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Speaker 1: Hello, I'm Joe Wisenthal and I'm Tracy Alloway, and you

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Speaker 1: are listening to a special edition of the Odd Loots

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Speaker 1: Podcast in your Bloomberg Surveillance podcast feed.

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Speaker 2: We are here in Jackson Hall, Wyoming, along with our

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Speaker 2: colleagues Tom Keane, Jonathan Farrow, and Lisa Bromovics covering the

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Speaker 2: fed's Annual Monetary Policy Symposium.

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Speaker 1: So keep listening for our conversation on this special edition

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Speaker 1: of Odlots. Hello, and welcome to another episode of the

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Speaker 1: Odd Loots Podcast. I'm Tracy Alloway and I'm Joe Wisenthal. Joe,

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Speaker 1: have you been watching treasury yield slightly?

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Speaker 3: Uh?

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Speaker 2: They're up, They've gone I'm that's it. That's the showwhere

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Speaker 2: that the line has gone up into the right lake.

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Speaker 1: Yes, but not just that, they've moved quite quickly.

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Speaker 2: Yes, up.

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Speaker 1: And I think volatility in the treasury market has once

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Speaker 1: again become a talking point. And I always get a

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Speaker 1: little bit of a sense of data because whenever things

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Speaker 1: start happening in the market for US government bonds, extreme things,

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Speaker 1: these extreme moves, it feels like everyone says, Oh, this

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Speaker 1: shouldn't be happening. In the world's most liquid market, the

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Speaker 1: world's safest market. We shouldn't be seeing these types of

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Speaker 1: dramatic shifts, right.

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Speaker 2: The expectation is this is like a very extremely liquid,

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Speaker 2: slow moving market. But it has been a very fast

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Speaker 2: move and people don't really know why. There's a lot

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Speaker 2: of debate. You have people talking about, well, look, the

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Speaker 2: economy is proving to be more resilient than people might

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Speaker 2: have guessed six months ago, even a month ago. And

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Speaker 2: I think there's this expectation, there's this sense that things

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Speaker 2: are moving faster. There's also a lot of talk about

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Speaker 2: treasury supply, supplied demand imbalances and so forth. So things

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Speaker 2: are on the move, to say the least, and you

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Speaker 2: see it in mortgage spreads are very wide. You see

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Speaker 2: it in other risk assets not seeming to like this

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Speaker 2: treasury volatility. So lots going on there.

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Speaker 1: So you mentioned a couple of things there, which is, yes,

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Speaker 1: the economy seems to be doing relatively well well, and yes,

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Speaker 1: the amount of treasury supply is exploding and has been

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Speaker 1: going up for a very long time. There's another factor here,

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Speaker 1: which is the actual inner workings of the treasury market,

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Speaker 1: so how treasuries are actually traded and whether or not

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Speaker 1: that is potentially contributing to some of the volatility that

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Speaker 1: we've seen. And again, I feel like this topic keeps

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Speaker 1: coming up. Every year there's some massive move in treasury

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Speaker 1: markets and everyone starts talking about liquidity issues, and yet

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Speaker 1: you don't really see any big solutions being proposed to it.

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Speaker 1: You see talk about, you know, maybe loosening some of

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Speaker 1: the regulation around the supplementary leverage ratio or something like that.

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Speaker 1: But it feels like we need to talk about this

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Speaker 1: and maybe try to come up with a solution.

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Speaker 2: Let's do it, and we're in a good place to

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Speaker 2: talk about it.

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Speaker 1: Yes, we're at Jackson Hole.

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Speaker 2: I thought you were. I thought that was going to

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Speaker 2: be the first Like do you acual? I like how

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Speaker 2: you like? We eat it into it a little bit.

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Speaker 1: I want this to be an evergreen episode for an

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Speaker 1: evergreen problem.

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Speaker 2: It feels like, but the people hear Carabau this topic.

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Speaker 1: Yes, absolutely, the way US treasury debt is traded has

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Speaker 1: a lot of implications, particularly for the cost of financing

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Speaker 1: the US deficit. That's an obvious one, and so we

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Speaker 1: should talk about it.

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Speaker 2: Let's talk about it.

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Speaker 1: I'm very pleased to say that we have the perfect guest.

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Speaker 1: We are going to be speaking with Daryl Duffy. He is,

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Speaker 1: of course, a professor of finance at Stanford's Graduate School

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Speaker 1: of Business, and he is presenting a paper at Jackson

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Speaker 1: Hole in front of the world's top central bankers, all

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Speaker 1: about this issue. It's called Resilience reducts in the US

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Speaker 1: Treasury market. So Darryl, thank you so much for coming on.

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Speaker 3: All thoughts, thanks for having me, Tracy, Joe. It's terrific

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Speaker 3: to be here.

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Speaker 2: You know, it's the perfect guest when it's the guest

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Speaker 2: and it's like not just it like we want to

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Speaker 2: have him on odd laws that the central the top

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Speaker 2: central banker is around the world want to hear from

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Speaker 2: a professor Duffy. So yes, on this issue. I'm very

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Speaker 2: excited about this episode.

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Speaker 1: When treasuries are moving, they call up Darryl Duffy. All right, well, professor,

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Speaker 1: thank you again for coming on. Why don't we just

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Speaker 1: start with the basics. We sort of alluded to this

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Speaker 1: in the intro, but it feels like this is a

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Speaker 1: subject that just keeps coming up and never really seems

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Speaker 1: to go away. What's going on here?

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Speaker 3: Well, over the past century, there have been, as you suggested,

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Speaker 3: many episodes of increased volatility and liquidity problems in the

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Speaker 3: treasury market, but I do think these are happening more

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Speaker 3: frequently just recently. I think you summarized pretty well some

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Speaker 3: of the stresses in the treasury market coming from the

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Speaker 3: fiscal side. The US is issuing more than people expected,

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Speaker 3: there was a recent downgrade by Fitch, and the Fed

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Speaker 3: is struggling with what to do about inflation. That additional

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Speaker 3: monetary policy uncertainty also contributes to volatility. Let me back

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Speaker 3: up a minute. I just spent most of the last

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Speaker 3: year on a sabbatical at the New York FED and

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Speaker 3: working with some terrific economists there, Michael Fleming, Frank Keane

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Speaker 3: or Shekhar, Peter Vontasso, Claire Nelson. We decided we needed

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Speaker 3: to look into the relationship between the volatility that you

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Speaker 3: two discussed and the liquidity in the market. They're closely intertwined.

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Speaker 3: So we dug deep and went into a lot of data,

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Speaker 3: and yeah, volatility seems to be the main determinant of

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Speaker 3: illiquidity in the market. So when fiscal uncertainty or debt

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Speaker 3: sealing debate, or a COVID crisis or monetary policy uncertainty

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Speaker 3: start to get a volatility higher and higher market becomes

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Speaker 3: less and less liquid. It's an extremely regular relationship. About

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Speaker 3: eighty percent of illiquidity is explained simply by variation and

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Speaker 3: yield volatility.

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Speaker 2: So just to press on this relationship between rates volatility

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Speaker 2: or yield volatility and illiquidity, like which way does the

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Speaker 2: direction run? Or because we can come up with these

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Speaker 2: fundamental stories, right, like Okay, maybe the economy is better

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Speaker 2: than expected, maybe we're going to have more raid hikes

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Speaker 2: than previously anticipated, in which case you say, okay, well

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Speaker 2: that's sort of like that's a fundamental story of fundamental driver.

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Speaker 2: And then you could look at certain nature of the structure,

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Speaker 2: like the size of dealer balance sheets, et cetera. It's like, okay,

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Speaker 2: well this is something technical that contributes to also could

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Speaker 2: be a contributor to volatility. How do you think about

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Speaker 2: like the directions of causality when you look into a problem.

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Speaker 3: Like this, Yeah, well both the direct kind of fundamentals

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Speaker 3: fiscal monetary fundamentals and global the global economy and geopolitics

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Speaker 3: recently all play a direct fundamental role. And then as

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Speaker 3: you alluded, there's also kind of a feedback effect when

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Speaker 3: volatility rises for fundamental reasons, dealers are going to struggle

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Speaker 3: with providing sufficient liquidity to the market, and to the

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Speaker 3: extent that dealer balance sheets are not sufficiently flexible to

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Speaker 3: accommodate the provision of liquidity to the market, That in

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Speaker 3: and of itself increases illiquidity, increases volatility, and they kind

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Speaker 3: of feedback on them, and you can get an episode

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Speaker 3: like we had when COVID hit in March twenty twenty,

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Speaker 3: where liquidity becomes even worse than would be suggested by

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Speaker 3: a volatility alone, much worse, And that's just a sign

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Speaker 3: that the market is not capable of intermediating those extreme

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Speaker 3: demands for liquidity.

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Speaker 1: Right, So this seems to be a distinct characteristic of

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Speaker 1: treasuries in particular, which is when stuff starts to go

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Speaker 1: really wrong like it did in March of twenty twenty,

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Speaker 1: people often sell the safest stuff first, which means they

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Speaker 1: sell treasury. So you get this big wave of selling

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Speaker 1: at precisely the moment that a lot of dealers want

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Speaker 1: to wind down or back away from risk. Is that

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Speaker 1: just a fundamental tension in the market. Is that always

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Speaker 1: going to be.

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Speaker 3: The case as long as US treasuries are the world's

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Speaker 3: most important safe haven, which is clearly the case by Miles,

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Speaker 3: that's always going to be the result for basically two reasons.

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Speaker 3: Number One, a whole lot of major investors like foreign

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Speaker 3: exchange reserve managers firms that are storing safe liquid asset

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Speaker 3: just in case, well the just in case happened, and

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Speaker 3: they are going to liquidate those positions. The other channel

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Speaker 3: for this is as the volatility grows and uncertainty grows,

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Speaker 3: a lot of investors are kind of finding it too

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Speaker 3: hot to handle and they have to unload some risk,

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Speaker 3: and treasuries are the easiest security to unload in the world.

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Speaker 3: The market's got a good reputation for being the deepest

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Speaker 3: and most liquid market in the world.

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Speaker 2: So I know we've talked about this a little bit

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Speaker 2: in the past with a few different guests, including Josh Younger.

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Speaker 2: He made the point on one of the episodes that

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Speaker 2: we did it just like if you're thinking about, like

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Speaker 2: what do we want to do to have better treasury

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Speaker 2: market structure, that it doesn't necessarily make sense to optimize

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Speaker 2: for well, we never want to have a March twenty

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Speaker 2: twenty again because you don't necessarily want to have optimized

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Speaker 2: for the one out of every one hundred year pandemic.

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Speaker 2: But what would you say, like is the goal? Like

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Speaker 2: if you're like, okay, there does seem to be this

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Speaker 2: relationship between volatility and illiquidity, It does seem like some

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Speaker 2: of these bouts of volatility and illiquidity become more frequent.

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Speaker 2: If you think about designing sort of an optimal market

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Speaker 2: structure for treasuries, what would you say we're trying to achieve?

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Speaker 3: Josh, I've known him since you worked at JP Morgan,

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Speaker 3: and now that he's moved to the FED, we get

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Speaker 3: to talk a lot more. This is a terrific insight

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Speaker 3: that he has, the kind of do you really want

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Speaker 3: to design a market for the worst day in a thousand?

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Speaker 3: Isn't that very expensive? And maybe overdoing it because nine

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Speaker 3: hundred ninety nine days out of a thousand you didn't

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Speaker 3: really need that kind of a market structure. I'm going

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Speaker 3: to be a little provocative here. I think you do

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Speaker 3: want to build a market for the worst day in

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Speaker 3: one thousand for the following reason. Great, if I'm let's say,

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Speaker 3: managing the foreign exchange reserves of an emerging market central bank,

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Speaker 3: when do I need to actually take advantage of the

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Speaker 3: depth and liquidity of the US Treasury market. It's that

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Speaker 3: one day in a thousand when all the other safe

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Speaker 3: haven investors are trying to do the same thing. In

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Speaker 3: the paper on that Tracy mentioned I'm giving here at

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Speaker 3: Jackson Hole, I talk about this wrong way risk. From

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Speaker 3: the viewpoint of illiquidity, you don't want the market to

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Speaker 3: be great except on that very singular day on which

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Speaker 3: everybody needs the liquidity. Why not, Well, because A, this

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Speaker 3: is the lynchpin of global financial market stability. You want

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Speaker 3: it to work day in, day out. And B if

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Speaker 3: you discourage safe haven investors from believing that even though

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Speaker 3: everybody else is liquidating that day, they could also liquidate

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Speaker 3: at low cost with ease, then they won't use the

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Speaker 3: US Treasury security as much as their safe haven. They'll diversify.

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Speaker 3: And that's where we've been seeing somewhat over the last

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Speaker 3: couple of decades, a degree of diversification away from the

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Speaker 3: US Treasury still by far the domin in a safe haven.

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Speaker 3: Something like fifty nine percent of foreign exchange reserves are

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Speaker 3: held in US treasuries. But from the viewpoint of the

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Speaker 3: US taxpayer, you want everyone to believe that on the

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Speaker 3: worst day in a thousand, that market is going to

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Speaker 3: be there for them.

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Speaker 1: Wait, I'm going to be provocative now or try to. Okay,

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Speaker 1: So on this note, we did see in March twenty twenty,

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Speaker 1: the FED unveiled all these different emergency programs aimed at

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Speaker 1: supporting the US treasury market. So, you know, we have

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Speaker 1: the new standing repo facility, and I think you know

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Speaker 1: they were buying US treasuries in exchange for reserves, and

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Speaker 1: then they exempted all of those from the supplementary leverage

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Speaker 1: ratios for banks. So it seems like the backstop is

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Speaker 1: in place. If something bad were to happen again, I

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Speaker 1: would presume that the FED would unveil either those exact

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Speaker 1: measures again or something very similar. So is the issue solved?

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Speaker 3: Yeah, you're tracy. That is provocative. So I would definitely.

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Speaker 1: Say that it's a polite way of saying you're so wrong.

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Speaker 3: No, the FED came out guns blazing unlimited financing in

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Speaker 3: the rebound market for anyone that had access to the

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Speaker 3: FED a trillion dollars of purchases in the first three weeks,

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Speaker 3: nearly a trillion of US treasuries, relieving the dealer balance

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Speaker 3: sheets of their overloading getting the supplementary leverage ratio dialed

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Speaker 3: back and it was causing problems. Took a little longer,

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Speaker 3: and it took I think some backroom negotiations with the

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Speaker 3: other bank regulators to come on board, so that got delayed,

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Speaker 3: and that was a problem. But the FED did a

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Speaker 3: terrific job at crisis management during those weeks. And I

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Speaker 3: say weeks because they didn't solve the problem. They only

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Speaker 3: made it less bad than it otherwise would have been.

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Speaker 3: It took five, six, seven, eight weeks before market liquidity

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Speaker 3: was restored. And again going back to my wrong way

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Speaker 3: risk point, if I'm looking for a market that's going

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Speaker 3: to work for me in a crisis, I don't want

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Speaker 3: to have to wait weeks in order to get liquidity

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Speaker 3: or to pay a low cost for liquidity. I want

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Speaker 3: it to be working all the time. Now, of course

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Speaker 3: it's unrealistic that it should work every single day. But

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Speaker 3: if we rely only on central banks, and I speak

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Speaker 3: more broadly to bail out their government securities market when

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Speaker 3: they get into trouble, it's not going to be one

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Speaker 3: hundred percent effective and it raises moral hazard. It says

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Speaker 3: to the rest of the world, we'll use the central

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Speaker 3: bank balance sheet to bail you out, you don't need

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Speaker 3: to focus on improving market structure reducing undue leverage. We

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Speaker 3: have your backs that message, while it needs to be,

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Speaker 3: there is not a substitute for improving the market structure.

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Speaker 2: Yeah, you sort of anticipated my next question, but okay,

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Speaker 2: it does seem like in an emergency, the FED can

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Speaker 2: say we're going to buy do QI at a scale

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Speaker 2: that we've never seen before, and as Trason mentioned, unveil

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Speaker 2: the unveil these new facilities kind of on the fly.

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Speaker 2: And it seems like basically since two thousand and eight

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Speaker 2: two thousand and nine, the FED has gotten really good.

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Speaker 2: It's standing up new facilities very quickly. So that's like

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Speaker 2: a skill that they've developed. But can you talk a

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Speaker 2: little bit more about what you perceive is to be

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Speaker 2: the cost of a sort of stability regime that sort

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Speaker 2: of presumpt presumes that, yeah, we know there's some frailties,

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Speaker 2: but our solution is that in that you know, seven

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Speaker 2: sigma or twelve sigma day that the FED is there,

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Speaker 2: and like, well, talk about more about why that's not

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Speaker 2: a good system.

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Speaker 3: Okay, Well, just I want to re emphasize that the

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Speaker 3: FED don't know.

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Speaker 2: How many sigma as it really is that every billion.

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Speaker 2: I don't know. I just put a throw out a number.

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Speaker 3: The FED does need to be there. It's not as

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Speaker 3: though one should say, let's take the Fed's balance sheet

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Speaker 3: out of the equation and try to do without it.

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Speaker 3: It needs to be there. It's a backstop. It's the

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Speaker 3: last resort. The FED is the buyer of last resort.

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Speaker 3: After it's become the lender of last resort. It can't

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Speaker 3: do anything else but bail at the market by buying securities.

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Speaker 3: But relying on that has several problems already mentioned. It's

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Speaker 3: not one hundred percent of effective on the first day.

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Speaker 3: And there's also the size of the Fed's balance sheet

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Speaker 3: that's controversial. Even if you think it's innocuous, it raises

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Speaker 3: political concerns. There are those that say, well, maybe the

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Speaker 3: Fed's balance sheet is too big, and we need to

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Speaker 3: curtail the ability of central banks, including the FED, to

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Speaker 3: expand their balance sheets to the extent that they have been,

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Speaker 3: and they've been using them very, very liberally over the

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Speaker 3: past couple of decades. The other concern is once the

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Speaker 3: balance sheet is large, it eventually is going to come

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Speaker 3: back down, and those treasuries are going to be adding

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Speaker 3: to the stock of securities that other investors need to have,

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Speaker 3: and that it means that the central banks, including the FED,

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Speaker 3: need to do that very gingerly. There's a lot of

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Speaker 3: volatility in the treasury market, and the FED is letting

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Speaker 3: its balance sheet come down. Other investors are having to

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Speaker 3: pick up the load. It's easier to expand the balance

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Speaker 3: sheet than it is to bring it down. So using

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Speaker 3: the Fed's balance sheet, while it's necessary, is not a

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Speaker 3: painless solution, and I would argue it's not the best

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Speaker 3: solution anyway. We can do better by improving market structure.

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Speaker 3: Pushing out into the extreme tails the number of events

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Speaker 3: in which the FED meets to step in and buy.

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Speaker 1: Why don't we talk about the market structure and maybe

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Speaker 1: before we start talking about improvements that could be made,

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Speaker 1: could you give us the sort of lay of the

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Speaker 1: land when it comes to how treasuries are traded today.

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Speaker 1: So there's primary dealers for the new issuans, and then

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Speaker 1: there's your sort of run of the mill dealers for

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Speaker 1: secondary market trades. But talk to us how it works

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Speaker 1: right now?

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Speaker 3: Terrific, Well, it's an extremely complex structure. But it can

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Speaker 3: be summarized pretty simply. There's two segments of the market.

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Speaker 3: There's the interdealer market, in which the dealers trade among themselves,

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Speaker 3: and then there's the customer to dealer market, in which

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Speaker 3: investors around the world trade with dealers. Notably, investors do

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Speaker 3: not trade directly with other investors. There is no al

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Speaker 3: too all trade in the US treasure market. No matter

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Speaker 3: whether you're an insurance company, a hedge fund, foreign exchange

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Speaker 3: reserve manager, you are going to be buying and selling

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Speaker 3: with a dealer if you're a dealer. On the other hand,

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Speaker 3: there is a very active interdealer market for the on

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Speaker 3: the run securities. Those are the latest issues of the treasury.

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Speaker 3: There's an order book market, which is a high frequency

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Speaker 3: trading market run by broker Tech, which is a subsidiary

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Speaker 3: of the Chicago Mercantile Exchange, where you have the same

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Speaker 3: kinds of high frequency trading that you see in the

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Speaker 3: stock market. The only other participants on the broker Tech

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Speaker 3: market are high frequency trading firms sometimes called principal trading

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Speaker 3: firms like Jump, like DRW, like Citadel, firms that have

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Speaker 3: a very special purpose of intermediating in the interdealer market

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Speaker 3: taking little bit offer spreads from the dealers and from

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Speaker 3: each other. That's the basic structure of the market. Again,

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Speaker 3: the notable feature is if you're an investor, you can

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Speaker 3: trade only with a dealer. If you're a dealer, you

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Speaker 3: have the ability layoff positions in the interdealer market.

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Speaker 2: Again, before we get into sort of like optimal structure,

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Speaker 2: I'm actually just curious. You know, you mentioned that you

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Speaker 2: spent the last year at the New York FED looking

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Speaker 2: into this and sort of getting this. What did you do?

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Speaker 2: How did you let go about your research? Like how

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Speaker 2: much is it sort of like a sort of statistical

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Speaker 2: base analysis versus how much was it talking to dealers

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Speaker 2: and understanding how they operate? Like I'd just be curious about.

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Speaker 3: The research process for this particular project was a combination

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Speaker 3: of meeting and discussing what needed to be done with

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Speaker 3: the economists that I mentioned earlier, and those would be

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Speaker 3: weekly meetings pretty in depth where we would go through

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Speaker 3: what we've already learned and what we need to do next.

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Speaker 3: And that happened for six months or so, and at

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Speaker 3: the same time, in the background, we're collecting volumes of

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Speaker 3: statistical data to FED because it's a member of the

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Speaker 3: official sector, has access not only to its own data,

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Speaker 3: but to exceptionally fine grained data on at the transactions level.

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Speaker 3: Let me give you one example. There is a data

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Speaker 3: set called Trace which records every single trade in the

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Speaker 3: treasury market. With a few minor exceptions. Those data are

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Speaker 3: only available to the official sector. They are not available

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Speaker 3: to the public. And by the way, I disagree with

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Speaker 3: that policy, and we could talk about that. I think

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Speaker 3: it actually contributes to the problem of illiquidity. But in

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Speaker 3: any case, the FED, as a member of that official

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Speaker 3: sector group, can go to its sister agencies in the

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Speaker 3: federal government and say, look, we have this project, here's

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Speaker 3: its objectives. We want to use these Trace data to

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Speaker 3: analyze liquidity in the US treasury market. And then we

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Speaker 3: get feedback saying, yeah, this looks good. The way that

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Speaker 3: pre zata are being presented will not reveal proprietary information,

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Speaker 3: so go ahead. And then we can do the same

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Speaker 3: thing with dealer balance sheet data. We can get exposures

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Speaker 3: of dealers not only to treasury securities, but to agency

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Speaker 3: mortgage backed securities, which turned out to be another big

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Speaker 3: load on their balance sheet, particularly during March of twenty twenty,

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Speaker 3: we can go to a wide range of data sets,

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Speaker 3: and we wrote a paper it explains the extent to

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Speaker 3: which we access all of these data bring them together.

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Speaker 3: We developed eighteen different liquidity metrics and many different metrics

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Speaker 3: on how dealer balance sheets are being loaded, and then

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Speaker 3: we would analyze these using reasonably intricate econometric methods like

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Speaker 3: quantile regressions and a number of other statistical approaches, and

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Speaker 3: then we would start to see the patterns emerge very

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Speaker 3: very clearly. That I described two key patterns that came

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Speaker 3: up over and over again in our discussion meetings. Where

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Speaker 3: A volatility seems to explain most of the variation in liquidity,

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Speaker 3: but b when it doesn't, it's dealer balance sheet that

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Speaker 3: explains the remaining part of illiquidity. It's a highly nonlinear effect.

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Speaker 3: When dealer balance sheets are normally loaded, they don't contribute

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Speaker 3: to I liquidity. But when they're reaching their extremes, where

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Speaker 3: dealers are handling more treasury trades and more agency MBS

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Speaker 3: trades and they've handled in the past, then you see

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Speaker 3: ill liquidity go up well beyond the level predicted by volatility.

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Speaker 3: So after analyzing all these data and discussing what's driving

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Speaker 3: these Then we turn to writing up our results, and

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Speaker 3: there's a lot of iterative work there, which you can

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Speaker 3: see in the paper that we wrote.

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Speaker 1: So you can see the dealer balance sheets on a

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Speaker 1: daily basis, not just at quarter end.

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Speaker 2: Not quite.

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Speaker 3: We can only see dealer balance sheets on a weekly

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Speaker 3: basis because the FED has a data set called FR

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Speaker 3: two thousand and four which collects those data only on

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Speaker 3: a weekly basis, and summaries of those data are available

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Speaker 3: publicly on the New York Fed's website.

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Speaker 1: So going back to this dealer balance sheet issue, I mean,

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Speaker 1: this is something that has come up basically ever since

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Speaker 1: the two thousand and eight financial crisis, and there have

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Speaker 1: been a lot of complaints from the dealers about all

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Speaker 1: this new regulation that limits their ability to take risk

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Speaker 1: on their balance sheet. And the argument for doing that

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Speaker 1: has always been one of financial stability. Will we want

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Speaker 1: the banks to be safer and if they have to

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Speaker 1: cut back on their intermediation capacity in the market, maybe

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Speaker 1: that's a fair trade. How do you thread the needle

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Speaker 1: between those two issues, especially in a market as important

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Speaker 1: as treasuries.

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Speaker 3: Okay, it's very tough because those much more demanding capital

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Speaker 3: requirements and other requirements that came in after the financial

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Speaker 3: crisis have clearly reduced liquidity and a broad set of

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Speaker 3: financial markets. It's glaringly obvious. However, we can't afford to

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Speaker 3: return to the pre Lehman days in which dealers would

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Speaker 3: expand their balance sheets for a few basis points of arbitrage,

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Speaker 3: creating financial instability. So while those new capital requirements are

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Speaker 3: necessary for protecting the economy from collapse of the financial

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Speaker 3: services sector, we do need to substitute for the liquidity

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Speaker 3: that's missing in other ways. There is one capital regulation

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Speaker 3: that I think is not necessary, and that's the one

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Speaker 3: you mentioned, Tracy, the supplementary leverage ratio. That rule penalizes

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Speaker 3: the provision of liquidity even for very safe assets. Let

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Speaker 3: me give you an example. When the FED was buying

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Speaker 3: treasury securities from mid March. It bought within three weeks

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Speaker 3: nearly a trillion dollars of treasuries, and one might think, oh,

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Speaker 3: thank goodness, that's lowering the making more space on dealer

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Speaker 3: balance sheets for other positions. However, from the viewpoint of

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Speaker 3: that capital regulation, there was really not much change at all,

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Speaker 3: because the FED paid for those trillion of treasuries with

434
00:24:03,560 --> 00:24:07,680
Speaker 3: a trillion of reserve balances, and reserve balances, although perfectly

435
00:24:07,720 --> 00:24:11,800
Speaker 3: safe and liquid, have the same impact on dealer capital

436
00:24:11,840 --> 00:24:16,080
Speaker 3: requirements as the treasury securities that they replaced, So there

437
00:24:16,160 --> 00:24:19,240
Speaker 3: wasn't really, from the viewpoint of the supplementary leverage ratio,

438
00:24:19,600 --> 00:24:23,199
Speaker 3: much benefit of the Treasury's purchases. There were benefits in

439
00:24:23,280 --> 00:24:27,160
Speaker 3: other respects because treasuries are risky and dealers were relieved

440
00:24:27,160 --> 00:24:29,280
Speaker 3: of that risk by the Fed's trades. But from the

441
00:24:29,359 --> 00:24:33,640
Speaker 3: viewpoint of that supplementary leverage ratio, it was very unfortunate,

442
00:24:33,720 --> 00:24:38,159
Speaker 3: and I and others have argued that the SLR supplementary

443
00:24:38,200 --> 00:24:41,880
Speaker 3: leverage ratio rule should be replaced with higher risk based

444
00:24:41,880 --> 00:24:42,879
Speaker 3: capital requirements.

445
00:24:43,480 --> 00:24:45,640
Speaker 2: Can you explain that when you say replaced with higher

446
00:24:45,680 --> 00:24:47,800
Speaker 2: risk based capital requirements, so.

447
00:24:48,080 --> 00:24:51,600
Speaker 1: The capital wouldn't be calculated on the basis of the

448
00:24:51,720 --> 00:24:55,200
Speaker 1: size of your total balance sheet, but on the riskiness

449
00:24:55,200 --> 00:24:57,199
Speaker 1: the actual makeup of the balance sheet.

450
00:24:57,359 --> 00:25:00,119
Speaker 3: That's right. There's been a kind of go around in

451
00:25:00,160 --> 00:25:02,840
Speaker 3: the world of in the basle world of capital requirements

452
00:25:02,880 --> 00:25:05,719
Speaker 3: for banks. Back in the eighties, we went from a

453
00:25:05,720 --> 00:25:09,600
Speaker 3: world where there were just basically leverage requirements that did

454
00:25:09,640 --> 00:25:13,520
Speaker 3: not consider risk to a world in which the financial

455
00:25:13,520 --> 00:25:15,439
Speaker 3: regulators were saying, hey, wait a minute, we should be

456
00:25:15,520 --> 00:25:19,920
Speaker 3: weighting these assets by risk, because that's what matters for insolvency.

457
00:25:20,280 --> 00:25:23,679
Speaker 3: And then it was discovered leading up to the crisis

458
00:25:24,200 --> 00:25:27,840
Speaker 3: and failure of Lehman that banks were playing games with

459
00:25:27,920 --> 00:25:31,320
Speaker 3: their risk based measures, or simply the measures were not

460
00:25:31,359 --> 00:25:35,520
Speaker 3: accurate enough, and so as a backstop or just in case,

461
00:25:36,040 --> 00:25:41,080
Speaker 3: the supplementary leverage racial rule was introduced to eliminate, from

462
00:25:41,080 --> 00:25:45,200
Speaker 3: the viewpoint of that capital requirement any consideration of risk, saying,

463
00:25:45,440 --> 00:25:47,960
Speaker 3: you know, no more games and no more uncertainty about

464
00:25:48,000 --> 00:25:50,400
Speaker 3: how much risk. We're just going to require for everye

465
00:25:50,480 --> 00:25:53,720
Speaker 3: hundred dollars of assets of any kind, even central bank deposits,

466
00:25:54,000 --> 00:25:56,080
Speaker 3: you have to have a certain number of dollars of

467
00:25:56,080 --> 00:25:59,040
Speaker 3: capital that doesn't depend on the risk. Well, in my view,

468
00:25:59,080 --> 00:26:03,600
Speaker 3: that's backfired and it's led to more illiquidity than necessary.

469
00:26:03,720 --> 00:26:06,920
Speaker 3: You could still have the same amount of financial stability

470
00:26:06,960 --> 00:26:10,879
Speaker 3: with less illiquidity if you dial back that rule and

471
00:26:11,080 --> 00:26:15,280
Speaker 3: dial up risk based requirements so that the system wide,

472
00:26:15,359 --> 00:26:17,920
Speaker 3: you're just as safe as you were before. But each

473
00:26:17,920 --> 00:26:21,840
Speaker 3: individual bank is not internalizing the cost of balance sheet space.

474
00:26:22,000 --> 00:26:24,120
Speaker 3: When it makes trades of safe assets.

475
00:26:24,400 --> 00:26:28,919
Speaker 1: What would that mean for bank's interest rate risk? And

476
00:26:29,000 --> 00:26:33,000
Speaker 1: I'm thinking specifically back to a different March, not twenty twenty,

477
00:26:33,040 --> 00:26:36,160
Speaker 1: but March of twenty twenty three, when we did see

478
00:26:36,320 --> 00:26:39,600
Speaker 1: a lot of banks hit by mark to market moves

479
00:26:39,640 --> 00:26:41,960
Speaker 1: on their bonds because interest rates were going up and

480
00:26:42,040 --> 00:26:45,639
Speaker 1: so the prices were lower. If you removed bonds from

481
00:26:45,720 --> 00:26:49,840
Speaker 1: the SLR calculations, would you still be able to take

482
00:26:49,880 --> 00:26:52,240
Speaker 1: into account interest rate risk or would you not really

483
00:26:52,280 --> 00:26:53,080
Speaker 1: need to anymore?

484
00:26:53,480 --> 00:26:55,359
Speaker 3: No, you would still need to do that, but you

485
00:26:55,400 --> 00:26:57,600
Speaker 3: could do that through a couple of measures that have

486
00:26:57,720 --> 00:27:00,639
Speaker 3: been proposed that came up after the failure of a

487
00:27:00,680 --> 00:27:03,280
Speaker 3: Silicon Valley bank and other banks. So one thing you

488
00:27:03,320 --> 00:27:06,600
Speaker 3: could do, which should be done, is that the very

489
00:27:06,720 --> 00:27:11,280
Speaker 3: large but not jes banks like those big regionals, should

490
00:27:11,280 --> 00:27:15,000
Speaker 3: be required to pass their losses due to interest rate

491
00:27:15,119 --> 00:27:19,760
Speaker 3: risk through to their capital accounts, so that when they

492
00:27:20,040 --> 00:27:22,720
Speaker 3: lose money on treasuries, they have to add capital to

493
00:27:22,760 --> 00:27:26,280
Speaker 3: replace that they were exempted from passing through those losses.

494
00:27:26,960 --> 00:27:30,080
Speaker 3: The second thing you can do, which surprisingly the FED

495
00:27:30,160 --> 00:27:34,920
Speaker 3: has not done recently, is to include shocks to interest

496
00:27:35,000 --> 00:27:38,879
Speaker 3: rates as a scenario in their stress tests, so that

497
00:27:38,960 --> 00:27:42,160
Speaker 3: banks would need to demonstrate that even if the Yuel

498
00:27:42,240 --> 00:27:45,160
Speaker 3: curve were to jump up a couple of hundred basis points,

499
00:27:45,480 --> 00:27:48,160
Speaker 3: they would have the capital necessary to weather that storm.

500
00:27:48,640 --> 00:27:51,560
Speaker 1: Right. This was the crazy thing about the bank stress test.

501
00:27:51,600 --> 00:27:55,040
Speaker 1: They were always for a recessionary scenario where interest rates

502
00:27:55,040 --> 00:27:58,280
Speaker 1: would plummet, and they never actually modeled interest rates going

503
00:27:58,320 --> 00:27:59,000
Speaker 1: sharply up.

504
00:27:59,359 --> 00:28:01,280
Speaker 2: I don't think I realized that. I mean, it's like

505
00:28:01,320 --> 00:28:03,920
Speaker 2: a classic like what fight it always is, right fight

506
00:28:03,960 --> 00:28:05,879
Speaker 2: the Last War. So it's like, Okay, we're gonna like

507
00:28:06,200 --> 00:28:09,760
Speaker 2: protect against this big collapse or recession and credit risk,

508
00:28:09,840 --> 00:28:12,520
Speaker 2: et cetera. And then the idea that like the next

509
00:28:12,800 --> 00:28:14,159
Speaker 2: I don't know if you'd call it a crisis, and

510
00:28:14,440 --> 00:28:16,359
Speaker 2: Tracy and I fight about whether it's a crisis, but

511
00:28:16,400 --> 00:28:16,920
Speaker 2: the next.

512
00:28:17,080 --> 00:28:20,080
Speaker 1: Settled on drama drama.

513
00:28:19,760 --> 00:28:22,800
Speaker 2: Would be in the other direction of the rates going higher.

514
00:28:22,800 --> 00:28:24,800
Speaker 2: But yeah, it makes sense that that would be part

515
00:28:24,800 --> 00:28:25,520
Speaker 2: of a stress test.

516
00:28:25,600 --> 00:28:28,600
Speaker 3: Yeah, Joe, I mean, the FED is already predicted that

517
00:28:28,640 --> 00:28:33,240
Speaker 3: it's going to make those losses pass through to capital,

518
00:28:34,520 --> 00:28:38,080
Speaker 3: and I predict personally that they will also include interest

519
00:28:38,120 --> 00:28:41,160
Speaker 3: rate risk scenarios and their stress tests. I would not

520
00:28:41,240 --> 00:28:43,160
Speaker 3: be surprised to see both of those in place soon.

521
00:28:47,600 --> 00:28:52,120
Speaker 1: Just going back to one suggestion for improving liquidity and treasuries,

522
00:28:52,400 --> 00:28:55,360
Speaker 1: you mentioned all to all trading earlier, So the idea

523
00:28:55,400 --> 00:28:59,920
Speaker 1: that investors could trade with one another. I am most

524
00:29:00,080 --> 00:29:04,800
Speaker 1: familiar with that model through multi year efforts to get

525
00:29:04,840 --> 00:29:07,920
Speaker 1: it going in corporate credit. There is a lot of

526
00:29:07,960 --> 00:29:11,080
Speaker 1: resistance to that from the dealers who don't want to

527
00:29:11,160 --> 00:29:14,320
Speaker 1: give up a lot of their pricing power in that market.

528
00:29:14,680 --> 00:29:15,080
Speaker 2: Is it a.

529
00:29:15,080 --> 00:29:18,720
Speaker 1: Similar story in US treasuries? Like, why doesn't all to

530
00:29:18,760 --> 00:29:20,440
Speaker 1: all trading exist already?

531
00:29:20,880 --> 00:29:25,440
Speaker 3: Okay, Well, the most influential market participants from the viewpoint

532
00:29:25,520 --> 00:29:30,560
Speaker 3: of designing and innovating market structure are the dealers themselves.

533
00:29:31,080 --> 00:29:34,440
Speaker 3: And if I were, you know, in the executive suite

534
00:29:34,440 --> 00:29:36,280
Speaker 3: of one of the largest dealers, I don't think I

535
00:29:36,280 --> 00:29:41,880
Speaker 3: would necessarily campaign to introduce a new set of competitors

536
00:29:42,640 --> 00:29:46,880
Speaker 3: for my trade, lowering my market share and reducing my

537
00:29:46,960 --> 00:29:50,200
Speaker 3: profit margin on each trade. So it's kind of understandable

538
00:29:50,280 --> 00:29:53,040
Speaker 3: that to the extent that the market hasn't evolved, that

539
00:29:53,920 --> 00:29:57,200
Speaker 3: you know, dealer dealers haven't been pushing for that. By

540
00:29:57,240 --> 00:30:00,480
Speaker 3: the way, I'm not advocating that the FED shouldn't mandate

541
00:30:00,520 --> 00:30:03,000
Speaker 3: all to all trade or other regulators should mandate that.

542
00:30:03,320 --> 00:30:06,560
Speaker 3: I think it needs to happen organically, because if it's

543
00:30:06,840 --> 00:30:10,400
Speaker 3: a rule requirement that trades in the treasury market must

544
00:30:10,440 --> 00:30:13,640
Speaker 3: be all to all, well, first you have to define

545
00:30:13,640 --> 00:30:15,719
Speaker 3: what that means, and that's going to gum up the

546
00:30:15,760 --> 00:30:18,280
Speaker 3: market design in and of itself. It's difficult. It's a

547
00:30:18,280 --> 00:30:21,520
Speaker 3: difficult design process. And secondly, there's a lot of trade

548
00:30:21,520 --> 00:30:24,200
Speaker 3: in that market that should be done bilaterally with dealers

549
00:30:24,320 --> 00:30:28,320
Speaker 3: for very large block trades, and dealers need to be

550
00:30:28,440 --> 00:30:31,920
Speaker 3: involved in the provision of liquidity directly to investors. So

551
00:30:32,200 --> 00:30:34,680
Speaker 3: in my view that all to all trade needs to

552
00:30:34,760 --> 00:30:37,880
Speaker 3: happen in a way that the market is guiding, but

553
00:30:38,320 --> 00:30:43,000
Speaker 3: there can be a nudge from other rules that would

554
00:30:43,120 --> 00:30:45,320
Speaker 3: lead that way, an example being central clearing.

555
00:30:45,840 --> 00:30:49,600
Speaker 1: Right, So this is the other suggestion in your paper,

556
00:30:49,720 --> 00:30:52,560
Speaker 1: So a shift towards all to all trading. I'm still

557
00:30:52,560 --> 00:30:55,800
Speaker 1: a little unclear on how that would happen organically, given

558
00:30:55,840 --> 00:30:58,040
Speaker 1: there seems to be a lot of resistance from the dealers.

559
00:30:58,080 --> 00:31:01,920
Speaker 1: I assume maybe it's one or two big investors. Know,

560
00:31:01,960 --> 00:31:03,760
Speaker 1: someone like a black Rock says we're going to do

561
00:31:03,800 --> 00:31:05,880
Speaker 1: it and then the dealers just have to come along

562
00:31:05,920 --> 00:31:09,600
Speaker 1: for the ride. But the other suggestion is central clearing.

563
00:31:09,720 --> 00:31:12,960
Speaker 1: And on this issue, again, correct me if I'm wrong.

564
00:31:13,040 --> 00:31:16,120
Speaker 1: My impression was always that the FED was a little

565
00:31:16,120 --> 00:31:17,920
Speaker 1: bit resistant to that idea.

566
00:31:18,400 --> 00:31:23,240
Speaker 3: Well, the Security is an Exchange Commission recently unanimously proposed

567
00:31:23,440 --> 00:31:26,760
Speaker 3: broad central clearing in the US treasury market. I don't

568
00:31:26,840 --> 00:31:31,720
Speaker 3: think there's that much resistance among the other key players

569
00:31:31,760 --> 00:31:34,720
Speaker 3: in the official sector. In the case of the treasury market,

570
00:31:34,760 --> 00:31:38,560
Speaker 3: those key players are the SEC itself, the New York FED,

571
00:31:38,920 --> 00:31:41,960
Speaker 3: the Federal Reserve Board, and the Treasury Department. I don't

572
00:31:42,000 --> 00:31:46,240
Speaker 3: see a significant amount of resistance across those four key players.

573
00:31:46,800 --> 00:31:51,560
Speaker 3: But it's not easily done. First, it's a difficult design

574
00:31:51,600 --> 00:31:55,240
Speaker 3: process itself. What is exactly are the requirements going to be?

575
00:31:55,320 --> 00:31:58,520
Speaker 3: And secondly, there is going to be industry resistance. And

576
00:31:59,240 --> 00:32:03,920
Speaker 3: even without singling out any particular regulator, I think industry

577
00:32:03,960 --> 00:32:07,280
Speaker 3: pushback on the cost side of that is understandable and

578
00:32:07,320 --> 00:32:09,440
Speaker 3: it's going to have to be overcome because leadership in

579
00:32:09,480 --> 00:32:11,600
Speaker 3: the official sector is going to be needed to push

580
00:32:11,640 --> 00:32:12,120
Speaker 3: that through.

581
00:32:12,400 --> 00:32:14,640
Speaker 2: Sorry, I'm going to play the role of the ignorant

582
00:32:14,760 --> 00:32:19,000
Speaker 2: listener aka me define central clearing and what is it

583
00:32:19,080 --> 00:32:22,600
Speaker 2: about it that, in your view, would contribute to sort

584
00:32:22,640 --> 00:32:24,920
Speaker 2: of like for the resultance stability in the market.

585
00:32:25,120 --> 00:32:27,840
Speaker 3: Okay, good, So let's just back up and describe what

586
00:32:27,920 --> 00:32:31,360
Speaker 3: it is. In the current US treasury market, the dealers

587
00:32:31,400 --> 00:32:35,200
Speaker 3: are required when they trade with each other to settle

588
00:32:35,200 --> 00:32:39,160
Speaker 3: their trades through the Fixed Income Clearing Corporation, which means

589
00:32:39,200 --> 00:32:41,400
Speaker 3: that they're not facing each other for settlement risk. If

590
00:32:41,440 --> 00:32:45,200
Speaker 3: I trade with you, then tomorrow I'll settle my trade

591
00:32:45,200 --> 00:32:47,600
Speaker 3: with the Fixed Income Clearing Corporation, and so would you.

592
00:32:48,240 --> 00:32:51,400
Speaker 3: That lowers our bilateral risk. It also allows me to

593
00:32:51,600 --> 00:32:55,680
Speaker 3: net down my purchases against my sales, because if I

594
00:32:55,760 --> 00:32:58,680
Speaker 3: buy from you Joe and I sell to Tracy in

595
00:32:58,720 --> 00:33:01,960
Speaker 3: a bilateral world with no central clearing, I've got two

596
00:33:02,520 --> 00:33:05,760
Speaker 3: settlements coming up that I have to pay attention to,

597
00:33:05,880 --> 00:33:08,840
Speaker 3: both of them from the viewpoint of settlement risk and

598
00:33:08,880 --> 00:33:13,360
Speaker 3: settlement failures meaning the trades are not done. If I

599
00:33:13,400 --> 00:33:16,080
Speaker 3: can net one hundred billion of purchases from you Joe

600
00:33:16,640 --> 00:33:21,240
Speaker 3: against say one hundred and ten of sales with Tracy,

601
00:33:21,640 --> 00:33:24,720
Speaker 3: that two hundred and ten billion gets netted down to

602
00:33:24,840 --> 00:33:28,880
Speaker 3: ten billion facing fixed income clearing corporation, so that massive

603
00:33:28,920 --> 00:33:32,800
Speaker 3: reduction in my settlement risk is really beneficial from the

604
00:33:32,880 --> 00:33:36,040
Speaker 3: viewpoint of using my balance sheet efficiently. There was a

605
00:33:36,040 --> 00:33:39,320
Speaker 3: study done at the New York FED year before last

606
00:33:39,400 --> 00:33:42,680
Speaker 3: by Michael Fleming and Frank Keene, two of my other collaborators,

607
00:33:42,920 --> 00:33:45,960
Speaker 3: in which they show that on the peak days of

608
00:33:46,440 --> 00:33:50,360
Speaker 3: the March twenty twenty COVID stress, the settlement in one

609
00:33:50,440 --> 00:33:53,720
Speaker 3: day for the US Treasury market facing the dealers was

610
00:33:53,720 --> 00:33:57,280
Speaker 3: in excess of a trillion dollars, and had those trades

611
00:33:57,360 --> 00:34:00,360
Speaker 3: been centrally cleared, it would have been as low is

612
00:34:00,440 --> 00:34:03,640
Speaker 3: three hundred billion, about a seventy percent reduction. Now that

613
00:34:03,920 --> 00:34:06,840
Speaker 3: not only relieves some space on dealer balance sheets, which

614
00:34:06,880 --> 00:34:09,800
Speaker 3: is one of the key problems here. If the central

615
00:34:09,800 --> 00:34:12,919
Speaker 3: clearing is done effectively in a kind of straight through

616
00:34:13,280 --> 00:34:17,360
Speaker 3: anonymous way, then investors in the market could say, well,

617
00:34:17,680 --> 00:34:20,000
Speaker 3: I could trade directly with another investor and I wouldn't

618
00:34:20,040 --> 00:34:23,040
Speaker 3: be reliant on my dealer to settle my trade for me.

619
00:34:23,680 --> 00:34:26,440
Speaker 3: If only a trade platform operator would offer that service,

620
00:34:26,520 --> 00:34:30,080
Speaker 3: I'd be all in. And then trade platform operators will say, well,

621
00:34:30,239 --> 00:34:34,040
Speaker 3: now that we have central clearing in this market, the

622
00:34:34,080 --> 00:34:37,640
Speaker 3: barriers to enter into the intermediation of this market are

623
00:34:37,719 --> 00:34:41,080
Speaker 3: much lower because investors can settle directly at the fixing

624
00:34:41,120 --> 00:34:45,120
Speaker 3: come clearing corporation or whatever central counterparty they choose. So

625
00:34:45,400 --> 00:34:49,919
Speaker 3: I think it would organically lower the barriers to more

626
00:34:49,920 --> 00:34:53,440
Speaker 3: a to all trade, in addition to reducing the amount

627
00:34:53,440 --> 00:34:56,040
Speaker 3: of space on dealer balance sheets and by the way,

628
00:34:56,120 --> 00:34:58,600
Speaker 3: lowering settlement risk in that crucial market. That's why it

629
00:34:58,640 --> 00:35:02,000
Speaker 3: was introduced in the first case back in the nineteen eighties,

630
00:35:02,080 --> 00:35:03,239
Speaker 3: to lower settlement risk.

631
00:35:03,560 --> 00:35:06,960
Speaker 1: So dealers get to use their balance sheet more efficiently

632
00:35:07,320 --> 00:35:11,319
Speaker 1: through central clearing, but there's still an added cost for them,

633
00:35:11,600 --> 00:35:14,160
Speaker 1: I believe, and there's still a sort of existential threat

634
00:35:14,200 --> 00:35:17,920
Speaker 1: to their business model if investors can settle with other investors.

635
00:35:18,640 --> 00:35:21,719
Speaker 1: So how do you You're sort of asking them to

636
00:35:22,320 --> 00:35:29,320
Speaker 1: put in higher individualized costs in exchange for more collective safety,

637
00:35:29,800 --> 00:35:33,120
Speaker 1: which when you're talking to dealer banks it sounds rational,

638
00:35:33,200 --> 00:35:35,840
Speaker 1: but a lot of them are very self interested for

639
00:35:35,920 --> 00:35:37,920
Speaker 1: obvious reasons. So how do you get them on side?

640
00:35:38,000 --> 00:35:39,400
Speaker 1: Do you need to get them on side?

641
00:35:40,040 --> 00:35:42,880
Speaker 3: You do simply by forcing the issue. But this is

642
00:35:42,920 --> 00:35:47,560
Speaker 3: the classic private cost public interest kind of trade offs

643
00:35:47,560 --> 00:35:51,040
Speaker 3: that where you need the official sector to step in

644
00:35:51,080 --> 00:35:54,520
Speaker 3: and make decisions. And by the way, when I said earlier,

645
00:35:54,800 --> 00:35:58,560
Speaker 3: as a dealer firm, I might not favor this because

646
00:35:58,600 --> 00:36:01,880
Speaker 3: of the costs and because it's threatening my market share

647
00:36:01,920 --> 00:36:05,120
Speaker 3: and my profits. I think if you take a really

648
00:36:05,160 --> 00:36:08,600
Speaker 3: long perspective on this, there's a chance that al too

649
00:36:08,600 --> 00:36:12,960
Speaker 3: all trade would massively increase the volume of trade in

650
00:36:12,960 --> 00:36:16,400
Speaker 3: the US treasury market. Let me go back to nineteen

651
00:36:16,520 --> 00:36:20,600
Speaker 3: seventy three, when none of us were probably aware of

652
00:36:20,600 --> 00:36:25,759
Speaker 3: what was going on, and talk about the equity options

653
00:36:25,800 --> 00:36:29,439
Speaker 3: market or stock options were being traded before seventy three

654
00:36:30,080 --> 00:36:34,400
Speaker 3: by laterally through dealers, just as the treasuries are done today.

655
00:36:34,680 --> 00:36:38,200
Speaker 3: Then the Chicago Board Options Exchange entered the market in

656
00:36:38,239 --> 00:36:41,360
Speaker 3: seventy three, and in the very first month of trade,

657
00:36:41,920 --> 00:36:45,040
Speaker 3: that exchange did more volume that had been done in

658
00:36:45,080 --> 00:36:49,560
Speaker 3: any prior year in the dealer intermediated market, and dealers

659
00:36:49,600 --> 00:36:53,520
Speaker 3: had a fraction of that trade, which was small fraction,

660
00:36:53,680 --> 00:36:57,680
Speaker 3: but big volume. Since nineteen seventy three, volumes in the

661
00:36:57,680 --> 00:37:03,000
Speaker 3: equity options market because was exchange traded have grown by

662
00:37:03,440 --> 00:37:07,360
Speaker 3: many orders of magnitude, on the order of a million

663
00:37:07,520 --> 00:37:10,360
Speaker 3: times the volume of trade that was in place in

664
00:37:10,400 --> 00:37:13,000
Speaker 3: nineteen seventy three. So while in a short run the

665
00:37:13,000 --> 00:37:16,760
Speaker 3: dealers got a smaller share of the market and faced

666
00:37:17,000 --> 00:37:22,440
Speaker 3: more competitive margins on each trade, eventually the volume of

667
00:37:22,480 --> 00:37:25,080
Speaker 3: trade just dominated that effect. And I don't think any

668
00:37:25,120 --> 00:37:28,120
Speaker 3: dealer would want to turn back the clock to the

669
00:37:28,200 --> 00:37:32,040
Speaker 3: days before exchange traded options. I predict the same thing

670
00:37:32,080 --> 00:37:35,200
Speaker 3: would happen in the US treasury market as around the world.

671
00:37:35,280 --> 00:37:39,200
Speaker 3: Investors would need liquidity in a much higher volume market,

672
00:37:39,520 --> 00:37:43,080
Speaker 3: and dealers would be providing a lot about liquidity, both

673
00:37:43,120 --> 00:37:44,759
Speaker 3: on exchange and off exchange.

674
00:37:45,080 --> 00:37:47,640
Speaker 2: Are there any other government bond markets around the world

675
00:37:47,640 --> 00:37:50,240
Speaker 2: that work kind of in the way that you are envisioning?

676
00:37:50,480 --> 00:37:54,240
Speaker 3: Terrific question. So a former stand for PhD student Melna Whitwer,

677
00:37:54,760 --> 00:37:58,360
Speaker 3: collaborated with two economists at the Bank of Israel on

678
00:37:58,680 --> 00:38:02,800
Speaker 3: what happened in Israel in March of twenty twenty. Is

679
00:38:02,800 --> 00:38:05,759
Speaker 3: Israeli government bonds are traded on an exchange. It's not

680
00:38:05,800 --> 00:38:09,200
Speaker 3: a dealer intermediated market, and that market came through. Now

681
00:38:09,239 --> 00:38:11,799
Speaker 3: it's not a comparison to the US treasure market in

682
00:38:11,880 --> 00:38:15,440
Speaker 3: terms of size and depth, but it came through without difficulty,

683
00:38:15,480 --> 00:38:19,840
Speaker 3: whereas most government securities markets did suffer in terms of

684
00:38:19,880 --> 00:38:21,360
Speaker 3: liquidity in March twenty twenty.

685
00:38:21,560 --> 00:38:24,600
Speaker 1: That's super interesting. Just one other Devil's Advocate question on

686
00:38:24,680 --> 00:38:27,359
Speaker 1: central clearing, which is a lot of critics will bring

687
00:38:27,440 --> 00:38:30,839
Speaker 1: up the issue of concentration risk, So you're taking risk

688
00:38:31,000 --> 00:38:33,600
Speaker 1: from the dealers and sort of moving it into this

689
00:38:33,680 --> 00:38:38,759
Speaker 1: one central counter party. What's your response to that critique.

690
00:38:39,000 --> 00:38:41,640
Speaker 3: Well, it's true. I mean you have to say, although

691
00:38:41,680 --> 00:38:46,040
Speaker 3: that it's considered a pejorative that the Fixed Income Clearing

692
00:38:46,080 --> 00:38:49,080
Speaker 3: Corporation is too big to fail and it would become

693
00:38:49,760 --> 00:38:53,520
Speaker 3: even bigger. So even more importantly, could not fail. You

694
00:38:53,560 --> 00:38:57,560
Speaker 3: couldn't You couldn't imagine the chaos that would ensue if

695
00:38:57,560 --> 00:39:00,760
Speaker 3: the central counterparty for the US treasure market were unable

696
00:39:00,800 --> 00:39:04,719
Speaker 3: to meet its obligations and had to create an enormous

697
00:39:04,760 --> 00:39:09,680
Speaker 3: crater on the global financial markets. So you are putting

698
00:39:09,719 --> 00:39:13,920
Speaker 3: the onus even more on the safety and soundness of

699
00:39:13,920 --> 00:39:17,839
Speaker 3: that central counterparty now, and I think regulators are up

700
00:39:17,840 --> 00:39:20,799
Speaker 3: to that. It's the Fixed Income Clearing Corporation has been

701
00:39:20,840 --> 00:39:25,719
Speaker 3: designated as systemically important. It is on the list of

702
00:39:25,960 --> 00:39:31,799
Speaker 3: Financial Stability Oversight Council's infrastructure that must get too big

703
00:39:31,840 --> 00:39:37,480
Speaker 3: to fail. Attention. I also hear sometimes the misunderstanding that

704
00:39:37,560 --> 00:39:41,440
Speaker 3: what we would be doing with central counterparties like FICK

705
00:39:42,320 --> 00:39:44,440
Speaker 3: is to take all of the risk in the market

706
00:39:45,080 --> 00:39:48,080
Speaker 3: and kind of like bulldoze it into one spot at

707
00:39:48,080 --> 00:39:51,880
Speaker 3: the central counterparty, making this enormous stack of risk all

708
00:39:51,880 --> 00:39:56,880
Speaker 3: in one failure point. That is not a correct metaphor,

709
00:39:57,160 --> 00:40:00,799
Speaker 3: because as you take all of these bilateral purchases in

710
00:40:00,880 --> 00:40:05,600
Speaker 3: sales and bring them into the central counterparty, all the

711
00:40:05,640 --> 00:40:10,040
Speaker 3: purchases almost get netted against all the sales and you

712
00:40:10,160 --> 00:40:13,560
Speaker 3: get a much smaller stack of risk. As a result,

713
00:40:14,000 --> 00:40:16,880
Speaker 3: the amount of risk goes down enormously. I mentioned the

714
00:40:17,320 --> 00:40:19,320
Speaker 3: study done by the New York Fed that shows about

715
00:40:19,320 --> 00:40:22,960
Speaker 3: a seventy percent reduction and settlement risk in the US

716
00:40:23,040 --> 00:40:26,680
Speaker 3: Treasury market from doing central clearing. So even though it

717
00:40:26,760 --> 00:40:29,280
Speaker 3: is true you're concentrating the risk more in one place,

718
00:40:29,480 --> 00:40:31,160
Speaker 3: the total amount of risk goes way down.

719
00:40:31,520 --> 00:40:35,200
Speaker 2: So you're here at Jackson Hall with the most impressive

720
00:40:35,680 --> 00:40:38,240
Speaker 2: audience in the world. I don't mean the odd lads,

721
00:40:38,880 --> 00:40:42,800
Speaker 2: hosts and listeners, although hopefully we're fairly impressive as well.

722
00:40:42,920 --> 00:40:46,000
Speaker 2: But beyond that, is there anything else, like, you know, like,

723
00:40:46,040 --> 00:40:48,080
Speaker 2: what are you trying to what are the key things

724
00:40:48,080 --> 00:40:51,719
Speaker 2: that you're like, hope that your research impresses upon this

725
00:40:51,840 --> 00:40:56,160
Speaker 2: audience in terms of next steps and things that beyond

726
00:40:56,239 --> 00:40:59,560
Speaker 2: say even what you've described in terms of like where

727
00:40:59,600 --> 00:41:01,000
Speaker 2: to go now with some of this stuff.

728
00:41:01,640 --> 00:41:03,440
Speaker 3: So, I think what you're going to see here at

729
00:41:03,520 --> 00:41:06,160
Speaker 3: Jackson Hole, or what you have seen by the time

730
00:41:06,560 --> 00:41:10,759
Speaker 3: that you think are listening, that your listeners hear this

731
00:41:11,400 --> 00:41:16,799
Speaker 3: is a lot of attention on fiscal risks. You're going

732
00:41:16,880 --> 00:41:21,960
Speaker 3: to see the importance of increasing government debt and how

733
00:41:22,000 --> 00:41:26,440
Speaker 3: that interplays with inflation risk. The work that we've been

734
00:41:26,440 --> 00:41:30,680
Speaker 3: discussing today on improving the liquidity of the US Treasury

735
00:41:30,680 --> 00:41:34,359
Speaker 3: market details well with the topic that I think will

736
00:41:34,400 --> 00:41:40,120
Speaker 3: be the headline topic here of inflation and sovereign debt risk,

737
00:41:41,360 --> 00:41:46,920
Speaker 3: by highlighting the importance of making the US Treasury market

738
00:41:47,200 --> 00:41:52,440
Speaker 3: and other government securities markets more resilient to the problems

739
00:41:52,480 --> 00:41:56,360
Speaker 3: that will arise as we get more and more stress

740
00:41:57,000 --> 00:42:03,600
Speaker 3: coming from inflation volatility, monitory uncertainty, sovereign debt risk, uncertainty,

741
00:42:04,000 --> 00:42:09,239
Speaker 3: not to mention political uncertainties. It's kind of a constellation

742
00:42:09,360 --> 00:42:12,520
Speaker 3: of risks, and you want to build a market that's

743
00:42:12,760 --> 00:42:15,720
Speaker 3: resilient to those risks. And I think those that prepared

744
00:42:15,719 --> 00:42:20,040
Speaker 3: the agenda for this meeting thought carefully about bringing all

745
00:42:20,080 --> 00:42:23,160
Speaker 3: of these topics together in the same symposium.

746
00:42:23,840 --> 00:42:25,880
Speaker 1: Just on that note, there was one more question I

747
00:42:25,920 --> 00:42:28,440
Speaker 1: wanted to ask you about all to all trading, which

748
00:42:28,480 --> 00:42:32,440
Speaker 1: is would the Treasury go for it? Because one of

749
00:42:32,480 --> 00:42:35,960
Speaker 1: the benefits of the primary dealer model right now is

750
00:42:36,000 --> 00:42:39,480
Speaker 1: that it is very hard to get a failed auction.

751
00:42:39,600 --> 00:42:42,359
Speaker 1: In fact, I think it's pretty much impossible. So if

752
00:42:42,400 --> 00:42:46,640
Speaker 1: you didn't have those primary dealers sort of beholden to

753
00:42:46,760 --> 00:42:50,040
Speaker 1: the Treasury at a time when the US is expected

754
00:42:50,080 --> 00:42:52,920
Speaker 1: to sell a lot more debt, that would seem to

755
00:42:52,960 --> 00:42:53,439
Speaker 1: be a risk.

756
00:42:54,239 --> 00:42:57,560
Speaker 3: It's certainly something that I've heard some at the largest

757
00:42:57,800 --> 00:43:04,160
Speaker 3: primary dealers say publicly and in conversations be cautious with

758
00:43:04,239 --> 00:43:07,319
Speaker 3: changing the structure of this market, because if dealers are

759
00:43:07,360 --> 00:43:13,120
Speaker 3: not sufficiently profitable in providing intermediation and the secondary market

760
00:43:13,120 --> 00:43:17,440
Speaker 3: for US treasuries where they're traded, then maybe the primary

761
00:43:17,440 --> 00:43:21,480
Speaker 3: dealers will not participate as actively by committing capital to

762
00:43:21,640 --> 00:43:25,480
Speaker 3: the primary market, which is where they're issued, And maybe

763
00:43:25,480 --> 00:43:28,120
Speaker 3: that would cost US taxpayers more because you wouldn't have

764
00:43:28,160 --> 00:43:32,200
Speaker 3: a reliable committed buyers at those auctions. That is a risk,

765
00:43:32,680 --> 00:43:37,080
Speaker 3: but it's not convincing to me that you can sit

766
00:43:37,160 --> 00:43:42,080
Speaker 3: back and try to sustain the current market structure when

767
00:43:42,440 --> 00:43:45,760
Speaker 3: the treasure market is growing bigger and bigger while balance

768
00:43:45,760 --> 00:43:49,840
Speaker 3: sheets are shrinking relative to GDP. The total US government

769
00:43:49,880 --> 00:43:53,200
Speaker 3: securities market relative to GDP is going to be about

770
00:43:53,239 --> 00:43:56,359
Speaker 3: one hundred and fifty percent or more according to the

771
00:43:56,400 --> 00:44:00,000
Speaker 3: projection of the Congressional Budget Office, whereas dealer balance sheets

772
00:44:00,120 --> 00:44:03,600
Speaker 3: are shrinking relative to GDP over the last ten years.

773
00:44:03,880 --> 00:44:07,319
Speaker 3: That's not sustainable. So simply to say we don't want

774
00:44:07,360 --> 00:44:10,600
Speaker 3: to disrupt the current market structure because the dealers won't

775
00:44:10,600 --> 00:44:14,359
Speaker 3: participate as much in the primary market is not going

776
00:44:14,400 --> 00:44:17,640
Speaker 3: to fix the problem. The dealers are now taking down

777
00:44:17,760 --> 00:44:20,840
Speaker 3: on the order of ten percent plus or minus, and

778
00:44:20,880 --> 00:44:23,440
Speaker 3: those auctions that number has been coming down over the years.

779
00:44:23,600 --> 00:44:26,120
Speaker 3: I predict they will continue to participate in the market

780
00:44:26,160 --> 00:44:28,239
Speaker 3: even if there is a change in market structure. But

781
00:44:28,440 --> 00:44:31,840
Speaker 3: that is not, in my mind, an overriding a concern

782
00:44:31,920 --> 00:44:33,200
Speaker 3: to fixing the market structure.

783
00:44:33,239 --> 00:44:36,600
Speaker 1: All right, Well, Daryl Duffy, that was a fantastic overview

784
00:44:36,760 --> 00:44:41,040
Speaker 1: of a sort of persistently stubborn problem in one of

785
00:44:41,040 --> 00:44:43,279
Speaker 1: the world's most important markets. So thank you so much

786
00:44:43,320 --> 00:44:45,160
Speaker 1: for coming on all thoughts and explaining it to us.

787
00:44:45,239 --> 00:44:48,560
Speaker 3: Thanks terrific conversation, Tracy, Joe, thank you so much.

788
00:44:48,600 --> 00:44:58,239
Speaker 1: Yeah, that was fantastic, So Joe, I really enjoyed that conversation.

789
00:44:58,320 --> 00:45:01,799
Speaker 1: And you're absolutely right, real treat to hear from the

790
00:45:01,840 --> 00:45:05,000
Speaker 1: guy that the central bankers are calling him to talk

791
00:45:05,040 --> 00:45:09,000
Speaker 1: about this. It does seem to be this persistent issue

792
00:45:09,040 --> 00:45:11,359
Speaker 1: in the market, and you see it happen more and more,

793
00:45:11,440 --> 00:45:15,800
Speaker 1: these like small bouts of volatility, but they're happening more often.

794
00:45:15,920 --> 00:45:18,200
Speaker 2: Well, and I was really glad you asked that last

795
00:45:18,280 --> 00:45:20,719
Speaker 2: question because that really crystallized something for me, which is

796
00:45:20,760 --> 00:45:23,960
Speaker 2: that like we are living in a period of like

797
00:45:24,560 --> 00:45:28,319
Speaker 2: big fiscal right for better or worse, and so it's like, well,

798
00:45:28,400 --> 00:45:31,440
Speaker 2: what is like unsustainable about it or where did the

799
00:45:31,640 --> 00:45:35,080
Speaker 2: how does that become a stress point? And to Daryl's point,

800
00:45:35,239 --> 00:45:38,879
Speaker 2: it's like, if you have this explosion of supply at

801
00:45:38,880 --> 00:45:42,160
Speaker 2: a time when the entities that are like tasked with

802
00:45:42,320 --> 00:45:45,080
Speaker 2: sort of like managing that supply either have constrained or

803
00:45:45,120 --> 00:45:48,319
Speaker 2: shrinking balance sheets, then setting aside you of a like

804
00:45:48,320 --> 00:45:51,879
Speaker 2: fiscal sustainability or inflation, you are going to run into

805
00:45:51,880 --> 00:45:54,799
Speaker 2: this basically like infrastructure bottleneck, and it feels like that's

806
00:45:54,880 --> 00:45:56,440
Speaker 2: really like the challenge here.

807
00:45:56,600 --> 00:45:58,719
Speaker 1: I think that's exactly right, and I mean you brought

808
00:45:58,800 --> 00:46:00,960
Speaker 1: up inflation just then. But seems to be the other

809
00:46:01,040 --> 00:46:04,800
Speaker 1: important factor, which is, well, maybe that model of trading

810
00:46:04,840 --> 00:46:08,279
Speaker 1: and dealing and treasuries worked for a period of very

811
00:46:08,320 --> 00:46:11,280
Speaker 1: low interest rates where we did have very subdued inflation.

812
00:46:11,800 --> 00:46:15,240
Speaker 1: But in an era where there is monetary policy tightening,

813
00:46:15,280 --> 00:46:18,160
Speaker 1: maybe you can't count on the central bank to always

814
00:46:18,640 --> 00:46:21,400
Speaker 1: backstop the treasury market, or if it backstops it, it's

815
00:46:21,480 --> 00:46:24,080
Speaker 1: going to need to sell some of those treasuries eventually.

816
00:46:24,280 --> 00:46:26,600
Speaker 1: Then that kind of changes the calculus.

817
00:46:26,920 --> 00:46:29,000
Speaker 2: So we're going to have to do an episode on

818
00:46:29,120 --> 00:46:34,200
Speaker 2: Israeli government. No, it's like the one country that everyone

819
00:46:34,239 --> 00:46:36,000
Speaker 2: else saw all this dress like I had no idea

820
00:46:36,040 --> 00:46:36,440
Speaker 2: about that.

821
00:46:36,520 --> 00:46:39,640
Speaker 1: Yeah we should. Actually that'd be really interesting. Okay, but

822
00:46:39,719 --> 00:46:42,239
Speaker 1: for now, shall we head back to the lodge at

823
00:46:42,320 --> 00:46:42,839
Speaker 1: Jackson Hole.

824
00:46:43,000 --> 00:46:43,879
Speaker 2: Let's do it all right?

825
00:46:44,000 --> 00:46:46,920
Speaker 1: This has been another episode of the Odd Loots podcast.

826
00:46:47,160 --> 00:46:50,480
Speaker 1: I'm Tracy Alloway. You can follow me at Tracy Alloway.

827
00:46:50,080 --> 00:46:53,120
Speaker 2: And I'm joll Wisenthal. You can follow me at the Stalwart,

828
00:46:53,360 --> 00:46:56,960
Speaker 2: Follow our guest Darryl Duffy He's at Darryl Duffy. Follow

829
00:46:57,040 --> 00:47:01,400
Speaker 2: our producers Carmen Rodriguez at Carmen R and Dashel Bennett

830
00:47:01,440 --> 00:47:05,640
Speaker 2: at Dashbot. And our special guest producer on this Jacksonhole trip,

831
00:47:05,719 --> 00:47:09,160
Speaker 2: Sebastian Escobark. He's at Under the Sea Bass. Follow the

832
00:47:09,160 --> 00:47:12,399
Speaker 2: rest of the Bloomberg podcasts under the handle at podcasts,

833
00:47:12,640 --> 00:47:15,680
Speaker 2: and for more Oddlots content, go to Bloomberg dot com

834
00:47:15,760 --> 00:47:18,520
Speaker 2: slash odd Lots, where we have transcripts, a blog, and

835
00:47:18,560 --> 00:47:22,160
Speaker 2: a newsletter and you can discuss all these topics twenty

836
00:47:22,160 --> 00:47:24,960
Speaker 2: four to seven with fellow listeners in the discord. I'm

837
00:47:25,000 --> 00:47:26,919
Speaker 2: sure there'll be a lot of conversation about this one

838
00:47:27,200 --> 00:47:29,920
Speaker 2: discord dot gg slash od Loots.

839
00:47:30,400 --> 00:47:33,920
Speaker 1: And if you like Oddlots, if you enjoy these discussions

840
00:47:33,960 --> 00:47:35,920
Speaker 1: and you want us to do an episode on the

841
00:47:35,960 --> 00:47:39,480
Speaker 1: structure of the Israeli government bond market, then please leave

842
00:47:39,560 --> 00:47:43,000
Speaker 1: us a positive review on your favorite podcast platform. Thanks

843
00:47:43,040 --> 00:47:43,560
Speaker 1: for listening.