Why is Reform Needed? A Brief History of Recent Market Disruptions

In Part I of this two-part blog series, we provide an overview of the critical role of the U.S. Treasury markets in our financial system and provide a brief history of recent events that have called into question the resiliency of those markets.

In Part II, we discuss emerging policy proposals for reforming the markets in light of these market disruptions.

Why are the U.S. Treasury Markets Important?

U.S. Treasuries are debt instruments issued by the U.S. government to finance its activities. Owing to the United States’ creditworthiness and status as the world’s leading economy, the U.S. Treasury market (comprised of the cash market as well as the repurchase agreement (“repo”) and futures markets) has been described as the “biggest, deepest and most essential bond market on the planet.”^[1] Investors view Treasuries historically as risk-free or near-cash assets i.e., assets that retain their value and can be easily sold during both normal and stressed market periods. Unsurprisingly then, Treasuries have tended to be viewed as safe havens for investors during market crises. Owing to their stability, U.S. Treasuries also often serve as benchmarks for other fixed-income securities and hedging positions; as a result, U.S. Treasury yields have an impact on the rates that consumers, businesses, and governments across the globe pay to borrow money. In addition, the U.S. Treasury repo market is a key transmission mechanism for U.S. monetary policy, and vital to the liquidity of the cash Treasury market. Put simply, the U.S. Treasury market is a bedrock of the global financial system.

How are the Treasury Securities Markets Structured?

The U.S. government’s ability to finance its debt at the lowest cost to taxpayers is built around a principal- or dealer-based market structure. This structure is reflected in the Treasury auction process and the significant role played by primary dealers (both in that auction process and as market-makers supporting secondary market activity).

The U.S. Treasury has structured the auction process to promote broad, competitive bidding and ensure the sale of the entire offering at the most advantageous rate for the government. Primary dealers – that is, banks and broker-dealers that have been designated as counterparties of the Federal Reserve Bank of New York (“FRBNY”) – have traditionally constituted the largest group of buyers in such auctions (bidding on behalf of their own accounts or on behalf of identified customers). Other direct auction bidders include investment funds, pensions and retirement funds, insurance companies, foreign accounts and others. Primary dealers are, however, the only market participants that are obligated to participate in all auctions of U.S. government debt and are each required to make pre-agreed minimum bids. The FRBNY further expects primary dealers to “[d]emonstrate a substantial presence as a market-maker that provides two-way liquidity in [the Treasury market], particularly Treasury cash and repo operations.”^[2] The obligation to support market liquidity extends not only to “on-the-run” securities (the most recently issued securities), but also to less liquid “off-the-run” securities.

In meeting these obligations, and in attempting to satisfy market and client demands, primary dealers are frequently required to commit a significant amount of capital. Principal trading activity in the “when-issued” market (i.e., securities that have been announced but have are yet to be issued), during auctions, in the aftermarket of auctions, and in the secondary market requires these dealers to hedge their positions with other Treasury-backed products. By contrast, other market participants are not similarly bound by the market-making obligations that put primary dealers in a position of providing both buy and sell quotes on a more-or-less continuous basis. The ability of primary dealers to do so supports the liquidity and overall functioning of the Treasury markets.

Finally, the characteristics of the Treasury markets also vary significantly across product segments. This is particularly true with respect to the on-the-run and off-the-run segments, with the on-the-runs trading much more frequently and often via electronic platforms relative to the less-actively traded off-the-runs.

Why are there concerns about the resiliency of the Treasury markets?

The resiliency of the Treasury markets has been called into question by a series of market disruption events (discussed below) in which market price volatility increased dramatically and/or where the depth of the market (i.e., the amount of liquidity available) decreased precipitously. While these events have differed in their scope and magnitude, collectively they have highlighted a variety of underlying structural problems in the Treasury markets. This in turn has led to calls for reforms, which we will discuss in Part II of this blog series.

The October 2014 “Flash Rally”

On October 15, 2014, the Treasury securities, futures, and other related markets experienced unusually high levels of volatility, with Treasury yields experiencing sharp declines and then rebounds in a matter of minutes. Various measures of market liquidity, including market depth, showed significant deterioration on that day. Unlike more recent events, there was no obvious exogenous factor driving what was often described as a “Flash Rally.” Instead, a report on the day’s events issued by the U.S. Treasury Department and other major financial regulators (“the Joint Staff Report”^[3]) suggested that structural changes in the Treasury markets may have caused the unusual market conditions on October 15, among them the growing presence of Proprietary Trading Firms (“PTFs”) and the declining role of bank-dealers in intermediating the growing market for Treasury securities. The Joint Staff Report recommended further study of the markets and efforts to strengthen monitoring and surveillance, and over the subsequent years steps were taken to improve inter-agency data sharing and trade reporting by market participants.^[4]

September 2019: Stresses in the Treasury-Backed Repo Markets

Events in mid-September 2019 raised deeper questions about the resiliency of the Treasury market. In this case, the problems occurred in the Treasury-backed repo market. Repos function as short-term collateralized loans, in which one party borrows cash by selling securities (typically government securities such as U.S. Treasuries) to the lender, with a commitment to repurchase the security at a later point plus a nominal rate of interest (the repo rate). Repos serve as liquidity redistribution mechanisms, giving some institutions such as broker-dealers and PFTs access to a cheap source of liquidity to help them fund their day-to-day operations. Repos also permit firms with large cash holdings, such as money market funds (“MMFs”) and insurance companies to invest safely to earn income (banks have more typically been “borrowers” of cash in the repo market but can also be “lenders”). Because of this, the Treasury-backed repo market is a crucial liquidity mechanism for the broader financial system, as witnessed when the repo markets came under extreme stress during the 2008 Great Financial Crisis (“GFC”).

On September 16, 2019, repo rates began increasing significantly; on September 17, this trend continued, with the intraday repo rate more than doubling and the intraday repo rate range, which normally fluctuates by no more than 10 or 20 basis points, approaching 700 basis points – a massive jump in volatility. Overall, repo rates jumped from approximately 200 basis points to nearly 1000 basis points in just two days. The Federal Reserve responded by agreeing to buy around $60 billion in short-term Treasury securities per month, a move which increased the supply of reserves in the system (i.e., cash to lend to repo borrowers), thereby abating the growing funding crisis in the Treasury-backed repo markets.^[5]

While there were exogenous events that may have contributed to the sudden demand for cash^[6], these explanations alone did not appear to explain the dramatic increase in the cost of funding and volatility that occurred. The Federal Reserve’s unwinding of its Quantitative Easing (“QE”) policy, which removed reserves from the system, undoubtedly contributed by making cash scarcer. Added to this, there is some evidence that money market funds felt reluctant to lend into the markets during the event owing to concerns about redemption requests.^[7] Banks, another potential source of cash, felt constrained in their ability to tap into their more limited reserves, potentially owing to regulatory constraints or supervisory expectations. But the event was also driven by the increase in the number of Treasury securities, a function of the growing federal deficit; Treasury purchases by dealers needed to be financed until they were sold on to end investors, thereby increasing the volume of Treasury-backed repo transactions.

In short, the September 2019 event was caused by a decrease in the supply of cash at a time when the demand was increasing. It once again highlighted longer-term structural challenges in the markets: the inventory of Treasuries was increasing while the capacity of dealers to intermediate in markets was constrained. The event also raised questions about the Federal Reserve’s role in the markets, and whether it ought to create a standing liquidity facility for repos to avoid a repeat of these stresses – a topic which we will return to in a subsequent blog looking at proposals for reform of the Treasury securities markets.

The March 2020 “Dash-for-Cash”

In March of last year, as the scale of the COVID-19 pandemic became apparent, the U.S. Treasury markets experienced unprecedented volatility. Initially, yields on 1-Year, 5-Year and 10-Year Treasury notes dropped significantly in the early days of March as investors sought out safe-haven assets. This type of yield decline was large but consistent with past behavior during market crises. However, beginning on March 9, yields on Treasuries began to sharply increase, as investors suddenly began to sell Treasuries (see Figure 1 below). The reasons for this are manifold, but it seems many market participants needed to liquidate Treasury positions to satisfy demands for cash. This included mutual funds that needed to meet redemption demands from investors; brokers and investors needing to meet clearinghouse margin calls; PTFs needing to rebalance portfolios or unwind trades; and foreign central banks that needed dollar cash liquidity to provide emergency support to their financial systems (with many selling deep “off-the-run” and longer-dated Treasuries). This broad-based sell-off of Treasuries, part of a broader “dash-for-cash” by investors, broke the patterns of behavior witnessed in past crises.

At this point, broker-dealers, who traditionally play a central intermediation role in the Treasury markets, faced balance sheet capacity constraints owing in large part to regulatory requirements. As a result, in many cases they were unable to absorb the vast number of Treasuries being sold by other market actors.^[8] Other actors that provided liquidity during normal periods, such as PTFs, withdrew from the market altogether.^[9] The depth of the markets^[10] (i.e. the quantity of liquidity) declined rapidly while bid-ask spreads widened, all suggesting that liquidity had evaporated in the Treasury markets.^[11] In order to stabilize the markets, the Federal Reserve engaged in a series of interventions beginning on March 15. This included significant purchases of off-the-run Treasuries and interventions in the repo markets, and ultimately ended in an open-ended commitment to support the Treasury market, as well as the creation of emergency liquidity facilities, such as the Primary Dealer Credit Facility (“PDCF”).^[12] These actions, combined with temporary relief that allowed bank dealers to expand their balance sheet capacity^[13], quickly restored stability to the market, with yields operating in a small range for the rest of 2020.^[14]

How can Treasury market liquidity be maintained, even during periods of stress?

That question is currently the subject of significant study and debate. Having published an initial, fact-based assessment of the global events of last March and April, the Financial Stability Board (“FSB”) has launched a major work program to study non-bank financial intermediation (“NBFI”) and its role in the market turmoil that occurred last year.^[15] Several of the FSB’s workstreams will be focused on the structure of core bond markets (particularly the Treasury markets) and the role played by different participants in those markets (both bank dealer and non-bank entities).

In anticipation of interest in this topic at both the international and domestic levels, studies have begun to emerge that try to identify structural reforms that could contribute to enhancing the capacity and resiliency (i.e., the ability of markets to remain deeply liquid during periods of extreme stress and volatility). Two white papers have been particularly prominent in this debate: one written by Stanford University Professor Darrell Duffie^[16], and another co-authored paper by former senior Federal Reserve staffers Nellie Liang (also of the Brookings Institution and now the U.S. Treasury Department) and Pat Parkinson.^[17]

In short, both sets of authors identify two structural challenges in the Treasury markets that they argue have made disruptive events such as those discussed above more likely. First, as the U.S. government debt has grown dramatically over the last two decades – growth that is set to continue owing to ongoing government stimulus measures – the amount of Treasury securities outstanding (i.e., supply) has also expanded (see Figure 2 below). Second, broker-dealers have become more constrained in their ability to intermediate these growing inventories of Treasuries primarily because of regulatory capital requirements, particularly the Supplementary Leverage Ratio (“SLR”), which penalizes banks for holding Treasuries and reserves (i.e., deposits) held at the Federal Reserve on their balance sheets).^[18]

Given that the growing volume of Treasury issuance seems unlikely to abate, the question becomes how to ensure adequate continued and resilient liquidity provision in those markets. That is the question we will turn to in Part II of this blog series.

Dr. Peter Ryan is a Managing Director and Head of International Capital Markets and Prudential Policy at SIFMA.

Robert Toomey is Managing Director and Associate General Counsel, Rates at SIFMA.

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^[1] The average daily trading volume in the cash Treasury markets in 2019 was $500 billion, compared to an average trading volume of $322 billion in the U.S. equity markets. See Committee on Capital Markets Regulation.

^[2] See New York Fed Policy on Counterparties for Market Operations (Primary Dealers)(Nov. 6, 2016), available at https://www.newyorkfed.org/markets/primarydealers.html.

^[3] “The Joint Staff Report on the U.S. Treasury Market on October 15, 2014,” July 13, 2015. Available at: Joint_Staff_Report_Treasury_10-15-2014.pdf.

^[4] E.g., see Mary Jo White, “Prioritizing Regulatory Enhancements for the U.S. Treasury Market,” October 24, 2016. Available at: SEC.gov | Prioritizing Regulatory Enhancements for the U.S. Treasury Market, which provides an overview of reforms. Among them was the mandatory reporting of transactions in U.S. Treasury securities to the Financial Industry Regulatory Authority’s (FINRA’s) Trade Reporting and Compliance Engine (TRACE). TRACE reporting for Treasury securities began in July 2017.

^[5] For more on the event, see Fernando Avalos, Torsten Ehlers and Egemen Eren, “September stress in dollar repo markets: passing or structural?,” BIS Quarterly Review, December 2019. Available at: September stress in dollar repo markets: passing or structural? (bis.org). For a higher level discussion, see Jeffrey Cheng and David Wessel, ‘What is the repo market, and why does it matter?,” Brookings Institution, January 28, 2020. Available at: What is the repo market, and why does it matter? (brookings.edu).

^[6] Specifically quarterly corporate taxes were coming due, and it was the settlement date for previously auctioned Treasuries, meaning that demand for cash from investors and corporations was elevated at the time.

^[7] See Avalos et. al.

^[8] Board of Governors of the Federal Reserve System, “Financial Stability Report: 2020,” available at: . The Fed wrote that “as investors sold less-liquid Treasury securities to obtain cash, dealers absorbed large amounts of these Treasury securities onto their balance sheets. It is possible that some dealers reached their capacity to absorb these sales, leading to a deterioration in Treasury market functioning.”

^[9] Nellie Liang and Pat Parkinson,

^[10] Per the Joint Staff Report, “market depth” is a measure of the “quantity of liquidity,” an example of which is the dollar amount of standing quotes in the central limit order books on cash and futures trading platforms.

^[11] Lorie Logan, “Treasury Market Liquidity and Early Lessons from the Pandemic Shock,” October 23, 2020. Available at: Treasury Market Liquidity and Early Lessons from the Pandemic Shock – FEDERAL RESERVE BANK of NEW YORK (newyorkfed.org).

^[12] See Board of Governors of the Federal Reserve System, “Federal Reserve Board announces establishment of a Primary Dealer Credit Facility (PDCF) to support the credit needs of households and businesses,” March 17, 2020. Available at: Federal Reserve Board – Federal Reserve Board announces establishment of a Primary Dealer Credit Facility (PDCF) to support the credit needs of households and businesses. See also: Board of Governors of the Federal Reserve System, “Federal Reserve announces extensive new measures to support the economy,” March 23, 2020.

^[13] 85 FR 20578, Board of Governors of the Federal Reserve System, Interim Final Rule – Regulatory Capital Rule: Temporary Exclusion of U.S. Treasury Securities and Deposits at Federal Reserve Banks from the Supplementary Leverage Ratio.

^[14] See Committee on Capital Markets Regulation, p. 5.

^[15] Financial Stability Board, “Holistic Review of the March Market Turmoil,” November 17, 2020. Available at NBTF-US-Treasury-Markets-During-Covid.pdf (capmktsreg.org). The report includes details on the NBFI work program.

^[16] Darrell Duffie, “Still the World’s Safe Haven? Redesigning the U.S. Treasury Market After the COVID-19 Crisis,” Hutchins Center Working Paper #62, Brookings Institution, June 2020. Available at: WP62_Duffie_v2.pdf (brookings.edu).

^[17] Nellie Liang and Pat Parkinson, “Enhancing Liquidity of the U.S. Treasury Market Under Stress,” Hutchins Center Working Paper #72, Brookings Institution, December 16, 2020. Available at: WP72_Liang-Parkinson.pdf (brookings.edu).

^[18] For more on the SLR and its impact, see Coryann Stefansson, “Extending the Supplementary Leverage Ratio is Essential to Main Street,” March 9, 2021. Available at: Extending the Supplemental Leverage Ratio is Essential to Main Street – Extending the Supplemental Leverage Ratio is Essential to Main Street – SIFMA.

Treasury Market Reform Blog Series

• Blog Series

  Part II: Proposals for Reforming US Treasury Markets

  Many approaches for reforming U.S. Treasury markets have been discussed on a standalone basis and most had been suggested prior to recent events. Although by no means exhaustive, it does seem that there are four broad categories of reform currently being debated. So they may now be considered holistically as a single package, we summarize four categories and discuss each in brief.

• Blog Series

  Part III: Evaluating the Benefits and Costs of Central Clearing in the Treasury Markets

  It appears that the relative benefits of central clearing in the repo market are greater than in the dealer-to-customer cash market. Mandating central clearing in the cash market could impede market functioning and diversity while simultaneously failing to provide the same capacity benefits that are seen in the repo market. Therefore, it is essential that policymakers thoroughly study the costs and benefits of central clearing on different segments of the market before implementing policies that would either incentivize or mandate its adoption.

Related Resources

• SIFMA Insights

  US Fixed Income Market Structure Primer

• SIFMA Research

  US Treasury Securities Statistics