Speaker 1: Hello, and welcome to another episode of the Odd Lots Podcast.
Speaker 2: I'm Tracy Alloway and I'm Joe Wisenthal.
Speaker 1: Joe, have you been watching treasury yield s lately?
Speaker 3: Uh?
Speaker 2: They're up, They've I'm that's it.
Speaker 1: That's the show where.
Speaker 2: That the line has gone up into the right lance.
Speaker 1: Yes, but not just that, they've moved quite quickly up.
Speaker 1: And I think volatility in the treasury market has once
Speaker 1: again become a talking point. And I always get a
Speaker 1: little bit of a sense of deja vu because whenever
Speaker 1: things start happening in the market for US government bonds,
Speaker 1: extreme things, these extreme moves, it feels like everyone says, Oh,
Speaker 1: they shouldn't be happening in the world's most liquid market,
Speaker 1: the world's safest market. We shouldn't be seeing these types
Speaker 1: of dramatic shifts, right.
Speaker 2: The expectation is this is like a very extremely liquid,
Speaker 2: slow moving market. But it has been a very fast
Speaker 2: move and people don't really know why. There's a lot
Speaker 2: of debate. You have people talk about, well, look, the
Speaker 2: economy is proving to be more resilient than people might
Speaker 2: have guessed six months ago, even a month ago. And
Speaker 2: I think there's this expectation. There's this sense that things
Speaker 2: are moving faster. There's also a lot of talk about
Speaker 2: treasury supply, supplied demand imbalances and so forth. So things
Speaker 2: are on the move, to say the least, and you
Speaker 2: see it in mortgage spreads are very wide. You see
Speaker 2: it another risk assets not seeming to like this treasury volatility.
Speaker 2: So lots going on there.
Speaker 1: So you mentioned a couple of things there, which is, yes,
Speaker 1: the economy seems to be doing relatively well, and yes,
Speaker 1: the amount of treasury supply is exploding and has been
Speaker 1: going up for a very long time. There's another factor here,
Speaker 1: which is the actual inner workings of the treasury market,
Speaker 1: so how treasuries are actually traded and whether or not
Speaker 1: that is potentially contributing to some of the volatility that
Speaker 1: we've seen. And again, I feel like this topic keeps
Speaker 1: coming up every year there's some massive move in treasury
Speaker 1: markets and everyone starts talking about liquidity issues, and yet
Speaker 1: you don't really see any big solutions being proposed to it.
Speaker 1: You see talk about, you know, maybe loosening some of
Speaker 1: the regulation around supplementary leverage ratio or something like that,
Speaker 1: But it feels like we need to talk about this
Speaker 1: and maybe try to come up with a solution.
Speaker 2: Let's do it, and we're in a good place to
Speaker 2: talk about it.
Speaker 1: Yes, we're at Jackson Hole.
Speaker 2: I thought you were. I thought that was going to
Speaker 2: be the first is like Jackson I like how you
Speaker 2: like we eat it into it a little bit.
Speaker 1: Oh, I want this to be an evergreen episode for
Speaker 1: an evergreen problem. It feels like, but.
Speaker 2: The people here care about this topic.
Speaker 1: Yes, absolutely. The way US treasury debt is traded has
Speaker 1: a lot of implications, particularly for the cost of financing
Speaker 1: the US deficit. That's an obvious one, and so we
Speaker 1: should talk about it.
Speaker 2: Let's talk about it.
Speaker 1: I'm very pleased to say that we have the perfect guest.
Speaker 1: We are going to be speaking with Darryl Duffy. He is,
Speaker 1: of course, a professor of finance at Stanford's Graduate School
Speaker 1: of Business, and he is presenting a paper at Jackson
Speaker 1: Hole in front of the world's top central bankers all
Speaker 1: about this issue. It's called Resilience reducs in the US
Speaker 1: Treasury market. So, Darryl, thank you so much for coming on.
Speaker 3: All thoughts, thanks for having me, Tracy, Joe, It's terrific.
Speaker 2: To be here, you know, it's the perfect guest when
Speaker 2: it's the guest, and it's like not just it, like
Speaker 2: we want to have him on odd laws that the
Speaker 2: central the top central banker is around the world want
Speaker 2: to hear from a Professor Duffy. So yes on this issue.
Speaker 2: I'm very excited about this episode.
Speaker 1: When treasuries are moving, they call up Daryl Duffy. All right, well, professor,
Speaker 1: thank you again for coming on. Why don't we just
Speaker 1: start with the basics. You know, we sort of alluded
Speaker 1: to this in the intro, but it feels like this
Speaker 1: is a subject that just keeps coming up and never
Speaker 1: really seems to go away. What's going on here?
Speaker 3: Well, over the past century, there have been, as you suggested,
Speaker 3: many episodes of increased volatility and liquidity problems in the
Speaker 3: treasury market, but I do think these are happening more frequently.
Speaker 3: Just recently. I think you summarized pretty well some of
Speaker 3: the stresses in the treasury market coming from the fiscal side.
Speaker 3: The US is issuing more than people expected, there was
Speaker 3: a recent downgrade by Fitch, and the Fed is struggling
Speaker 3: with what to do about inflation. That additional monetary policy
Speaker 3: uncertainty also contributes to volatility. Let me back up a minute.
Speaker 3: I just spent most of the last year on a
Speaker 3: sabbatical at the New York FED and working with some
Speaker 3: terrific economists there, Michael Fleming, Frank Keene or Shekhar, Peter
Speaker 3: von tassl Claire Nelson. We decided we needed to look
Speaker 3: into the relationship between the volatility that you two discussed
Speaker 3: and the liquidity in the market. They're closely intertwined. So
Speaker 3: we dug deep and went into a lot of data,
Speaker 3: and yeah, volatility seems to be the main determinant of
Speaker 3: lil liquidity in the market. So when fiscal uncertainty or
Speaker 3: debt ceiling debate, or a COVID crisis or monetary policy
Speaker 3: uncertainty start to get a volatility higher and higher, market
Speaker 3: becomes less and less liquid. It's an extremely regular relationship.
Speaker 3: About eighty percent of illiquidity is explained simply by variation
Speaker 3: and yield volatility.
Speaker 2: So just to press on this relationship between rates volatility
Speaker 2: or yield volatility and illiquidity, like which way does the
Speaker 2: direction run? Or because we can come up with these
Speaker 2: fundamental stories right, like Okay, maybe the economy is better
Speaker 2: than expected. Maybe we're going to have more rate hikes
Speaker 2: than previously anticipated, in which case you say, okay, well
Speaker 2: that's sort of like that's a fundamental story of fundamental driver.
Speaker 2: And then you could look at certain nature of the structure,
Speaker 2: like the size of dealer balance sheets, et cetera. It's like, okay, well,
Speaker 2: this is something technical that contributes to also could be
Speaker 2: a contributor to volatility. How do you think about like
Speaker 2: the directions of causality when you look into a problem.
Speaker 3: Like this, Yeah, well, both the direct fundamentals, fiscal monetary
Speaker 3: fundamentals and global the global economy and geopolitics recently all
Speaker 3: play a direct fundamental role. And then, as you alluded,
Speaker 3: there's also kind of a feedback effect. When volatility rises
Speaker 3: for fundamental reasons, dealers are going to struggle with providing
Speaker 3: sufficient liquidity to the market, and to the extent that
Speaker 3: dealer balance sheets are not sufficiently flexible to accommodate the
Speaker 3: provision of liquidity to the market, that in and of
Speaker 3: itself increases illiquidity, increases volatility, and they kind of feedback
Speaker 3: on themselves, and you can get an episode like we
Speaker 3: had when COVID hit in March twenty twenty, where liquidity
Speaker 3: becomes even worse than would be suggested by volatility alone,
Speaker 3: much worse. And that's just a sign that the market
Speaker 3: is not capable of intermediating those extreme demands for liquidity.
Speaker 1: Right. So, this seems to be a distinct characteristic of
Speaker 1: treasuries in particular, which is when stuff starts to go
Speaker 1: really wrong like it did in March of twenty twenty,
Speaker 1: people often sell the safest stuff first, which means they
Speaker 1: sell treasury. So you get this big wave of selling
Speaker 1: at precisely the moment that a lot of dealers want
Speaker 1: to wind down or back away from risk. Is that
Speaker 1: just a fundamental tension in the market. Is that always
Speaker 1: going to be the case?
Speaker 3: As long as US treasuries are the world's most important
Speaker 3: safe haven, which is clearly the case by Miles, that's
Speaker 3: always going to be the result for basically two reasons.
Speaker 3: Number One, a whole lot of major investors like foreign
Speaker 3: exchange reserve managers firms that are storing a safe liquid
Speaker 3: asset just in case, Well, the just in case happened,
Speaker 3: and they are going to liquidate those positions. The other
Speaker 3: channel for this is as the volatility grows and uncertainty grows,
Speaker 3: of investors are you know, kind of finding it too
Speaker 3: hot to handle and they have to unload some risk,
Speaker 3: and treasuries are the easiest security to unload in the world.
Speaker 3: The market's got a good reputation for being the deepest
Speaker 3: and most liquid market in the world.
Speaker 2: So I know, we we've talked about this a little
Speaker 2: bit in the past with a few different guests, including
Speaker 2: Josh Younger. He made the point on one of the
Speaker 2: episodes that we did, which is like, if you're thinking about,
Speaker 2: like what do we want to do to have better
Speaker 2: treasury market structure, that it doesn't necessarily make sense to
Speaker 2: optimize for well, we never want to have a March
Speaker 2: twenty twenty again, because you don't necessarily want to have,
Speaker 2: you know, optimized for the one out of every one
Speaker 2: hundred year pandemic. But what would you say, like is
Speaker 2: the goal, Like if you're like, okay, there does seem
Speaker 2: to be this relationship between volatility and illiquidity. It does
Speaker 2: seem like some of these bouts of volatility and illiquidity
Speaker 2: become more frequent. If you think about designing sort of
Speaker 2: an optimal market structure for treasuries, what would you say
Speaker 2: we're trying.
Speaker 3: To each Josh I've known him since you worked at
Speaker 3: JP Morgan, and now that he's moved to the FED,
Speaker 3: we get to talk a lot more. This is a
Speaker 3: terrific insight that he has, the kind of do you
Speaker 3: really want to design a market for the worst day
Speaker 3: in a thousand? Isn't that very expensive? And maybe overdoing
Speaker 3: it because nine ninety nine days out of a thousand
Speaker 3: you didn't really need that kind of a market structure.
Speaker 3: I'm going to be a little provocative here. I think
Speaker 3: you do want to build a market for the worst
Speaker 3: day in a thousand for the following reason. If I'm
Speaker 3: let's say, managing the foreign exchange reserves of an emerging
Speaker 3: market central bank, when do I need to actually take
Speaker 3: advantage of the depth and liquidity of the US Treasury market.
Speaker 3: It's that one day in a thousand when all the
Speaker 3: other safe haven investors are trying to do the same thing.
Speaker 3: In the paper on that Tracy mentioned I'm giving here
Speaker 3: at Jackson Hole, I talk about this wrong way risk
Speaker 3: from the viewpoint of illiquidity. You don't want the market
Speaker 3: to be great except on that very same regular day
Speaker 3: on which everybody needs the liquidity. Why not? Well, because
Speaker 3: a this is the lynchpin of global financial market stability.
Speaker 3: You wanted to work day in, day out, and b
Speaker 3: If you discourage safe haven investors from believing that even
Speaker 3: though everybody else is liquidating that day, they could also
Speaker 3: liquidate at low cost with ease, then they won't use
Speaker 3: the US Treasury security as much as they're safe haven.
Speaker 3: They'll diversify. And that's what we've been seeing somewhat over
Speaker 3: the last couple of decades, a degree of diversification away
Speaker 3: from the US Treasury, still by far the dominant safe haven.
Speaker 3: Something like fifty nine percent of foreign exchange reserves are
Speaker 3: held in US treasuries. But from the viewpoint of the
Speaker 3: US taxpayer, you want everyone to believe that on the
Speaker 3: worst day NF thousand, that market is going to be
Speaker 3: there for them.
Speaker 1: Wait, I'm going to be provocative now or try to. Okay,
Speaker 1: So on this note, we did see in March twenty twenty,
Speaker 1: the FED unveiled all these different emergency programs aimed at
Speaker 1: supporting the US treasury market. So you know, we have
Speaker 1: the new standing repo facility, and I think you know
Speaker 1: they were buying US treasuries in exchange for reserves, and
Speaker 1: then they exempted all of those from the supplementary leverage
Speaker 1: ratios for banks. So it seems like the backstop is
Speaker 1: in place. If something bad were to happen again, I
Speaker 1: would presume that the FED would unveil either those exact
Speaker 1: measures again or something very similar. So is the issue solved?
Speaker 3: Yeah, you're tracy. That is provocative, So I would definitely.
Speaker 1: Say it's a polite way of saying you're so wrong.
Speaker 3: No, the FED. The FED came out guns blazing unlimited
Speaker 3: financing and the rebound market for anyone that had access
Speaker 3: to the FED a trillion dollars of purchases in the
Speaker 3: first three weeks, nearly a trillion of US treasuries, relieving
Speaker 3: the other dealer balance sheets of their overloading. Getting the
Speaker 3: supplementary leverage ratio back and it was causing problems took
Speaker 3: a little longer, and it took I think some backroom
Speaker 3: negotiations with the other bank regulators to come on board,
Speaker 3: so that got delayed, and that was a problem. But
Speaker 3: the FED did a terrific job at crisis management during
Speaker 3: those weeks, and I say weeks because they didn't solve
Speaker 3: the problem. They only made it less bad than it
Speaker 3: otherwise would have been. It took five, six, seven, eight
Speaker 3: weeks before market liquidity was restored. And again going back
Speaker 3: to my wrong way risk point, if I'm looking for
Speaker 3: a market that's going to work for me in a crisis,
Speaker 3: I don't want to have to wait weeks in order
Speaker 3: to get liquidity or to pay a low cost for liquidity.
Speaker 3: I wanted to be working all the time. Now, of
Speaker 3: course it's unrealistic that it should work every single day.
Speaker 3: But if we rely only on central banks and I
Speaker 3: speak more broadly, to bail out their government securities market
Speaker 3: when they get into trouble, it's not going to be
Speaker 3: one hundred percent effective and it raises moral hazard. It
Speaker 3: says to the rest of the world, we'll use the
Speaker 3: central bank balance sheet to bail you out. You don't
Speaker 3: need to focus on improving market structure reducing undue leverage.
Speaker 3: We have your backs that message. While it needs to be,
Speaker 3: there is not a substitute for improving the market structure.
Speaker 2: Yeah, you sort of anticipated my next question, but okay,
Speaker 2: it does seem like in an emergency the FED can
Speaker 2: say we're going to know by do QUI at a
Speaker 2: scale that we've never seen before, and as Tracy mentioned,
Speaker 2: unveil these unveil these new facilities kind of on the fly,
Speaker 2: and it seems like basically since two thousand and eight
Speaker 2: two thousand and nine, the FED has gotten really good
Speaker 2: at standing up new facilities very quickly. So that's like
Speaker 2: a skill that they've developed. But can you talk a
Speaker 2: little bit more about what you perceive is to be
Speaker 2: the cost of a sort of stability regime that sort
Speaker 2: of presumpt presumes that, yeah, we know there's some frailties,
Speaker 2: but our solution is that in that you know, seven
Speaker 2: more twelve sigma day that the FED is there, and like, well,
Speaker 2: talk about more about why that's not a good system.
Speaker 3: Okay, Well, just I want to re emphasize that the FED, I.
Speaker 2: Don't know how many sigmas it really is that billion,
Speaker 2: I don't know. I just put throughout a number.
Speaker 3: The FED does need to be there. It's not as
Speaker 3: though one should say, let's take the fed's balance sheet
Speaker 3: out of the equation and try to do without it.
Speaker 3: It needs to be there. It's a backstop. It's the
Speaker 3: last resort. The FED is the buyer of last resort.
Speaker 3: After it's become the lender of last resort. It can't
Speaker 3: do anything else. But bail at the market by buying securities.
Speaker 3: But relying on that has several problems. I already mentioned
Speaker 3: it's not one hundred percent of effective on the first day.
Speaker 3: And there's also the size of the Fed's balance sheet
Speaker 3: that's controversial. I mean, even if you think it's innocuous,
Speaker 3: it raises political concerns. There are those that say, well,
Speaker 3: maybe the Fed's balance sheet is too big, and we
Speaker 3: need to curtail the ability of central banks, including the FED,
Speaker 3: to expand their balance sheets to the extent that they
Speaker 3: have been and they've been using them very, very liberally
Speaker 3: over the past couple of decades. The other concern is
Speaker 3: once the balance sheet is large, it eventually is going
Speaker 3: to come back down and those treasuries are going to
Speaker 3: be adding to the stock of securities that other investors
Speaker 3: need to have, and that it means that the central banks,
Speaker 3: including the FED, need to do that very gingerly. There's
Speaker 3: a lot of volatility in the treasury market, and the
Speaker 3: FED is letting its balance sheet come down. Other investors
Speaker 3: are having to pick up the load. It's easier to
Speaker 3: expand the balance sheet than it is to bring it down.
Speaker 3: So using the Fed's balance sheet while it's necessary, is
Speaker 3: not a painless solution, and I would argue it's not
Speaker 3: the best solution anyway. We can do better by improving
Speaker 3: market structure. Pushing out into the extreme tails the number
Speaker 3: of events in which the FED needs to step in
Speaker 3: and linch.
Speaker 1: Why don't we talk about the market structure and maybe
Speaker 1: before we start talking about improvements that could be made,
Speaker 1: could you give us the sort of lay of the
Speaker 1: land when it comes to how treasuries are traded today.
Speaker 1: So there's primary dealers for the new issuance, and then
Speaker 1: there's your sort of run of the mill dealers for
Speaker 1: secondary market trades. But talk to us how it works
Speaker 1: right now?
Speaker 3: Terrific. Well, it's an extremely complex structure, but it can
Speaker 3: be summarized pretty simply. There's two segments of the market.
Speaker 3: There's the interdealer market, in which the dealers trade among themselves,
Speaker 3: and then there's the customer to dealer market, in which
Speaker 3: investors around the world trade with dealers. Notably, investors do
Speaker 3: not trade directly with other investors. There is no alto
Speaker 3: all trade in the US treasure market, no matter whether
Speaker 3: you're an insurance company, a hedge fund, a foreign exchange reserve, manager.
Speaker 3: You are going to be buying and selling with a
Speaker 3: dealer if you're a dealer. On the other hand, there
Speaker 3: is a very active interdealer market for the on the
Speaker 3: run securities. Those are the latest issues of the Treasury.
Speaker 3: There's an order book market, which is a high frequency
Speaker 3: trading market run by Brokertech, which is a subsidiary of
Speaker 3: the Chicago Mercantile Exchange, where you have the same kinds
Speaker 3: of high frequency trading that you see in the stock market.
Speaker 3: The only other participants on the broker Tech market are
Speaker 3: high frequency trading firms sometimes called principal trading firms like Jump,
Speaker 3: like DRW, like Citadel, firms that have a very special
Speaker 3: purpose of intermediating in the interdealer market, taking you know,
Speaker 3: little bit offer spreads from the dealers and from each other.
Speaker 3: That's the basic structure of the market. Again, the notable
Speaker 3: feature is if you're an investor, you can trade only
Speaker 3: with a dealer. If you're a dealer, you have the
Speaker 3: ability to lay off positions in the interdealer market.
Speaker 2: Again, before we get into sort of like optimal structure,
Speaker 2: I'm actually just curious. You know, you mentioned that you
Speaker 2: spent the last year at the New York FED looking
Speaker 2: into this and sort of getting this. What did you do?
Speaker 2: How did you let go about your research? Like, how
Speaker 2: much is it sort of like a sort of statistical
Speaker 2: base analysis versus how much was it talking to dealers
Speaker 2: and understanding how they are. I'd just be curious about.
Speaker 3: The research process for this particular project was a combination
Speaker 3: of meeting and discussing what needed to be done with
Speaker 3: the economists that I mentioned earlier, and those would be
Speaker 3: weekly meetings pretty in depth where we would go through
Speaker 3: what we've already learned and what we need to do next.
Speaker 3: And that happened for six months or so. And at
Speaker 3: the same time, in the background, we're collecting volumes of
Speaker 3: statistical data to FED, because it's a member of the
Speaker 3: official sector, has access not only to its own data,
Speaker 3: but to exceptionally fine grained data on at the transactions level.
Speaker 3: Let me give you one example. There is a data
Speaker 3: set called trace which records every single trade in the
Speaker 3: treasure market with a few minor exceptions. Those data are
Speaker 3: only available to the official sector. They're not available to
Speaker 3: the public. And by the way, I disagree with that policy,
Speaker 3: and we could talk about that. I think it actually
Speaker 3: is contributes to the problem of illiquidity. But in any case,
Speaker 3: the FED, as a member of that official sector group,
Speaker 3: can go to its sister agencies in the federal government
Speaker 3: and say, look, we have this project, here's its objectives.
Speaker 3: We want to use these trace data to analyze liquidity
Speaker 3: in the US treasury market. And then we get feedback saying, yeah,
Speaker 3: this looks good. The way that pre zata are being
Speaker 3: presented will not reveal proprietary information, so go ahead. And
Speaker 3: then we can do the same thing with dealer balance
Speaker 3: sheet data. We can get exposures of the dealers not
Speaker 3: only to treasury securities, but to agency mortgage backed securities,
Speaker 3: which turned out to be another big load on their
Speaker 3: balance sheet, particularly during March of twenty twenty. We can
Speaker 3: go to a wide range of data sets, and we
Speaker 3: wrote a paper it explains the extent to which we
Speaker 3: access all of these data bring them together. We developed
Speaker 3: eighteen different liquidity tricks and many different metrics on how
Speaker 3: dealer balance sheets are being loaded. And then we would
Speaker 3: analyze these using reasonably intricate econometric methods like quantile regressions
Speaker 3: and a number of other statistical approaches, and then we
Speaker 3: would start to see the patterns emerge very very clearly.
Speaker 3: That I describe two key patterns that came up over
Speaker 3: and over again in our discussion meetings. Where A volatility
Speaker 3: seems to explain most of the variation in liquidity, but
Speaker 3: b when it doesn't, it's dealer balance sheet loading that
Speaker 3: explains the remaining part of illiquidity. It's a highly nonlinear effect.
Speaker 3: When dealer balance sheets are normally loaded, they don't contribute
Speaker 3: to ill liquidity. But when they're reaching their extremes, where
Speaker 3: dealers are handling more treasury trades and more agency MBS
Speaker 3: trades and they've handled in the past, then you see
Speaker 3: illiquidity go up well beyond the level predicted by volatility.
Speaker 3: So after analyzing all these data and discussing what's driving these,
Speaker 3: then we turn to writing up our results and there's
Speaker 3: a lot of iterative work there which you can see
Speaker 3: in the paper that we wrote.
Speaker 1: So you can see the dealer balance sheets on a
Speaker 1: daily basis, not just at quarter.
Speaker 2: End, not quite.
Speaker 3: We can only see dealer balance sheets on a weekly
Speaker 3: basis because the FED has a data set called FR
Speaker 3: two thousand and four which collects those data only on
Speaker 3: a weekly basis and summaries of those data are available
Speaker 3: publicly on the New York Fed's website.
Speaker 1: So going back to this dealer balance sheet issue, I mean,
Speaker 1: this is something that has come up basically ever since
Speaker 1: the two thousand and eight financial crisis, and there have
Speaker 1: been a lot of complaints from the dealers about all
Speaker 1: this new regulation that limits their ability to take risk
Speaker 1: on their balance sheet. And the argument for doing that
Speaker 1: has always been one of financial stability. Well, we want
Speaker 1: the banks to be safer, and if they have to
Speaker 1: cut back on their intermediation capacity in the market, maybe
Speaker 1: that's a fair trade. How do you thread the needle
Speaker 1: between those two issues, especially in a market as important
Speaker 1: as treasuries.
Speaker 3: Okay, it's very tough because those much more demanding capital
Speaker 3: requirements and other requirements that came in after the financial
Speaker 3: crisis have clearly reduced liquidity and a broad set of
Speaker 3: financial markets. It's glaringly obvious. However, we can't afford to
Speaker 3: return to the pre Lehman days in which dealers would
Speaker 3: expand their balance sheets for a few basis points of arbitrage,
Speaker 3: creating financial instability. So while those new capital requirements are
Speaker 3: necessary for protecting the economy from collapse of the financial
Speaker 3: services sector. We do need to substitute for the liquidity
Speaker 3: that's missing in other ways. There is one capital regulation
Speaker 3: that I think is not necessary, and that's the one
Speaker 3: you mentioned, Tracy, the supplementary leverage ratio. That rule penalizes
Speaker 3: the provision of liquidity, even for very safe assets. Let
Speaker 3: me give you an example. When the FED was buying
Speaker 3: treasury securities from mid March. It bought within three weeks
Speaker 3: nearly a trillion dollars of treasuries, and one might think, oh,
Speaker 3: thank goodness, that's lowering the making more space on dealer
Speaker 3: balance sheets for other positions. However, from the viewpoint of
Speaker 3: that capital regulation, there was really not much change at all,
Speaker 3: because the FED paid for those trillion of treasuries with
Speaker 3: a trillion of reserve balances, and reserve balances, although perfectly
Speaker 3: safe and liquid, have the same impact on dealer capital
Speaker 3: requirements as the treasury securities that they replaced, so there
Speaker 3: wasn't really, from the viewpoint of the supplementary leverage ratio,
Speaker 3: much benefit of the Treasury's purchases. There were benefits in
Speaker 3: other respects because treasuries are risky and dealers were relieved
Speaker 3: of that risk by the fed's trades. But from the
Speaker 3: viewpoint of that supplementary leverage ratio, it was very unfortunate.
Speaker 3: And I and others have argued that the SLR supplementary
Speaker 3: leverage ratio rule should be replaced with higher risk based
Speaker 3: capital requirements.
Speaker 2: So can you explain that when you say replaced with
Speaker 2: higher risk based capital requirements, So.
Speaker 1: The capital wouldn't be calculated on the basis of the
Speaker 1: size of your total balance sheet, but on the riskiness
Speaker 1: the actual makeup of the balance sheet.
Speaker 3: That's right. There's been a kind of go around in
Speaker 3: the world of in the basle world of capital requirements
Speaker 3: for banks. Back in the eighties, we went from a
Speaker 3: world where there were just basically leverage requirements that did
Speaker 3: not consider risk to a world in which the financial
Speaker 3: regulators were saying, hey, wait a minute, we should be
Speaker 3: weighting these assets by risk because that's what matters for insolvency.
Speaker 3: And then it was discovered leading up to the ChRI
Speaker 3: and failure of Lehman, that banks were playing games with
Speaker 3: their risk based measures, or simply the measures were not
Speaker 3: accurate enough, and so as a backstop or just in case,
Speaker 3: the supplementary leverage racial rule was introduced to eliminate, from
Speaker 3: the viewpoint of that capital requirement any consideration of risk, saying,
Speaker 3: you know, no more games and no more uncertainty about
Speaker 3: how much risk. We're just going to require for every
Speaker 3: one hundred dollars of assets of any kind, even central
Speaker 3: bank deposits, you have to have a certain number of
Speaker 3: dollars of capital that doesn't depend on the risk. Well,
Speaker 3: in my view, that's backfired and it's led to more
Speaker 3: illiquidity than necessary. You could still have the same amount
Speaker 3: of financial stability with less illiquidity if you dial back
Speaker 3: that rule and dial up risk based requirements so that
Speaker 3: the system wide you're just as safe as you were before.
Speaker 3: But each individual bank is not internalizing the cost of
Speaker 3: balance sheet space when it makes trades safe assets.
Speaker 1: What would that mean for bank's interest rate risk? And
Speaker 1: I'm thinking specifically back to a different March, not twenty twenty,
Speaker 1: but March of twenty twenty three, when we did see
Speaker 1: a lot of banks hit by mark to market moves
Speaker 1: on their bonds because interest rates were going up and
Speaker 1: so the prices were lower. If you removed bonds from
Speaker 1: the SLR calculations, would you still be able to take
Speaker 1: into account interest rate risk or would you not really
Speaker 1: need to anymore?
Speaker 3: No, you would still need to do that, but you
Speaker 3: could do that through a couple of measures that have
Speaker 3: been proposed that came up after the failures of a
Speaker 3: Silicon Valley bank and other banks. So one thing you
Speaker 3: could do, which should be done, is that the very
Speaker 3: large but not jes banks like those big regionals, should
Speaker 3: be required to pass their losses due to interest rate
Speaker 3: risk through to their capital accounts, so that when they
Speaker 3: lose money on treasuries they have to add capital to
Speaker 3: replace them. They were exempted from passing through those losses.
Speaker 3: The second thing you can do, which surprisingly the FED
Speaker 3: has not done recently, is to include shocks to interest
Speaker 3: rates as a scenario in their stress tests, so that
Speaker 3: banks would need to demonstrate that even if the Yuel
Speaker 3: curve were to jump up a couple of hundred basis points,
Speaker 3: they would have the capital necessary to weather that storm.
Speaker 1: Right. This was the crazy thing about the bank stress test.
Speaker 1: They were always for a recessionary scenario where interest rates
Speaker 1: would plummet, and they never actually modeled interest rates going
Speaker 1: sharply up.
Speaker 2: I don't think I realized that. I mean, it's like
Speaker 2: a classic like what fight. It always is right to
Speaker 2: fight the last war. So it's like, Okay, we're gonna
Speaker 2: like protect against this big collapse or recession and credit risk,
Speaker 2: et cetera. And then the idea that like the next
Speaker 2: I don't know if you'd call it a tracy and
Speaker 2: I fight about whether it's a crisis, but the next.
Speaker 1: Bar settled on drama.
Speaker 2: The drama would be in the other direction of the
Speaker 2: rates going higher. But yeah, sense that that would be
Speaker 2: part of a stress test.
Speaker 3: Yeah, Joe, I mean, the FED is already predicted that
Speaker 3: it's going to make those losses pass through to capital,
Speaker 3: and I predict personally that they will also include interest
Speaker 3: rate risk scenarios in their stress text. I would not
Speaker 3: be surprised to see both of those in place soon.
Speaker 1: Just going back to one suggestion for improving liquidity and treasuries,
Speaker 1: you mentioned all to all trading earlier, So the idea
Speaker 1: that investors could trade with one another. I am most
Speaker 1: familiar with that model through multi year efforts to get
Speaker 1: it going. In corporate credit. There is a lot of
Speaker 1: resistance to that from the dealers who don't want to
Speaker 1: give up a lot of their pricing power. In that market.
Speaker 1: Is it a similar story in US treasuries? Like, why
Speaker 1: doesn't all to all trading exist already?
Speaker 3: Okay, Well, the most influential market participants from the viewpoint
Speaker 3: of designing and innovating market structure are the dealers themselves.
Speaker 3: And if I were, you know, in the executive suite
Speaker 3: of one of the largest dealers, I don't think I
Speaker 3: would necessarily campaign to introduce a new set of competitors
Speaker 3: for my trade, lowering my market share and reducing my
Speaker 3: profit margin on each trade. So it's kind of understandable
Speaker 3: that to the extent that the market hasn't evolved, that
Speaker 3: you know, dealer dealers haven't been pushing for that. By
Speaker 3: the way, I'm not advocating that the FED shouldn't mandate
Speaker 3: all to all trade or other regulators should mandate that.
Speaker 3: I think it needs to happen organically, because if it's
Speaker 3: a rule requirement that trades in the treasury market must
Speaker 3: be all to all, well, first you have to define
Speaker 3: what that means, and that's going to gum up the
Speaker 3: market design in and of itself. It's difficult. It's a
Speaker 3: difficult design process. And secondly, there's a lot of trade
Speaker 3: in that market that should be done by with dealers
Speaker 3: for very large block trades, and dealers need to be
Speaker 3: involved in the provision of liquidity directly to investors. So
Speaker 3: in my view that all to all trade needs to
Speaker 3: happen in a way that the market is guiding, but
Speaker 3: there can be a nudge from other rules that would
Speaker 3: lead that way, an example being central clearing.
Speaker 1: Right, So this is the other suggestion in your paper,
Speaker 1: So a shift towards all to all trading. I'm still
Speaker 1: a little unclear on how that would happen organically, given
Speaker 1: there seems to be a lot of resistance from the dealers.
Speaker 1: I assume maybe it's one or two big investors, you know,
Speaker 1: someone like a black Rock says we're going to do it,
Speaker 1: and then the dealers just have to come along for
Speaker 1: the ride. But the other suggestion is central clearing. And
Speaker 1: on this issue, again, correct me if I'm wrong. My
Speaker 1: impression was always that the FED was a little bit
Speaker 1: resistant to that idea.
Speaker 3: Well, the Security Is and Exchange Commission recently unanimously proposed
Speaker 3: broad central clearing in the US treasury market. I don't
Speaker 3: think there's that much resistance among the other key players
Speaker 3: in the official sector in the case of the treasury market,
Speaker 3: those key players are the SEC itself, the New York Fed,
Speaker 3: the Federal Reserve Board, and the Treasury Department. I don't
Speaker 3: see a significant amount of resistance across those four key players,
Speaker 3: but it's not easily done. First, it's a difficult design
Speaker 3: process itself. What is exactly are the requirements going to be?
Speaker 3: And secondly, there is going to be industry resistance. And
Speaker 3: even without singling out any particular regulator, I think industry
Speaker 3: pushback on the cost side of that is understandable and
Speaker 3: it's going to have to be overcome because leadership in
Speaker 3: the official sector is going to be needed to push
Speaker 3: that through.
Speaker 2: Sorry, I'm going to play the role of the ignorant
Speaker 2: listener AKA may define central clearing and what is it
Speaker 2: about it that, in your view would contribute to sort
Speaker 2: of like for the rest stability in the market.
Speaker 3: Okay, good, So let's just back up and describe what
Speaker 3: it is. In the current US treasury market, the dealers
Speaker 3: are required when they trade with each other to settle
Speaker 3: their trades through the Fixed Income Clearing Corporation, which means
Speaker 3: that they're not facing each other for settlement risk. If
Speaker 3: I trade with you, then tomorrow, I'll settle my trade
Speaker 3: with the Fixed Income Clearing Corporation, and so would you.
Speaker 3: That lowers our bilateral risk. It also allows me to
Speaker 3: net down my purchases against my sales, because if I
Speaker 3: buy from U Joe and I sell to Tracy in
Speaker 3: a bilateral world with no central clearing, I've got two
Speaker 3: settlements coming up that I have to pay attention to,
Speaker 3: both of them from the viewpoint of settlement risk and
Speaker 3: settlement failures, meaning the trades are not done. If I
Speaker 3: can net one hundred billion of purchases from you Joe
Speaker 3: against say one hundred and ten of sales with Tracy,
Speaker 3: that two hundred and ten billion gets netted down to
Speaker 3: ten billion facing fixed Income Clearing Corporation. So that massive
Speaker 3: reduction in my settlement risk is really beneficial from the
Speaker 3: viewpoint of using my balance sheet efficiently. There was a
Speaker 3: study done at the New York Fed year before last
Speaker 3: by Michael Fleming and Frank Keen, two of my other collaborators,
Speaker 3: in which they showed that on the peak days of
Speaker 3: the March twenty twenty COVID stress, the settlement in one
Speaker 3: day for the US Treasury market facing the dealers was
Speaker 3: in excess of a trillion dollars, and had those trades
Speaker 3: been centrally cleared, it would have been as low as
Speaker 3: three hundred billion, about a seventy percent reduction. Now that
Speaker 3: not only relieve some space on dealer balance sheets, which
Speaker 3: is one of the key problems here. If the central
Speaker 3: clearing is done effectively and a kind of straight through
Speaker 3: anonymous way, then investors in the market could say, well,
Speaker 3: I could trade directly with another investor and I wouldn't
Speaker 3: be reliant on my dealer to settle my trade for me.
Speaker 3: If only a trade platform operator would offer that service,
Speaker 3: I'd be all in. And then trade platform operators will say, wow,
Speaker 3: now that we have central clearing in this market, the
Speaker 3: barriers to enter into the intermediation of this market are
Speaker 3: much lower because investors can settle directly at the fixing
Speaker 3: come clearing corporation, or whatever central counterparty they choose. So
Speaker 3: I think it would organically lower the barriers to more
Speaker 3: all to all trade in addition to reducing the amount
Speaker 3: of space on dealer balance sheets and by the way,
Speaker 3: lowering settlement risk in that crucial market. That's why it
Speaker 3: was introduced in the first case back in the nineteen
Speaker 3: eighties to lower settlement risk.
Speaker 1: So dealers get to use their balance sheet more efficiently
Speaker 1: through central clearing. But there's still an added cost for them,
Speaker 1: I believe, and there's still a sort of existential threat
Speaker 1: to their business model if investors can settle with other investors.
Speaker 1: So how do you You're sort of asking them to
Speaker 1: put in high or individualized costs in exchange for more
Speaker 1: collective safety, which when you're talking to dealer banks it
Speaker 1: sounds rational, but a lot of them are very self
Speaker 1: interested for obvious reasons. So how do you get them
Speaker 1: on side? Do you need to get them on side?
Speaker 3: You do simply by forcing the issue. But this is
Speaker 3: the classic private cost public interest kind of trade offs
Speaker 3: that where you need the official sector to step in
Speaker 3: and make decisions. And by the way, when I said earlier,
Speaker 3: as a dealer firm, I might not favor this because
Speaker 3: of the costs and because it's threatening my market share
Speaker 3: and my profits. I think if you take a really
Speaker 3: long perspective on this, there's a chance that also all
Speaker 3: trade would massively increase the volume of trade in the
Speaker 3: US treasury market. Let me go back to nineteen seventy three,
Speaker 3: when none of us were probably aware of what was
Speaker 3: going on and talk about the the equity options market,
Speaker 3: where stock options were being traded before seventy three by
Speaker 3: laterally through dealers, just as the treasuries are done today.
Speaker 3: Then the Chicago Board Options Exchange entered the market in
Speaker 3: seventy three, and in the very first month of trade
Speaker 3: that exchange did more volume that had been done in
Speaker 3: any prior year in the dealer intermediated market, and dealers
Speaker 3: had a fraction of that trade, which was small fraction
Speaker 3: but big volume. Since nineteen seventy three, volumes in the
Speaker 3: equity options market, because it was exchange traded, have grown
Speaker 3: by many orders of magnitude, on the order of a
Speaker 3: million times the volume of trade that was in place
Speaker 3: in nineteen seventy three. So while in a short run
Speaker 3: the dealers got a smaller share of the market and
Speaker 3: faced more competitive margins on each trade, eventually the volume
Speaker 3: of trade just dumbedminated that effect. And I don't think
Speaker 3: any dealer would want to turn back the clock to
Speaker 3: the days before exchange traded options. I predict the same
Speaker 3: thing would happen in the US treasury market, as around
Speaker 3: the world, investors would need liquidity in a much higher
Speaker 3: volume market and dealers would be providing a lot about
Speaker 3: liquidity both on exchange and off exchange.
Speaker 2: Are there any other government bond markets around the world
Speaker 2: that work kind of in the way that you are envisioning?
Speaker 3: Terrific question. So, a former stand for PhD student, Malna Whitwer,
Speaker 3: collaborated with two economists at the Bank of Israel on
Speaker 3: what happened in Israel in March of twenty twenty. Israeli
Speaker 3: government bonds are traded on an exchange. It's not a
Speaker 3: dealer intermediated market, and that market came through. Now it's
Speaker 3: not a comparison to the US treasury market in terms
Speaker 3: of size and depth, but it came through without difficulty,
Speaker 3: whereas most government securities markets did suffer in terms of
Speaker 3: liquidity in March twenty twenty.
Speaker 1: That's super interesting. Just one other Devil's Advocate question on
Speaker 1: central clearing, which is a lot of critics will bring
Speaker 1: up the issue of concentration risk, So you're taking risk
Speaker 1: from the dealers and sort of moving it into this
Speaker 1: one central counter party. What's your response to that critique.
Speaker 3: Well, it's true, I mean you have to say, although
Speaker 3: that it's considered a pejorative that the Fixed Income Clearing
Speaker 3: Corporation is too big to fail, and it would become
Speaker 3: even bigger, So even more importantly, could not fail. You
Speaker 3: couldn't You couldn't imagine the chaos that would ensue if
Speaker 3: the central counterparty for the US treasure market were unable
Speaker 3: to meet its obligations and had to create an enormous
Speaker 3: crater on the global financial markets. So you are putting
Speaker 3: the onus even more on the safety and soundness of
Speaker 3: that central counterparty now, and I think regulators are up
Speaker 3: to that. It's the Fixed Income Clearing Corporation has been
Speaker 3: designated as systemically important. It is on the list of
Speaker 3: financial stability Oversight Councils infrastructure that must get too big
Speaker 3: to fail. Attention. I also hear sometimes the misunderstanding that
Speaker 3: what we would be doing with central counterparties like FICK
Speaker 3: is to take all of the risk in the market
Speaker 3: and kind of like bulldoze it into one spot at
Speaker 3: the central counterparty, making this enormous stack of risk all
Speaker 3: in one failure point. That is not a correct metaphor,
Speaker 3: because as you take all of these bilateral purchases and
Speaker 3: sales and bring them into the central counterparty, all the
Speaker 3: purchases almost get netted against all the sales, and you
Speaker 3: get a much smaller stack of risk. As a result,
Speaker 3: the amount of risk goes down enormously. I mentioned the
Speaker 3: study done by the New York Fed that shows about
Speaker 3: a seventy percent reduction and settlement risk in the US
Speaker 3: chrudgure market from doing central clearing. So even though it
Speaker 3: is true you're concentrating the risk more in one place,
Speaker 3: the total amount of risk goes way down.
Speaker 2: So you're here at Jackson Hall with the most impressive
Speaker 2: audience in the world. I don't mean the odd lat
Speaker 2: to host listeners, although hopefully we're fairly impressive as well.
Speaker 2: But beyond that, is there anything else, like you know,
Speaker 2: like what are you trying to what are the key
Speaker 2: things that you're like, hope that your research impresses upon
Speaker 2: this audience in terms of next steps and things that
Speaker 2: beyond beyond say even what you've described in terms of
Speaker 2: like where to go next with some of this stuff.
Speaker 3: So I think what you're going to see here at
Speaker 3: Jackson Hole, or what you have seen by the time
Speaker 3: that you people are listening, that your listeners hear this
Speaker 3: is a lot of attention on fiscal risks you're going
Speaker 3: to see the importance of increasing government debt and how
Speaker 3: that interplays with inflation risk. The work that we've been
Speaker 3: discussing today on improving the liquidity of the US Treasury
Speaker 3: market details well with the topic that I think will
Speaker 3: be the headline topic here of inflation and sovereign debt risk,
Speaker 3: by highlighting the importance of making the US Treasury market
Speaker 3: and other government securities markets more resilient to the problems
Speaker 3: that will arise as we get more and more stress
Speaker 3: coming from inflation volatility, monetary uncertainty, sovereign debt risk, uncertainty,
Speaker 3: not to mention political uncertainties. It's kind of a constellation
Speaker 3: of risks, and you want to build a market that's
Speaker 3: resilient to those risks. And I think those that prepared
Speaker 3: the agenda for this meeting thought carefully about bringing all
Speaker 3: of these topics together in the same symposium.
Speaker 1: Just on that note, there was one more question I
Speaker 1: wanted to ask you about all to all trading, which
Speaker 1: is would the Treasury go for it? Because one of
Speaker 1: the benefits of the primary dealer model right now is
Speaker 1: that it is very hard to get a failed auction.
Speaker 1: In fact, I think it's pretty much impossible. So if
Speaker 1: you didn't have those primary dealers sort of beholden to
Speaker 1: the treasury at a time when the US is expected
Speaker 1: to sell a lot more debt, that would seem to
Speaker 1: be a risk.
Speaker 3: It's certainly something that I've heard some at the largest
Speaker 3: primary dealers say publicly and in conversations be cautious with
Speaker 3: changing the structure of this market, because if dealers are
Speaker 3: not sufficiently profitable in providing intermediation and the secondary market
Speaker 3: for US treasuries where they're traded, then maybe the primary
Speaker 3: dealers will not participate as actively by committing capital to
Speaker 3: the primary market, which is where they're issued, and maybe
Speaker 3: that would cost US taxpayers more because you wouldn't have
Speaker 3: a reliable, committed buyers at those auctions. That is a risk,
Speaker 3: but it's not convincing to me that you can sit
Speaker 3: back and try to sustain the current market structure when
Speaker 3: the treasure market is growing bigger and bigger while balance
Speaker 3: sheets are shrinking relative to GDP. The total US government
Speaker 3: securities market relative to GDP is going to be about
Speaker 3: one hundred and fifty percent or more according to the
Speaker 3: projection of the Congressional Budget Office, Whereas dealer balance sheets
Speaker 3: are shrinking relative to GDP over the last ten years.
Speaker 3: That's not sustainable. So simply to say we don't want
Speaker 3: to disrupt the current market structure because the dealers won't
Speaker 3: participate as much in the primary market is not going
Speaker 3: to fix the problem. The dealers are now taking down
Speaker 3: on the order of ten percent plus or minus, and
Speaker 3: those auctions, that number has been coming down over the year.
Speaker 3: I predict they will continue to participate in the market
Speaker 3: even if there is a change in market structure. But
Speaker 3: that is not, in my mind, an overriding a concern
Speaker 3: to fixing the market structure.
Speaker 1: All right, Well, Daryl Duffy, that was a fantastic overview
Speaker 1: of a sort of persistently stubborn problem in one of
Speaker 1: the world's most important markets. So thank you so much
Speaker 1: for coming on all thoughts and explaining it to us.
Speaker 3: Thanks terrific conversation.
Speaker 2: Tracing, Joe, thank you so much.
Speaker 1: Yeah, that was fantastic, So, Joe, I really enjoyed that conversation.
Speaker 1: And you're absolutely right. It's a real treat to hear
Speaker 1: from the guy that the central bankers are calling in
Speaker 1: to talk about this. It does seem to be this
Speaker 1: persistent issue in the market, and you see it happen
Speaker 1: more and more, these like small bouts of volatility, but
Speaker 1: they're happening more often.
Speaker 2: Well, and I was really glad you asked that last
Speaker 2: question because that really crystallized something for me, which is
Speaker 2: that we are living in a period of like big
Speaker 2: fiscal right for better or worse. And so it's like, well,
Speaker 2: what is like unsustainable about it or where did the
Speaker 2: how does that become a stress point? And to Daryl's point,
Speaker 2: it's like, if you have this explosion of supply at
Speaker 2: a time when the entities that are like tasked with
Speaker 2: sort of like managing that supply either have constrained or
Speaker 2: shrinking balance sheets, then setting aside you of a like
Speaker 2: fiscal sustainability or inflation, you are going to run into
Speaker 2: this basically like infrastructure bottleneck. And it feels like that's
Speaker 2: really like the challenge here.
Speaker 1: I think that's exactly right, and I mean you brought
Speaker 1: up inflation just then, but this seems to be the
Speaker 1: other important factor, which is, well, maybe that model of
Speaker 1: trading and dealing and treasuries worked for a period of
Speaker 1: very low interest rates where we did have very subdued inflation,
Speaker 1: but in an era where there is monetary policy tightening,
Speaker 1: maybe you can't count on the Central Bank to always
Speaker 1: backstop the treasury market, or if it backstops it, it's
Speaker 1: going to need to sell some of those treasure reies eventually.
Speaker 1: Then that kind of changes the calculus.
Speaker 2: So we're gonna have to do an episode on Israeli government. No,
Speaker 2: it's like the one country that just everyone else saw
Speaker 2: all this dress like I had no idea about that.
Speaker 1: Yeah, we should. Actually that'd be really interesting. Okay, but
Speaker 1: for now, shall we head back to the lodge at
Speaker 1: Jackson Hole.
Speaker 2: Let's do it all right?
Speaker 1: This has been another episode of the Oddlots podcast. I'm
Speaker 1: Tracy Alloway. You can follow me at Tracy Alloway.
Speaker 2: And I'm Joe Wisenthal. You can follow me at the Stalwart.
Speaker 2: Follow our guest Darryl Duffy. He's at Darryl Duffy. Follow
Speaker 2: our producers Carmen Rodriguez at Carmen Arman and dash Ol
Speaker 2: Bennett at Dashbot. And our special guest producer on this
Speaker 2: Jackson Hole trip, Sebastian Escobar. He's at Under the Sea Bass.
Speaker 2: Follow the rest of the Bloomberg podcasts under the Handle
Speaker 2: at Podcasts and for more Oddlogs content, go to Bloomberg
Speaker 2: dot com slash odd Lots, where we have transcripts, a blog,
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Speaker 2: twenty four to seven with fellow listteners in the discord.
Speaker 2: I'm sure there'll be a lot of conversation about this
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Speaker 1: And if you like odd Lots, if you enjoy these discussions,
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Speaker 1: structure of the Israeli government bond market, then please leave
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Speaker 1: for listening.