Primary dealers, the banks that are tasked with providing a stream of prices for Treasuries
Industry data suggests primary dealers, the banks that are tasked with providing a stream of prices for Treasuries, pulled back from the market in February and March last year before the Fed stepped in

US government bond specialists are starting to fret over how the world’s most important market will cope when the Federal Reserve pulls back its pandemic-era support.

The $22tn Treasuries market forms the basis for pricing other assets around the world. It is famed for its liquidity — a broad term meaning it is easy to hop in and out of trades. But on several occasions since Covid-19 first hit, gaps in liquidity have appeared, creating jerky price movements.

When the Fed starts to trim its $120bn-a-month bond buying scheme, possibly as soon as November, some participants fear the lack of once-reliable market support could generate more instability.

The Treasury market system “is primed so that high-frequency traders and primary dealers pull back when there are problems”, said Yesha Yadav, a professor at Vanderbilt Law School in Nashville who studies Treasury market structure and regulation.

“The way this is set up is designed to fail. It is exceptionally fragile,” Yadav said.

The Treasuries market whipsawed in the Covid shock of 2020. That was perhaps the inevitable result of investors globally rushing to reshape portfolios. But central banks and regulators were also alarmed when at one point Treasury prices fell fast — the opposite to typical patterns in times of stress — because liquidity evaporated. More recently, in February, weak take-up of a standard seven-year debt auction sparked a significant move lower in price.

“For folks who have March 2020 and February 2021 fresh in their minds, this does remind people that there are risks for Treasury market functioning as we see the Fed trying to remove themselves from the market,” said Mark Cabana, head of US rates strategy at Bank of America.

Some key responsibility here lies with so-called primary dealers, the 24 financial firms that are tasked with providing a stream of buy and sell prices for Treasuries by the Fed. They include banks such as JPMorgan Chase, Citigroup and Goldman Sachs. Data from the Financial Industry Regulatory Authority suggest they pulled back in February and March last year before the Fed stepped in to stabilise the market.

Primary dealers transact directly with the Treasury department, and they theoretically help backstop the market as buyers when other investors are trying to sell. But Dodd-Frank regulation in the wake of the 2008 financial crisis forced banks to hold more capital on their balance sheets to offset the debt they owned. In response, primary dealers have reduced the amount of debt they carry relative to the size of the Treasury market.

Line chart of Ratio of positions in the repo market compared to total debt outstanding showing Primary dealer positions in Treasuries have fallen dramatically

“The banks never were there to catch the falling knife but they certainly did act as a pretty huge liquidity buffer to the marketplace in a way that they can’t or won’t today,” said Kevin McPartland, head of market structure and technology research at Coalition Greenwich.

The Securities Industry and Financial Markets Association, an industry lobbying firm representing big lenders, wrote earlier this year that changing bank balance sheet rules would ensure smooth market functioning.

“Some modest loosening of primary dealer balance sheets would likely help reduce these more frequent bouts of volatility, and we would still have a much safer system” than before the financial crisis, said Tyler Wellensiek, global head of rates market structure at Barclays.

But keeping the rules brings benefits: the capital requirements placed on banks are likely to have prevented major crises in the sector during the coronavirus recession, according to the Bank for International Settlements. And changing capital requirements would potentially put the US in violation of the post-2008 international Basel agreement, said Greg Peters, the co-chief investment officer of PGIM Fixed Income.

As primary dealers have stepped back from their market-making role, hedge funds and high-frequency traders including Citadel Securities, Virtu Financial and Jump Trading have moved into their place. But when markets become volatile, high-frequency trading funds also can pull out.

Data from Coalition Greenwich show that order-book volume — a large portion of which is made up of high-frequency trader activity — has shrunk during recent liquidity glitches. In March last year, average daily order book volume on a relative basis compared to other execution methods dropped to the lowest level since 2014 and has not fully recovered since.

Regulators have discussed making changes to bolster Treasury market liquidity. But progress on all these reforms has been slow and the lack of a centralised Treasury market regulator can cause confusion.

Still, not everyone is expecting a crisis.

“This has been very well telegraphed by the Fed,” said Jan Nevruzi, a strategist at NatWest Markets. That communication is likely to prevent a taper tantrum of the sort seen in 2013.

The Fed’s reverse repo programme — which allows banks to put cash in the US central bank overnight in exchange for Treasuries — can stabilise liquidity in the event of a crisis, said Ellis Phifer, a market strategist at the financial advisory firm Raymond James.

But the reverse repo facility is a backstop, said Edward Al-Hussainy, analyst at Columbia Threadneedle Investments, and not a permanent solution to market functioning.

“This is not a market that is ready for the kind of environment that we’re in where shocks are frequent,” Al-Hussainy said. “We’re seeing events that are supposed to be rare occurring with unsettling frequency.”

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