Markets Wired

As Prepared for Delivery

Thank you for the invitation to be part of this impressive conference on financial market quality and the opportunity to speak with you.^[1]

In my remarks today, I will focus on the Treasury market. This market serves the role of financing our government at the lowest cost to the taxpayer over time and is at the core of global financial markets. It provides the benchmark risk-free yield curve, and it helps underpin the role of the dollar in global transactions. And being the deepest and most liquid market in the world, it serves as a key source of safe and liquid assets for investors and is used for liquidity risk management by many financial firms, both banks and nonbanks.

The Treasury market has evolved significantly over the last couple decades, driven in part by regulatory and technological changes—themes that connect naturally with this conference’s focus on “innovation and uncertainty.” For example, increased electronic trading and shifting types of market intermediaries have changed how market liquidity is provided. While traditional dealers had been the main participants in the interdealer cash market, principal trading firms (PTFs) now represent the majority of trading activity in the futures and electronically brokered interdealer cash markets. We saw an implication of these changes in the Treasury “flash rally” on October 15, 2014. It was that event that led to the expansion of the work of the Inter-Agency Working Group on Treasury Market Surveillance (IAWG).^[2]

At the same time, we have seen an increase in the amount of Treasury securities outstanding relative to the capacity of dealers to provide liquidity to those markets, partly reflecting the regulations adopted in response to the Global Financial Crisis of 2007-09.^[3] Moreover, in recent years, demand for U.S. Treasuries has become more broad-based and shifted toward more price-sensitive investors, such as pension funds, money market funds, mutual funds, and hedge funds.^[4] Some of these funds are reliant on the ability to quickly sell Treasuries to meet liquidity needs, which increases the potential for surges in Treasury sales.

I will turn now to an overview of current Treasury market conditions. Next, I will review our most significant efforts in recent years to strengthen the resilience of the Treasury market. Finally, I will conclude with a few thoughts on some unfinished business.

Current Treasury Market Conditions

To assess Treasury market functioning, we monitor a variety of metrics for both the secondary and primary markets. These metrics are similar to the ones followed broadly by market participants.

The figure on the left of this slide shows our composite index of trading conditions for 2-year and 10-year Treasury securities, from 2019 to present. Its inputs are bid-ask spreads, market depth, and price impact measures; higher values indicate higher costs of transacting and less-liquid market conditions. There are two things to note: first, costs can rise sharply, as evident in March 2020 at the onset of the pandemic, and in March 2023, when several banks faced depositor runs and failed. Second, costs generally do not vary significantly day-to-day, but have been slightly higher since mid-2022 than in the period before. This pattern reflects the fact that transaction costs are generally highly correlated with interest rate volatility. You can see this relationship in the right panel. There is an upward slope between rate volatility and this index for the 10-year Treasury note, with volatility and costs lowest in 2019 and both higher in 2022 and 2023.

You can also see the red dots “above the cloud,” which illustrates that in March 2020, transaction costs were much higher than might be expected even given the higher volatility. This outsized reaction illustrates the “dash for cash” episode when Treasury prices fell sharply, in contrast to a typical pattern for prices to rise in periods of high uncertainty when investors run to safety. It reflects that some investors, including open-end bond funds and hedge funds, rapidly sold Treasury securities to meet redemptions or margin calls, in amounts that exceeded the ability or willingness of dealers to supply liquidity. In this episode, the Federal Reserve had to step in and purchased Treasury securities in significant amounts to support smooth market functioning.

Since then, market liquidity conditions have been more stable. When volatility rose sharply in 2023 after the bank deposit runs, the higher transaction costs, shown by the purple dots for 2023, were relatively in line with the volatility. Importantly, market conditions remained orderly, and moderately reduced liquidity did not amplify volatility during this period. I would note that the event in early August of this year is captured within the green dot cloud, suggesting that the steep drop in global stock prices with some unwinding of carry trades did not cause a deterioration in Treasury market liquidity.

Turning to primary markets, they also are functioning well. Treasury’s longstanding “regular and predictable” issuance strategy, described recently by Assistant Secretary Josh Frost, helps to support smooth market functioning.^[5]  On this slide, you can see two commonly used metrics to assess primary market functioning for the 2- and 10-year Treasury notes. One indicator is the bid-to-cover ratio—the total amount of bids divided by the total amount of Treasury debt offered for sale. This measure has been stable and well above 1 over the past several years, notably even when there were sharp increases in secondary market costs in March 2020. Bid-to-cover also has not changed as issuance has been increasing, suggesting continued strong demand for Treasury securities.

Similarly, as shown on the right, data on auction tails—which compares the yield set in the auction with the yield in when-issued trading—show that auction results have fluctuated both above and below market expectations within a pretty tight range (of +/- 3 basis points), even as the variability increased when interest rate volatility moved up starting in 2022.

A Review of Recent Efforts to Increase the Resilience of the Treasury Market

At the start of this Administration and following the “dash for cash” in March 2020, we embarked on a comprehensive effort to improve the infrastructure of the Treasury market to ensure that the Treasury market remains the deepest and most liquid market in the world. Through the IAWG, we set out guiding principles, including transparency that fosters public confidence, fair trading, and a liquid market, and prices that appropriately reflect economic and financial conditions.^[6]  We also put a strong emphasis on ensuring its resilience in periods of stress.

The five workstreams that are at the heart of our efforts are outlined on this next slide. We’ve documented our progress each year and will publish a new update next week. Overall, we have made significant progress, as I will describe, even as some work remains.

Starting with improving data quality and disclosures, we have made great strides. Working with FINRA, starting in February 2023, we began publishing aggregate transaction volume data on a daily basis—only weekly data were available before that. Furthermore, earlier this year, we began to disclose data on price and volume (with caps) for on-the-run securities at the transaction-level at the end of each day. While we have greatly expanded data availability for market participants, we also have been deliberate to avoid potential harms such as disclosing data that could reveal confidential trading positions.

In addition, we have taken steps to close a large data gap in the critically important repo market, for non-centrally cleared bilateral repo. Data collection at the transaction level will start in December, based on the rule finalized by the Office of Financial Research. These new data will allow the official sector to better assess vulnerabilities in this market.

Second, to strengthen the resilience of market intermediation, Treasury started a buyback program earlier this year. This program creates predictable opportunities for dealers to sell off-the-run securities, which should encourage market-making and free up balance sheet allocated to less-liquid positions. We are monitoring closely how this new program will affect trading activity and liquidity.

In addition, relative to March 2020, there now are two Federal Reserve facilities that should support liquidity in periods of high stress: the Standing Repo Facility (SRF) to finance Treasury repo with pre-authorized banks and primary dealers, and the Foreign and International Monetary Authorities (FIMA) facility for certain foreign central banks.

Third, on trading venues and oversight, the SEC adopted new rules this year that requires firms that have significant liquidity-provision roles, such as PTFs, to register with the SEC as a dealer, and is working to finalize its proposed Regulation ATS to enhance the resilience of electronic trading venues. The new rules recognize the emergence of new types of firms and practices based on advances in data and computing, and will better protect investors and promote market stability.  

Fourth, a key IAWG initiative was to evaluate central clearing for Treasury securities.^[7] After substantive engagement with market participants and other regulators, the SEC adopted final rules to require central clearing of Treasury securities transactions. Expanded central clearing could increase the intermediation capacity of dealers through netting. It also could reduce counterparty risk and increase transparency in these markets, and incentivize some all-to-all trading.  Market participants are working towards deadlines for cash securities by year-end 2025 and for repo by the end of June 2026.

All these efforts help to ensure the Treasury market remains liquid and resilient. However, there is also some unfinished business; I will touch on these next.

What Remains

Continuing with central clearing, there is important implementation work ahead.  The new mandate will lead to a significant increase in the volume of transactions to be centrally cleared, and currently there is only one firm that clears U.S. Treasuries. Other firms have signaled an interest in entering this market, which raises interesting questions around the benefits and costs of having multiple clearinghouses for Treasuries. Would participants benefit from greater competition, or would they lose netting benefits? From a macro perspective, are there gains to operational resilience from multiple clearinghouses or higher risks from additional complexity? Regulators will need to monitor progress and address these types of questions.

While central clearing should help ease dealer balance sheet constraints, as I mentioned, the banking regulators also should consider changes to the supplementary leverage ratio (SLR) to improve the elasticity of the supply of market liquidity. Proposed options include excluding reserves held at the central bank and making the enhanced-SLR buffer countercyclical, to be released in periods of market-wide stress.^[8] These types of changes could be accomplished without reducing the overall amount of capital in the system and would allow bank dealers to be better able to make markets in periods of stress.

Finally, as I noted earlier and going back to the fifth workstream, Treasury securities are used for liquidity risk management by some types of investment funds, such as open-end bond and loan mutual funds, which have grown to hold a significant share of corporate credit. These funds have a liquidity mismatch between daily redemptions offered to shareholders and the longer time it takes to sell the underlying bonds and loans. To address this “phantom” liquidity and the need to rapidly sell large amounts of Treasuries for liquidity (as we saw in March 2020), the IAWG advocated for reforms and the SEC proposed a rule with some options. However, there was substantial industry pushback because of operational impediments to swing pricing, and the recently issued final rule dropped this feature.^[9] The SEC and industry should continue to explore possible solutions.

In addition, we also saw in March 2020 that leverage in the Treasury market could become excessive and destabilizing. Much attention has focused on the cash-futures basis trade, in which hedge funds take short positions in Treasury futures corresponding to long positions by asset managers, and finance their long cash Treasury hedges with repo.^[10] This basis trade supports Treasury market functioning in normal times by tying together cash and futures markets and serving as an important source of demand for Treasury securities. However, research has highlighted repo haircuts reported at zero and that deleveraging by hedge funds contributed to the dynamics in March 2020.^[11]    

While reported haircuts on repo may not fully reflect the leverage of the overall trade, several reforms mentioned above will shed a brighter light on practices.^[12] In the near term, the SEC now collects more Form PF data on hedge fund leverage and makes aggregated data available, and bank supervisors are enhancing their work on how banks manage their hedge fund exposures.^[13]Over time, the new data collection on bilateral repo transactions and the central clearing mandate for repo should improve transparency and standardization, providing some market-based discipline to prevent excessive leverage from building. As the basis trade remains sizable, it is important for regulators to continue to monitor leverage, and to balance the benefits of leverage for repo versus resilience in periods of stress.^[14]

Conclusion

To conclude, our indicators suggest continued robust demand for Treasury securities, and the market remains the deepest and most liquid market in the world. This strength of the Treasury market is a privilege that allows the U.S. government to finance itself at a lower cost than it would otherwise. But it also comes with a responsibility to continue to ensure its resilience. For the past few years, Treasury and the financial regulators, consulting with industry, have made important changes to the market infrastructure. I believe these changes have made the Treasury market more transparent and more resilient, even as some work remains. Of course, we should expect that the market will continue to evolve with new technologies and innovations, and regulators will need to continue to address new risks while allowing for the benefits of innovations as they arise.

Thanks again, I now look forward to our conversation and your questions.

The slides and figures referenced in these remarks are available here.

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_[1] I would like to thank Burcu Duygan-Bump and Brian Smith for assistance in preparing these remarks, and Dave Chung for help with the figures.

_[2]The IAWG was formed originally in 1992 by the Treasury Department, SEC, and Federal Reserve Board to improve monitoring and surveillance and strengthen interagency coordination with respect to the Treasury markets following the Salomon Brothers auction bidding scandal. See U.S. Department of the Treasury, Securities and Exchange Commission, and Board of Governors of the Federal Reserve System, 1992, “Joint Report on the Government Securities Market,” U.S. Government Printing Office, January 22.  Today, the IAWG consists of staff from the Treasury Department, SEC, Federal Reserve Board, Federal Reserve Bank of New York, and CFTC.

_[3] Liang, Nellie and Pat Parkinson (2020), “Enhancing Liquidity of the U.S. Treasury Market Under Stress,” Hutchinson Center Working Paper #72, Brookings, December, and Duffie, Darrell, Michael Fleming, Frank Keane, Claire Nelson, Or Shachar, and Peter Van Tassel (2023), “Dealer Capacity and U.S. Treasury Market Functionality” Federal Reserve Bank of New York Staff Reports, no. 1070, August.

_[4] TBACCharge2Q42023.pdf (treasury.gov) and TBACCharge2Q32024.pdf (treasury.gov).

_[5] Remarks by Assistant Secretary for Financial Markets Joshua Frost on Principles of U.S. Debt Management Policy | U.S. Department of the Treasury.

_[6] IAWG (2021) report “Recent Disruptions and Potential Reforms in the U.S. Treasury Market: A Staff Progress Report,” November 8, 2021.

_[7] See IAWG (2021) report “Recent Disruptions and Potential Reforms in the U.S. Treasury Market: A Staff Progress Report,” November 8, 2021, and Duffie, Darrell (2020), “Still the World’s Safe Haven? Redesigning the U.S. Treasury Market After the COVID-19 Crisis,” Hutchinson Center Working Paper #62, Brookings, June.

_[8] Liang, Nellie and Pat Parkinson (2020), “Enhancing Liquidity of the U.S. Treasury Market Under Stress,” Hutchinson Center Working Paper #72, Brookings, December, and G30 Report (2021), “U.S. Treasury Markets

Steps Toward Increased Resilience,” July.

_[9] In particular, the industry has pointed to high costs of adjusting their operations to make swing pricing work because a fund’s net asset value must be set before flows are recorded each day. This operational constraint appears to be a problem in the United States, but not in other jurisdictions that already feature swing pricing. One alternative to swing pricing that could be considered could be to lengthen the period in which investors should be able to redeem shares, from daily to the number of days it would typically be expected to take to sell the underlying securities even in normal periods.

_[10] The role of asset managers’ demand for futures is also gaining attention. See, for example, Barth, Daniel and Kahn, R. Jay and Monin, Phillip and Sokolinskiy, Oleg, “Reaching for Duration and Leverage in the Treasury Market,” May 3, 2024. The Treasury Borrowing Advisory Committee highlighted that while mutual funds may prefer futures for several reasons, including their liquidity, there also may be some non-economic incentives. For example, there are accounting differences that require the reporting of repo borrowing as an expense, but do not apply to implied financing costs for futures. This expense may raise a fund’s reported expense ratio, which is a metric often used by investors to evaluate a fund’s attractiveness. For additional detail, see TBACCharge1Q12024.pdf (treasury.gov).

_[11] See, for example, Barth, Daniel and R. Jay Kahn (2021), “Hedge Funds and the Treasury Cash-Futures Disconnect,” OFR Brief Series 20-01, April 1, 2021, and Banegas, Ayelen, Phillip J. Monin, and Lubomir Petrasek (2021), “Sizing hedge funds’ Treasury market activities and holdings,” FEDS Notes, Washington: Board of Governors of the Federal Reserve System, October 6, 2021.

_[12] See Banegas, Ayelen, and Phillip Monin (2023), “Hedge Fund Treasury Exposures, Repo, and Margining,” FEDS Notes, Washington: Board of Governors of the Federal Reserve System, September 8, 2023.

_[13]For example, this year’s supervisory stress tests added an exploratory scenario asking the largest U.S. banks to consider the implications from the failure of their five largest hedge fund exposures. These exercises are helpful views into hedge fund leverage even as they are incomplete because hedge funds also get leverage from other institutions, including non-banks.

_[14]Glicoes, Jonathan, Benjamin Iorio, Phillip Monin, and Lubomir Petrasek (2024), “Quantifying Treasury Cash-Futures Basis Trades,” FEDS Notes, Washington: Board of Governors of the Federal Reserve System, March 8, 2024.