US Treasury market needs urgent reform, warn former policymakers

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Capital markets updates

The $22tn market for US government debt risks being rattled by frequent bouts of dysfunction that threaten global financial stability unless urgent reforms are made to enhance liquidity, according to a group of heavyweight former policymakers.

A consortium that includes former US Treasury secretaries Timothy Geithner and Larry Summers as well as retired central bankers such as the Bank of England’s Mervyn King on Wednesday proposed sweeping changes to how Treasuries are traded, regulated and backstopped by the Federal Reserve.

Their report, which was also backed by Bill Dudley, the former president of the New York Fed, and Axel Weber, the Bundesbank president turned UBS chair, said the reforms were needed to ensure the biggest, deepest and most essential bond market is able to function smoothly — especially during periods of acute stress.

“This is a market that has outgrown its infrastructure and its regulatory framework. Oversight is fragmented and diffused. The capacity of existing market makers has not grown with the size of the Treasury market itself,” Geithner said at a briefing on Wednesday.

“The Treasury market needs a world-class regulatory framework with high standards for transparency, a more diverse set of participants and a stronger financial foundation.”

The fragility of the market was again exposed in March 2020, when pandemic fears sparked a frenzied dash-for-cash that sent prices haywire. Trading conditions in what is supposed to be the safest haven in the financial system turned turbulent, with broker screens at times going blank as liquidity evaporated, prompting the Fed to intervene.

Regulators have tried to piece together what went wrong, but little has been done to fortify the market. The report published on Wednesday by the Group of 30, an independent collection of private and public sector experts, included 10 recommendations designed to “increase, diversify and stabilise market-making capacity”.

One such proposal is for the Fed to establish a permanent facility, which would allow eligible market participants to swap Treasuries for cash at a rate that discouraged frequent use when markets are functioning normally without causing stigma when used at times of stress.

That would help to limit demands for market liquidity when it is most scarce, as investors would have an alternative to selling their holdings, the G30 said.

The group said that the “standing repo” facility was the “single most important near-term measure” that policymakers should adopt. Along with another facility designed for foreign counterparties, it has recently been endorsed by the Fed. The US central bank began sketching out potential designs at its June policy-setting meeting. 

The G30 also suggested amendments to the so-called supplemental leverage ratio, which requires large banks to have capital equal to at least 3 per cent of their assets, or 5 per cent for the largest, systemically important institutions.

The Fed made temporary adjustments to the ratio at the height of the Covid crisis by allowing lenders to exclude holdings of Treasuries and cash kept in reserve at the central bank from their assets when calculating it. But those measures lapsed earlier this year.

Without permanent changes to the SLR, “banks are highly unlikely to allocate more capital to market-making in the Treasury and Treasury repo markets”, the G30 warned.

It added: “A regulation that was intended to be stabilising will continue to undermine the stability of [the] market.”

It also called on regulators to set up central clearing for all Treasury trading in a bid to increase market transparency and reduce counterparty risk. More reporting and public disclosure on trading was also needed, along with more co-ordination on supervision of the market, the G30 added.

“Financial crises play a valuable role in exposing problems in the structure of financial systems that may not be evident in periods of relative calm, and yet it’s often the case following periods of financial stress that the impetus to reform fades quickly,” said Geithner.

“In the Treasury market in particular, the pressure for reform can be undermined by the belief that the Fed can always step in and fix things. This is not a particularly wise approach, it’s better to act when the memory of the last crisis is still fresh.”

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