As Prepared for Delivery
Thank you for the invitation to be part of this conference and to speak with you today. The conference agenda lays out some of the significant opportunities and challenges of expanding central clearing in the Treasury market, and I look forward to hearing your perspectives.
In my remarks, I will focus on the critical roles and evolution of the Treasury market, and review the significant progress made to strengthen the Treasury market as well as what remains to be done. I will highlight the recent work done under the umbrella of the Inter-Agency Working Group on Treasury Market Surveillance (IAWG), which was formed in 1992, to strengthen the resilience of the Treasury market.[i] I would emphasize that an efficient and resilient Treasury market has been a shared goal and is a place for common ground across Administrations and over time. I will conclude with the importance of expanded central clearing for resilience and financial stability, as market participants and regulators, some in the audience today, move forward with implementation.
The Critical Roles of the Treasury Market and its Liquidity
The Treasury market serves a range of critical functions. A strong Treasury market is key for financing our government at the lowest cost to the taxpayer over time. It is also at the core of global financial markets and provides the benchmark risk-free yield curve. It helps to underpin 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. This last point is increasingly relevant for nonbank financial institutions, and in particular investment funds, who do not have access to central bank liquidity and rely on Treasury market liquidity in periods of stress.
There is no larger thoroughfare for global capital than the U.S. Treasury market, which averages around $900 billion in transactions per day, with high volume days in recent years around $1.5 trillion.[ii] There is roughly $4 trillion in repo financing each day.[iii] And the U.S. Treasury futures market is itself large and important, with an average daily trading volume of about $750 billion in notional so far in 2024.[iv]
The depth and liquidity of the Treasury market are central to serving its critical functions. Currently, primary markets are functioning well, helped by Treasury’s longstanding “regular and predictable” issuance strategy.[v] On this slide, you can see two commonly used metrics to assess primary market functioning. One indicator is the bid-to-cover ratio, which has been stable and well above 2 over the past several years, for both the 2- and 10-year Treasury notes, even as issuance has been increasing. Similarly, as shown on the right, auction tails — which compare the yield set in the auction with the yield in when-issued trading — indicate that auction results have fluctuated within a pretty tight range (about +/- 3 basis points), even as the variability increased when interest rate volatility moved up starting in 2022. Both figures indicate continued strong demand for Treasury securities.
Turning to secondary markets, liquidity conditions are often proxied by actual trading costs. An index based on bid-ask spreads, market depth, and price impact measures is shown on the left; higher values indicate higher costs and less liquidity. While these costs generally do not vary significantly day-to-day, they have been slightly higher since mid-2022 than in prior years. This pattern reflects the positive correlation with interest rate volatility, which has risen, and is shown by the upward slope between costs and volatility on the chart to the right.
Another notable feature of market liquidity is that it can deteriorate quickly when unexpected shocks hit. This was evident in March 2020 at the onset of the pandemic, as well as in March 2023, when some banks faced rapid depositor runs. Also, as can be seen by the red dots on the figure to the right, illiquidity was worse than might be expected given the volatility in March 2020. These dots illustrate the “dash for cash” when the desire to sell Treasury securities surged, especially by investment funds, and exceeded the ability or willingness of dealers to supply liquidity. As you know, the market dysfunction was resolved only after the Federal Reserve itself provided liquidity by directly purchasing Treasury securities in significant amounts.
In contrast to 2020, during the bank deposit runs in 2023 — shown by the purple dots — the increase in transaction costs was relatively in line with the rise in volatility. Importantly, moderately-reduced liquidity did not amplify volatility during that period, and market conditions remained orderly, though likely helped by the actions taken by the Treasury and Federal Reserve to reduce contagion from the bank failures. More recently, as highlighted by the green dots for 2024, Treasury market liquidity did not deteriorate unusually following the steep drop in global stock prices and unwinding of carry trades in early August of this year.
The Evolution of the Treasury Market
But this is not where the story ends as Treasury market structure is changing continually. It has evolved significantly over the last couple decades, driven in part by regulatory and technological changes as more data have become available and computing power has advanced.
One such change is increased electronic trading and how shifting types of market intermediaries have transformed the provision of market liquidity. While traditional dealers had been the main participants in the interdealer cash market, principal trading firms (PTFs) now represent most 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 IAWG.
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 (GFC) of 2007-09.[vi] Moreover, the investor base has shifted as holdings by more price sensitive investors, including private funds with liquidity mismatch or leverage, have increased. Currently, money market and mutual funds hold about 16% of total outstanding Treasury debt, respectively, and the household sector, which includes hedge funds, holds about 10%.[vii]
A Review of Recent Efforts to Increase the Resilience of the Treasury Market
In response to these changes and the events of March 2020, the IAWG initiated a comprehensive review and set out a program to strengthen the Treasury market.
In its 2021 public report, the IAWG proposed six guiding principles for public policy in the Treasury markets.[viii] At its core, policy should promote a Treasury market where prices reflect the current and expected economic and financial conditions, liquidity in the market is resilient and elastic, and both are underpinned by effective infrastructure, appropriate risk management, and transparency. We set out five workstreams that are outlined on this next slide. I will highlight some of the work that has been done, and what remains.
First, we have significantly improved the quality and availability of data on the Treasury market. In February 2023, FINRA began to publish aggregate transaction volume data on a daily basis—only weekly data were available before then. Earlier this year, FINRA began to disclose daily transaction-level data for on-the-run securities. These data represent about one-half of overall daily trading and about 75% of the daily activity in nominal coupon securities. While the IAWG’s efforts have led to greatly expanded data availability, we also have been deliberate to avoid potential harms, such as to confidential positions by placing caps on trade sizes.
In addition, we are closing a large data gap in the repo market for non-centrally cleared bilateral repo. Treasury’s Office of Financial Research (OFR) has been working with dealers so that everyone is prepared to start the data collection at the transaction level in the first week of December. Based on the pilot conducted in 2022 and earlier work, the new data from this collection may give the official sector insights into the more than 45% percent of the repo market that has been opaque since before the GFC.[ix]
Moreover, the Securities and Exchange Commission (SEC) is collecting more information on hedge funds through recent improvements in Form PF filings. In addition, OFR launched a new Hedge Fund Monitor that makes aggregated data on hedge fund activities from Form PF and other sources more accessible to the public. An example from this monitor is shown on this next slide, which highlights a significant increase in repo (mostly Treasury) and prime brokerage borrowing underlying an increase in leverage of some hedge funds. And starting in March 2025, Form PF will collect more detailed data for large hedge funds, such as separate reporting of Treasury cash and derivatives.
Turning back to the IAWG workstreams, the second one is to improve the resilience of market intermediation. We have put in place a number of changes here as well. Earlier this year, Treasury started a buyback program that creates predictable opportunities for dealers to sell off-the-run securities to support market liquidity. While the program is modest in size and not designed to respond to crises, it should free up dealer balance sheets allocated to less-liquid positions. Since the launch of the program in May, Treasury has purchased close to $40 billion of securities in 24 operations, sometimes buying less than the stated maximum depending on the offers we receive relative to prevailing market prices. We recently posted some metrics on the operations and are monitoring the effects of this program.[x]
In addition, since March 2020, the Federal Reserve has put in place two facilities that should support liquidity in periods of stress: the Standing Repo Facility (SRF) to finance Treasury repo with pre-authorized banks and primary dealers, and the Foreign and International Monetary Authorities facility for certain foreign central banks. We saw that the SRF was tapped at the last quarter-end, indicating initial signs of success by the regulators to encourage its use and avoiding stigma.
One idea that remains open is to reconsider changes to the supplementary leverage ratio (SLR), which currently requires firms to hold the same amount of capital on reserves and Treasury securities as they do on risky debt. Proposed options vary and can include excluding reserves held at the central bank and perhaps some Treasury securities from the SLR calculation. Another is to make the enhanced-SLR buffer countercyclical, to be released in periods of market-wide stress based on triggers that are defined ex ante so that banks could plan ahead. This could be accomplished without reducing the overall amount of required capital in the system.
The third and fourth workstreams focus on ensuring efficient and effective infrastructure, recognizing the emergence of new types of firms and trading practices mentioned earlier. The SEC adopted new rules this year that require firms with significant liquidity-provision roles, such as PTFs, to register with the SEC as a dealer. It also has been working to finalize its proposed amendments to Regulation ATS to enhance the resilience of alternative trading venues. Another key infrastructure reform is expanded central clearing, which I will turn to shortly in more detail.
The fifth workstream focuses on the potential for surges in demand for Treasury liquidity in periods of stress from liquidity mismatch and excessive leverage of some types of investment funds. For example, open-end bond and loan mutual funds have a liquidity mismatch between daily redemptions offered to shareholders and the longer time it takes to sell the underlying bonds and loans. The SEC proposed a rule with options to address this “phantom” liquidity to help avoid a repeat of the surge in Treasury sales in March 2020, though there was substantial industry pushback because of operational impediments to swing pricing. However, as these funds have grown to hold a significant share of corporate credit, the SEC and the industry should continue to explore possible solutions.
In addition, we saw in March 2020 that excessive leverage in the Treasury market could become 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. 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, the basis trade is typically highly leveraged — research has highlighted the leverage arising both from zero haircuts on bilateral uncleared Treasury repo offered to hedge funds, and from long futures positions at asset managers. Asset managers may prefer futures to repo because futures are less operationally cumbersome, but also because they do not require the interest expense reporting that repo does.[xi] Hedge fund leverage in this trade may be mitigated by portfolio and cross-margining not reflected by the zero haircuts on repo, but practices are opaque. It is important for regulators to mitigate excessive leverage to prevent forced unwinds during stress periods, especially as the cash basis trade has continued to grow.
The Central Clearing Mandate and What Comes Next
This brings us to expanded central clearing for Treasury securities transactions, which is an important structural change.[xii] Central clearing is used for a number of other asset classes, including equities and exchange-traded derivatives. In addition, parts of the Treasury market are already centrally cleared, such as the entire futures market and parts of the cash and repo markets.
Evaluating expanded central clearing was put forward by the IAWG to increase intermediation capacity and reduce risk. Expanded central clearing should increase the intermediation capacity of bank-affiliated dealers because bank capital and leverage requirements recognize the risk-reducing effects of multilateral netting of centrally-cleared trades. Combined with increased disclosures, it may also enable a path forward to some all-to-all trading. On the risk side, central clearing should lead to better risk management by enhancing and standardizing practices. A central counterparty (CCP), for example, could establish margins that better reflect the market risk and concentration of positions rather than just the low-risk nature of Treasury securities. The centralization of transactions also provides greater visibility into market conditions.
Last year, after substantive engagement with market participants and other regulators, the SEC finalized rules to require central clearing of Treasury securities transactions, with deadlines for cash securities by year-end 2025 and for repo by the end of June 2026. Market participants now are moving deliberately and quickly to implement and to meet interim deadlines and an important date is fast approaching. By March 31, 2025, covered CCPs need to implement customer clearing models and segregate house and customer margins, among other requirements.
I know some have noted that expanded central clearing could cause the Treasury transactions costs to increase because CCPs would impose costs related to meeting risk management and other operational requirements. As a result, some intermediaries could pull back from the market or widen bid-ask spreads. However, private costs to individual market participants may not reflect the systemic costs to the broader financial system. Expanded central clearing that requires market participants to internalize costs of better risk management should prevent excessive risk taking and reduce systemic risk. Moreover, to avoid unnecessary cost increases, there is room in implementation to look at the cross-margining of futures and cash securities such that margins are calibrated appropriately to the economic risks. While cross-margining can already be used for house accounts, how it is extended to customer accounts and the implications for systemic risk should be considered carefully.
Turning to the implementation work ahead, there are many open issues to ensure market participants are ready, including around market structure, client access models, accounting, regulatory capital, and MMF access. I will comment on just two of these issues.
Starting with market structure, the new mandate will lead to a significant increase in the volume of transactions to be centrally cleared. Treasury clearing activity is expected to increase by more than $4 trillion each day, and at least 7,000 new relationships between direct and indirect participants are expected to be needed in advance of the deadlines.[xiii] Currently there is only one CCP for U.S. Treasuries, though some firms are actively considering entering this market. Entry could lead to greater competition and innovation and bring with it different clearing offerings and pricing, and from a macro perspective, there could be gains to operational resilience from multiple CPPs. These are important potential benefits even as there are some open questions about a loss in netting benefits and fragmentation of liquidity pools when there is more than one CCP.
The issue of market structure also is tied to client access models. The current Treasury market practice for centrally cleared trades is for trade clearing and execution to be bundled together, following a “done-with” model, as dealers have preferred to link the use of their scarce balance sheet with revenues from execution. But there is significant demand for “done-away” models, which are commonplace in other markets with central clearing, namely futures and swaps. In this model, trades executed with one counterparty can be cleared separately through a different clearinghouse member. As such, a big advantage is that it could provide greater competition in trade execution and trade clearing, which would support improved market functioning.
Of course, there are operational issues to wrestle with to achieve expanded central clearing. SIFMA’s new report and its work on developing master clearing agreements for done-with models are helpful steps to support the upcoming transition, alongside the work under way at many other organizations here today.[xiv] Taking a step back, though, the work to expand central clearing offers significant benefits by reducing risks to financial stability, increasing competition and innovation, and improving operational resilience.
Conclusion
To conclude, Treasury and the financial regulators, working closely with the industry, have made significant progress to strengthen the resilience of the Treasury market and implementing expanded central clearing is advancing in ways that would reduce systemic risk and expand product offerings. Some work remains, however, to address reduced bank-dealer capacity and a growing nonbank sector that relies on Treasury market liquidity in periods of stress. Given the critical role the Treasury market plays in the U.S. and the global economy, it is imperative to continue to execute on the current program and evaluate the market’s performance against the principles laid out earlier. This work has become more significant with projections for elevated levels of issuance over the coming years. I want to thank you for your engagement and cooperation throughout the reform efforts. Industry and policymakers working together has been critical to the progress and I encourage you to continue this important work.
The slides and figures referenced in these remarks are available here.
[i] The IAWG was formed in 1992 by the Treasury Department, the Securities and Exchange Commission (SEC), and the Board of Governors of the Federal Reserve System (the 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 Commodity Futures Trading Commission.
[ii] Treasury Daily Aggregate Statistics | FINRA.org.
[iii] US Repo Statistics – SIFMA – US Repo Statistics – SIFMA.
[iv] U.S. Treasury futures, options, and cash – CME Group.
[v] Remarks by Assistant Secretary for Financial Markets Joshua Frost on Principles of U.S. Debt Management Policy | U.S. Department of the Treasury.
[vi] 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.
[vii] TBACCharge2Q32024.pdf (treasury.gov).
[viii] IAWG (2021) report “Recent Disruptions and Potential Reforms in the U.S. Treasury Market: A Staff Progress Report,” November 8, 2021.
[ix] Non-centrally Cleared Bilateral Repo | Office of Financial Research and OFR’s Pilot Provides Unique Window Into the Non-centrally Cleared Bilateral Repo Market | Office of Financial Research.
[x] TreasurySupplementalQ42024.pdf.
[xii] See IAWG (2021) report “Recent Disruptions and Potential Reforms in the U.S. Treasury Market: A Staff Progress Report,” November 8, 2021; 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; Liang, Nellie and Pat Parkinson (2020), “Enhancing Liquidity of the U.S. Treasury Market Under Stress,” Hutchinson Center Working Paper #72, Brookings, December.
[xiii] Treasury Clearing Mandate Survey White Paper | DTCC and U.S. Treasury Central Clearing.
[xiv] US Treasury Central Clearing: Industry Considerations Report – SIFMA – US Treasury Central Clearing: Industry Considerations Report – SIFMA and SIFMA and SIFMA AMG Publish Master Treasury Securities Clearing Agreement.