Dealing fix for Treasury securities market is needed now

The Trump Show made the point that the US never really settled the war with the Confederacy. During the Biden administration, the conflict between large dealer banks and the populist left will be more bitter than ever.

To the dealer banks, the Dodd Frank Act and the Basel Accords on bank regulation were heavy handed over-reach. To US financial reform activists, the banks and their traders are still getting away with too much money and freedom of action.

Unfortunately, the squabbles between the dealer banks and activists could interfere with financing the ambitious Biden administration and Congressional spending plans, which come on top of Trump’s $7.8tn borrowing spree.

Central bankers outside the US have their doubts about whether the US dealer banks have sufficient balance sheet capacity to maintain an orderly market for Treasury securities.

As one of them says: “There was already a lot to be done in the plumbing of the Treasury market, and those requirements get more pronounced with the bigger budgets. If we cannot get reliable Treasury prices, other markets become even more unstable.”

Disruptions in the Treasury market and repo market (for lending against securities) such as those in March of last year, and September 2019, now seem to occur every few months, rather than every couple of decades. To reduce the systemic risk of market dysfunction, the dealer banks argue they need fewer Dodd-Frank and Basel constraints and charges on the size of their trading books. The activists take the opposite view, saying there should be more rules, enforced more strictly.

The moderate reformers fiddle with their bow ties and murmur that Treasuries and repo need a better and more heavily reinforced plumbing system for the Treasury and repo market flows. Specifically, there is increasing support in the academic and bureaucratic wings of the financial system for putting all Treasury trading and repo transactions through a central clearinghouse, or CCP.

Many people on dealer bank trading desks are unenthusiastic about a giant Treasury-repo-CCP construction. What they really want is to have the constraints and costs on balance sheet growth lifted, at least for Treasury securities and repo.

As one of them says: “When Trump and (Fed governor Randy) Quarles came in we thought we would see some real easing of regulation of the dealers. Instead, the Treasury and Fed went along with all the Basel influenced limits on our ability to warehouse Treasuries and do repo.”

Sadly, from the point of view of the dealer-desk people, Trump-promised deregulation did not happen. In March of last year, the Fed announced a temporary change in the big dealer bank’s SLRs (supplementary lending ratios) to exclude Treasury positions from the limiting rules for bank holding companies. As our dealer person says, though: “They did not carve out repo (positions from leverage limits). So the carve-outs they did were ineffective.”

And even the temporary carve out of Treasury positions from the regulators’ calculations of the banks’ leverage limits expires at the end of March. Financial reform activists have already said they will oppose an extension of the Fed’s temporary rule-loosening, although they will probably not be successful — this time. But stricter regulation of dealers’ behaviour and balance sheets is coming soon.

The US dealer banks appear to have enough room on their balance sheets to accommodate sedate, day-to-day trading in the Treasury market, for now. There is, however, greater risk of discontinuous or disorderly markets with even a moderate piece of bad news.

Would putting all Treasury trades through a CCP reduce the risk of market instability and outright dysfunction?

Darrell Duffie, a Stanford finance professor and Treasury clearing house advocate, says yes. “It would take these trades off the dealers’ balance sheets, and you would have an opportunity for exchanges to allow investors to trade directly with each other.

“It would at least initially be more expensive but it would prevent market failures. And there is no way the dealer balance sheets can grow as fast as Treasury issuance. We need bigger pipes.”

A Treasury CCP would take a couple of hundred billion in capital and years in set-up time. Congress will have to act — soon — on funding and enabling legislation.

Letter in response to this article:

​Co-ordinating regulation is not for the faint-hearted / From John Pattison, Toronto, ON, Canada​