> 00:45:37,440 Speaker 1: up inflation just then, but this seems to be the 800 00:45:37,480 --> 00:45:41,000 Speaker 1: other important factor, which is, well, maybe that model of 801 00:45:41,080 --> 00:45:44,440 Speaker 1: trading and dealing and treasuries worked for a period of 802 00:45:44,840 --> 00:45:48,000 Speaker 1: very low interest rates where we did have very subdued inflation, 803 00:45:48,520 --> 00:45:51,960 Speaker 1: but in an era where there is monetary policy tightening, 804 00:45:52,000 --> 00:45:54,880 Speaker 1: maybe you can't count on the Central Bank to always 805 00:45:55,400 --> 00:45:58,200 Speaker 1: backstop the treasury market, or if it backstops it, it's 806 00:45:58,200 --> 00:46:00,800 Speaker 1: going to need to sell some of those treasure reies eventually. 807 00:46:01,040 --> 00:46:03,359 Speaker 1: Then that kind of changes the calculus. 808 00:46:03,640 --> 00:46:07,960 Speaker 2: So we're gonna have to do an episode on Israeli government. No, 809 00:46:08,040 --> 00:46:11,399 Speaker 2: it's like the one country that just everyone else saw 810 00:46:11,400 --> 00:46:13,200 Speaker 2: all this dress like I had no idea about that. 811 00:46:13,280 --> 00:46:16,360 Speaker 1: Yeah, we should. Actually that'd be really interesting. Okay, but 812 00:46:16,480 --> 00:46:18,960 Speaker 1: for now, shall we head back to the lodge at 813 00:46:19,040 --> 00:46:19,600 Speaker 1: Jackson Hole. 814 00:46:19,719 --> 00:46:20,640 Speaker 2: Let's do it all right? 815 00:46:20,760 --> 00:46:24,080 Speaker 1: This has been another episode of the Oddlots podcast. I'm 816 00:46:24,080 --> 00:46:26,760 Speaker 1: Tracy Alloway. You can follow me at Tracy Alloway. 817 00:46:26,840 --> 00:46:29,880 Speaker 2: And I'm Joe Wisenthal. You can follow me at the Stalwart. 818 00:46:30,080 --> 00:46:33,720 Speaker 2: Follow our guest Darryl Duffy. He's at Darryl Duffy. Follow 819 00:46:33,800 --> 00:46:37,680 Speaker 2: our producers Carmen Rodriguez at Carmen Arman and dash Ol 820 00:46:37,719 --> 00:46:41,319 Speaker 2: Bennett at Dashbot. And our special guest producer on this 821 00:46:41,480 --> 00:46:45,360 Speaker 2: Jackson Hole trip, Sebastian Escobar. He's at Under the Sea Bass. 822 00:46:45,480 --> 00:46:48,120 Speaker 2: Follow the rest of the Bloomberg podcasts under the Handle 823 00:46:48,160 --> 00:46:51,560 Speaker 2: at Podcasts and for more Oddlogs content, go to Bloomberg 824 00:46:51,640 --> 00:46:55,200 Speaker 2: dot com slash odd Lots, where we have transcripts, a blog, 825 00:46:55,239 --> 00:46:58,600 Speaker 2: and a newsletter and you can discuss all these topics 826 00:46:58,640 --> 00:47:01,239 Speaker 2: twenty four to seven with fellow listteners in the discord. 827 00:47:01,520 --> 00:47:03,360 Speaker 2: I'm sure there'll be a lot of conversation about this 828 00:47:03,400 --> 00:47:06,680 Speaker 2: one discord dot gg slash od lots. 829 00:47:07,160 --> 00:47:10,719 Speaker 1: And if you like odd Lots, if you enjoy these discussions, 830 00:47:10,719 --> 00:47:12,640 Speaker 1: and you want us to do an episode on the 831 00:47:12,719 --> 00:47:16,200 Speaker 1: structure of the Israeli government bond market, then please leave 832 00:47:16,280 --> 00:47:19,800 Speaker 1: us a positive review on your favorite podcast platform. Thanks 833 00:47:19,800 --> 00:47:20,280 Speaker 1: for listening.