Odd Lots - Josh Younger Explains Why the Bond Market Has Been So Volatile

Episode Date: July 11, 2022

The market for US Treasuries is arguably one of the most important and liquid markets in the world. But it's been experiencing a number of hiccups in recent years, such as the sudden selloff of March 2020. And in more recent weeks, yields on US government debt have also spiked as the Federal Reserve raises interest rates. Some of that makes sense as the central bank makes big changes to its forecast for inflation and markets adjust to the new path. But the degree of the moves has also led some traders to conclude that there's a problem in the way this huge market is functioning. So why does a market that should be pretty boring keep experiencing all this drama? On this episode, we bring back Josh Younger, Managing Director and Global Head of ALM Research and Strategy at JPMorgan, to talk about why bonds keep going through all these shocks and what can be done to minimize them. See omnystudio.com/listener for privacy information.

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And I'm Joe Wisenthall. Joe, what's more volatile than cryptocurrencies at the moment? I don't know. We. This is a trick question because I think there are a number of things. But one thing that most people didn't expect up until recently was bonds. U.S. government bonds. I don't think they've been as volatile as cryptocurrencies, but they have been

volatile. Now, wait a second. Oh, am I wrong? There was a day where they actually were more volatile than Bitcoin at least. And I think it was, it was earlier this month after the Wall Street Journal released that article saying that the Fed might hike rates by 75 basis points. Right. And suddenly we had this big move in bond yields. And I think the 10-year U.S. Treasury, the yield on that jumped something like 28 basis points in a day, which was, I know you love this, a four standard deviation move and the kind of thing that's only supposed to happen based on normal distributions like once in a century. Have you ever seen that tweet about the Seem-Tileb breaking through the wall like the

Kool-Aid man? Have you ever seen that tweet? Every time someone says standard deviation. I'm not surprised. I'll find it for you. Thank you. There's a really funny tweet about it. Anyway.

I will say. That was a wild day. I remember that Nick Timrose, Hottwold Shuron, said they're going to go 75 instead of 50, and everyone believed them. and of course, it was right, and it was just this huge instant repricing of the entire curve, like really shocking. Right. And so a four standard deviation move, make of that what you will, but Bitcoin's, like,

move in the same period was something like 2.7 standard deviations. So we're talking about the market for U.S. treasury debt, which is one of the most, probably the most important market in the world. It's basically the risk-free asset against which all other assets are judged. and it's supposed to be the most liquid market in the world as well. And yet, it's having these big moves. And this isn't the first time, right? You know, I said a move that's only supposed to happen once in a century,

but actually we see these moves relatively often. And of course, we had the big blow-up in yields in March of 2020. We had a big rally in yields in, I think it was 2014. We've had numerous other high-profile incidents where the market just seems to, like, go nuts. In extreme periods of volatility, we do see the stress. And it's not supposed to happen, right? No. Like, that's the whole idea here, which is that there are certain financial assets where, yeah, it's supposed to happen kind of with treasuries because they're theoretically risk-free and because, say, they can theoretically be, you know, theoretically from an economic standpoint, be like equivalent to reserves or almost like cash at some point. The ultimate safe haven asset, they're supposed to just be that. Like the one, the one, the one. predictable thing, the sun of the, you know, the sun around which the financial universe revolves around. And everyone in a while, it doesn't happen. And that's not good. Yes. Not good is a good way

of putting it. The other thing that's happening at the moment is the Fed has started to unwind its massive balance sheet, right? Yeah. No, so it's like, again, another factor here. Right. And that actually happened. I think they started unwinding in the same week where they raised interest rates by 75 basis point. So, of course, no one actually noticed that this had started. But there's all these things going on in the market. It seems like we keep getting these dramatic events. So we really, we need to dig into it, don't we? Let's do it. All right. We do actually have the perfect person to discuss. We are going to be speaking with Josh Younger. He is currently a managing director and global head of asset liability management research and strategy at JPMorgan. He was previously doing

sell-side research at JPM, writing about interest rates and money markets, which I think was last time we had him on. And I didn't know this, but he was previously an astrophysicist studying things like black holes and what happens when large objects collide against each other. So maybe the perfect analogy for the bond market. Perfect. All right. Josh, thank you so much for coming on all thoughts. Thanks very much for having me. It's great to be back. So maybe just as a beginning question, I think people have probably heard that there may be liquidity issues in the U.S. Treasury market, or certainly there are these bouts of volatility.

But could you maybe give us some color of what exactly we mean when we talk about illiquidity in the Treasury market and what exactly happens on a day like the one we saw recently where 10-year yields made this massive move? Yeah. So I know it's always weird to see a four standard deviation event, but if people were around in 2014, we had a 15 standard deviation event, at least over a short time scale. So pulling in my old education, that's not supposed to happen in the lifetime of the universe. So standard deviations have their place, but the normal assumption, the bell curve assumption,

is not always necessarily the best one. And for treasury markets in particular, people like to say that there are lots of fat tails, like unfrequent things happen at a much higher frequency than you or otherwise expect. That's true of all financial markets. It's definitely true of bond markets. But the question when we bring up liquidity is if we look at big changes in Is that because things have really changed or is it because there's some kind of market functioning or other issue that is causing the price change to be exacerbated for reasons other than

fundamentals? So this is a tough environment because, you know, the Fed is actually raising rates by 75 basis points in a meeting. So the outlook is truly changing rapidly. And so rapid price changes would be expected just because, you know, the fundamentals are shifting at the same pace. But we do want to figure out and watch if the market is unable to transfer risk, because that's kind of what the market's supposed to do. There's a lineup buyers and sellers and take care of those bonds that don't have an immediate buyer but have an immediate seller or vice versa.

They're supposed to smooth out these fluctuations by having somebody in the middle. It's a market maker who's the buyer to the sellers and the seller to the buyers and can hold on to stuff that doesn't have an immediate home. It's just basically like running a store, right? You're running a candy store, you got inventory, you have orders coming in, you've got customers coming in, you need shelf space, but you also need to make sure you have enough customers to take out the inventory you're getting in. So you need to line all those things up. And unfortunately, when you're a marketmaker, you can't really control your inventory, right? That's someone else's decision as opposed to the candy store. But there are different ways to look at this. Usually we talk about the depth of the market, which is if you look at the screen, you're a trader on a desk at any given dealer. And you looked at the screen, you electronic markets between dealers where they put up, you know, I'm willing to buy this much at this price or sell this much at that price, how much size could you move near the current price in the market? That's the market depth. That's really low. So that's immediately concerning because if depth is low, that means if I go to sell something that's bigger than the size on the

screen, presumably the price is going to change. And if that size on the screen is really small, than an incrementally larger trade, still small in the grand scheme of things, is going to move the price a lot. And the implication is the market can't transfer risk without a big price impact. So that's really important. Before moving on from that, on market depth. So, okay, like Nick Timrose comes out and says they're going to go 75 instead of 50. Of course you would expect to see a big move because there's fundamental news. There's a reason for the price of the curve to change as markets digest the sort of new thing about the Fed trajectory. But as you say, it's like, okay, that's going to happen. How do you measure depth? What would be sort of normal or healthy depth? Like, how would you

quantify that? And then what is the quantification of depth right now when the dealers look at their screen? So we're data limited here because there's really two kinds of markets that exist in something like a hub and spoke or a network. Okay. The first is the net, the end users, right? So, the holders of treasury bonds, it could be a foreign central bank, it could be an asset manager, a hedge fund, but the non-dealer, non-bank end users of bond debt. So they just hold it as an investment or a speculative asset. And that market faces the dealers because when you go to sell that bond or buy another bond, you call up your dealer. So there's an interface there. That is not particularly observable. We don't really know what's going on there. Usually people call that voice

trading, which is really like in the institutional market, I would call up my dealer and say, I need to sell you a billion of tenure notes, like big trades, big institutional trades. And when retail gets smaller sizes, usually there's some institution standing between them and the dealers. And then there's the market between the dealers themselves. And in this context, dealer, we'll talk about, I'm sure, the HFT component of this, the high frequency component. But like the inter-dealer market is the way that dealers pass risks around between each other. And in some sense, that's the more important market, because if you think of yourself as buying whatever someone's selling and selling whatever someone's buying, the amount of size you're willing to show, the size of trade you're willing to do,

is informed by how easily and cheaply you can hedge that. So the way I like to think about this, and I'll get to your question in a second, the way to think about this is you've got sort of risk coming in from the outside, end users selling a bond, for example, say they're selling a billion of those tenure notes. They're going to call one or two dealers, not going to call everybody. those one or two dealers are going to buy that debt at some price, and they're going to try to hedge it. And what hedging really is is socializing that slug of risk across the broader complex of dealers. So they're all going to keep a piece of it, but they're not going, one dealer's not going to hold the whole billion outright. There's too much risk to hold as a market maker.

It yields move a little bit. All of a sudden, you've run through all of your capital, and that's a problem. So the act of hedging is the act of taking pieces of that and spreading it around. And that's what the interdealer market does. That's the electronic market. That trades much more frequently. It's a decent chunk of the overall volume traded, but it's almost entirely concentrated in recently issued bonds, broker techs by part of the biggest venue for that.

And that's where we have good data because it's electronic. So we can see the screens, so to speak, and we can capture that data. And we can look at, say, the total number of bids and offers within, say, two to three levels of the best price. This is the Central Limit Order book. People call them Klobs, which is always kind of a fun acronym. But they can track that and say, within three levels of the best price, there is X million dollars on the screen to trade on average during, say, the New York trading session. When you do that on average, it's something like 150 million over long periods of time over the past 10 years. That's averaged something like 150 to 200 million. So that would be

sort of typical and bad times that can go down to five to ten that's what we had in 2020 now it's probably around 40 or 50 million on average now this fluctuates a lot over the course of the trading day but this is like if you were to close your eyes and then you know pick a time and look at it you get something like 40 to 50 million to trade within three levels of the best price so that's low the reason why that's important again is because that's that's the liquidity available to the dealers themselves to hedge their risk. And so if that number gets higher, they're willing to make bigger markets facing clients. If that number gets smaller, they're willing to make smaller markets because they don't have confidence that they can hedge out of

the risk. So that's low along the lines of different volatility episodes we've seen in the past. So if this was August 2011, it would be probably a similar number. If this was June or July of 2013, the Taper Tantrum, you get a similar number to that. March of 2020 was much lower. In November of 2008, it was much lower. So, you know, it's been worse, but it's definitely not great out there. Can we talk a little bit about March 2020? Because I think that was when we first had you on, and we were talking about this big sell-off in the bond market, which was exactly what people didn't expect to happen when we had a huge risk-off event,

which was the global pandemic and equities sliding and all of that. What exactly is the consensus around what happened? in March of 2020. What was the issue that that whole incident exposed? Yeah. So it's funny. I think if memory serves I was supposed to talk about LIBOR reform when we talked about this. I think we eventually did like a few months later, but it's like, we did. Yeah. More interesting events intervened. Yeah. So this brings up a really important question, which is illiquidity versus market functioning. Like what was so much worse back then? Because the Fed is unwinding their balance sheet. Like you said, they're not buying $3 trillion

dollars worth of assets over a few weeks, or $2 trillion rather. So there's clearly a lot less sense of urgency about the impact of this illiquid episode versus the events of 2020. And that's where I think we should be very specific about what we mean by liquidity. Because what we really mean, we're always feeling around, this is the different people feeling different parts of the elephant, but like one's a trunk, one's a one's a foot, but they don't really know the whole picture. I think if we were to have the full picture of the market, all the part of the participants and all of their risk tolerance and positioning. And we would really be asking this question, can I sell, when there's more sellers

than buyers, how much does it move the price? And the implication there is, can I turn my treasuries into cash at a reasonable cost in a reasonable period of time at scale? And that's not just part of the fact that the Treasury market is perceived as risk-free and is quite large. It's built into a lot of the law. The liquidity coverage ratio does not distinguish between treasuries and cash. I'm not a lawyer, but there's, I believe, a part of the IRS code that says you can actually pay your taxes in treasuries, which is the only financial asset you can directly pay your taxes in.

So like a charterist would say, well, then they're money, right? And so treasuries have special status in lots of different ways. The reason they do is because they're supposed to be as close to cash as any financial asset can be. And that means I can move large size at low cost, because when you, when you turn your bank account into physical cash, they don't charge you a fee. So I need something that's convertible into real currency, the low cost. And back in 2020, not only was depth low, but the bid-esque spread in the market was very wide. So what's going on now is the depth is low, but if you're able to trade, you're able to trade at roughly the bid-ass spread you were able to trade out a year ago,

especially in sort of benchmark issues like the tenure note. Back in 2020, it was three, four, five times wider. So there were no bids or offers within three-level. of that market price. In fact, the market price, if you don't have bids or offers within one or two ticks of the market price, then it's not really the market price. We don't really know where the market price is. And so back then, the market was not functioning. It was not just illiquid. And that's where the urgency comes in. So the question is, what's different now versus then? What's going on now is a revision to expectations. But more importantly, this is an environment

that's sort of familiar in certain respects. You know, we've had inflation before, not recently, We've had it before. We know what it is. We know why the Fed is raising rates. We have reasonable confidence around the range of potential outcomes. We'll argue about where the Fed's going to stop, but we know they're going to keep raising rates until inflation comes down. And we can say 3%, 4%, 5%, but I don't think anyone's out there calling for a 30% at funds rate.

So these are within the bounds of things we've seen before. Back in 2020, it's so easy to forget just how crazy the set of uncertainties was. And like, for example, there was speculation they would just close. close the market for some indeterminate period of time. So if the market's closed, the bid ask spread is infinite because you can't transact. So if you need cash, you need to get it now. So like that creates a lot of urgency. So just going back to March 2020 for a second. And as you laid out nicely, like, the law basically says treasuries are cash or very close to cash or cash like and should be treated as such. But if I recall, like with March 2020, part of the issue and part of the reason we

saw the sort of extreme widening of the spread is that even though there's theoretically free money on the table for someone to come in and close these spreads, that the demand for like pure cash was so strong that nobody, no actors in any, any port of the ecosystem, whether it's hedge funds or banks or whatever, wanted to deploy capital, deploy balance sheet to close these spreads, to take advantage of these opportunities at scale. And so is the problem or is there sort of like a core problem with, yes, we want to treat treasuries as cash, but the way we have the system set up is such that we still depend on the risk-taking appetite of private investors to actually do that job in the end.

Yeah, so this gets to, you know, what are these dealers actually doing? And I was referring to, you know, matching buyers and salaries as one function and holding inventory as the other. I'm going to reference the SLR, the supplementary leverage ratio, because it's one example of a regulation. It creates a very different set of incentives for dealers. that are housed within banks. And what the SLR does is it makes all balance sheet count the same towards your capital requirements. It makes balance sheet a scarce commodity.

And that's not necessarily a problem if it's not strictly binding or there's relatively two-way flow, meaning as many buyers are sellers, but in a one-sided market where there's mostly sellers, and that's what you're referring to, the most people want cash, they don't want securities. It makes it very difficult for a dealer that's housed within a bank to hold. hold that inventory. Because what balance sheet constraints do, what leverage constraints do, is they turn that allocation of balance sheet into a zero-sum game. So when the Treasury Desk, for example, wants to buy that billion dollars with the tenure notes, and they are near their allocation limit,

because if you want to limit the amount of balance sheet of business uses, you just gave everyone a limit. That's a plausible way to do it. So that creates rigidities. And let's say they call up their manager and they call their manager and it goes all the way up the chain. They say, I need another $5 billion of balance sheet because there's so many sellers. And on the Treasury desk. I'm processing the most important market in the world, right? So I need, I need that extra balance sheet. The reaction is, well, so does the prime business, so does the credit business, so does the front end business, the short-term credit desk, so does the corporate lending business where you're drawing in revolvers. So everyone's got their hand out. And that's a zero-sum game in the

sense that, like, there is a balance sheet allocation that the firm can use. And it makes it very hard in practice, especially at a high frequency, like a high pace, things were moving quickly to get those allocations where they need to be, when they need to be there. If you think back to that period of time, it's easy with hindsight to say, well, there wasn't that much selling, but you don't know that in the moment. It's like driving a car 300 miles an hour towards a wall with your eyes closed. And like, it might work out, but like it might not. And that creates a lot of hesitation. So you have in 2020, what's been referred to as the dash for cash, but it's really about a relative urgency to find liquid assets, not securities, not long-term securities.

So due to this concern that, one, you might need that cash for something and two, they might close the market tomorrow. That's the background. I think the important thing to keep in mind as well, and I think we talked about this back in 2020, there was this push over several years to take those market-making functions and in part split them into two parts and pushed them out of the banking sector. Now, this wasn't purposeful, but that was the set of incentives that were created. So when you think about matching buyers and sellers, high-frequency traders took on a lot of that responsibility. And they did that by doing very, very high-frequency fast, arbitrage trades to try to spread the risk around really quickly and go home with no inventory. So high-frequency

traders generally don't have inventory at the end of the day. So they're doing only matching. That's most of their function. And they were 70, 80% of that on-screen depth. So they were the majority of the market. But they can't operate in a high volatility environment. So they tend to, the thing about HFT is it tends to actually back away if something big is happening, right? Like if there's a big data release, like often the machines will kind of back away from making that market until things settle down a bit. Yeah. Like at the time, if you were to, if you were to look at the way the market trades in the three seconds before the payroll number drops on monthly Fridays and look at any day, any period of that two weeks span and just how the market was trading. It felt like payroll

Friday at 830 all day long for two weeks. And the reason is because if you're a high frequency trader, you're trying to make those bid-esque spreads. You need to sell for a dollar and, and buy it back for a little less. And so like if markets are moving around a lot, it's really hard to monetize those spreads. So there's a reason for this. But in making it more, complicated and costly for bank dealers to perform that market-making function in businesses like treasuries, the HFTs stepped in to fill that need, like a life-fines-away moment. So they step in to fill the need. They do a great job until things get dicey.

And then that business model does not operate well when VAL is very high. So they tend to jump and drop the size they're willing to show. Can you talk a little bit about the overall size of the treasury market as well? because we have seen the U.S. deficit growing. I think the amount of Treasury is outstanding is at something like $23 trillion at the moment. And it's gotten a lot larger in recent years, even though the Fed has been purchasing U.S. Treasuries up until recently. How does that impact ease of trading or the way the market functions? Well, the Fed helps a lot when they buy half of the net supply for the past two years. So there's been sort of two things going on there. The first is the first is, the Fed is really there to absorb the supply. And the second is the commercial banking sector, which I believe is the sixth or seven, the U.S. commercial banking sector, which I think is the sixth or seventh largest holder

of treasuries, has been the second largest buyer over the past two years. And that's because when you grow the size of the banking system, which is what QE quantitative easing does, there's this natural need to find assets to support those new deposits, those new liabilities. And so, you know, banks have stepped in to absorb a lot of that supply. And there's a bunch of other components of the market that do sort of take on a decent share of it. But the question is more, is the market too big for the intermediation capacity offered? I would argue that's probably still the case.

It's certainly grown, if anything, and bank appetite to market making treasuries is not increased. But that introduces vulnerabilities. So just because that ratio is a little off doesn't mean. the whole world is going to fall apart at any moment. But when the stress hits, which is what happened in 2020, it really struggles to serve that function. And that sort of brings up the second thing that non-bank dealers were doing, which is on the hedge fund side, we probably talked at the time about basis trades and specifically holding securities levered with repo, so levered longs in treasury securities that were hedged with futures positions. There was a big position that built up

over time because if balance sheet again is a scarce commodity, it's a zero-sum game, then you have to sort of use it or lose it as a client. And one way to do that is to have positions that utilize a repo line. You're sort of using your line of credit, but you're hedging the risk in the futures market. And so you're not actually taking any market risk, but you're using your allocation, which looks a lot like holding inventory. What dealers tend to do is they tend to be long off-to-run securities. Off-to-run securities are bonds that were issued a little while ago.

They're not the most recently issued security. That's what long-term holders tend to have, like stuff that was issued a while ago. When they sell it, they always hold that inventory and they hedge in the futures market. On the hedge fund side, there was a position that built up, which was pretty passive, mostly designed to use it rather than lose it on balance sheet. And that looked a lot like inventory. And so you have these two functions of matching trades performed by HFTs and holding inventory performed by hedge funds. That was a brittle arrangement because it was basically taking the market-making. capacity and allocating it away from banks to relatively unregulated institutions who are not

subject to the SLR, for example. And what happens in 2020 is that whole system comes crashing down because of a variety of operational and market-related concerns that basically make it untenable to hold those basis positions and very difficult to operate a high-frequency trading operation. And so you have all of this intermediation capacity that's in principle provided by non-banks, all of a sudden disappears. And when the banks are asked to take on the slack, they simply can't do it for a reasonable price, which is why this whole arrangement came to be in the first place. And so the market stops functioning. Can I just ask, is this sponsored repo? So this is just repo in general. Some of it's sponsored. Sponsored repo is definitely worth talking

about in terms of some of the solutions that have proposed to this issue of intermediation capacity. But this is just repo funded positions in general, sponsored or other ones. Okay. Should we talk a bit about sponsored repo in that case? Because this is, we're talking about dealer's ability to intermediate the market being perhaps too small or too constrained versus what's going on there. And as you say, one of the solutions to this issue has been the idea of sponsored repo, which I think basically, I wrote about this years ago, so I can't remember everything, but I think it basically allows banks to transact with counterparties like hedge funds without necessarily bumping up against balance sheet constraints.

And I think they get it from the FDIC or no, sorry, from the FICC from FIC. Yeah. So if the issue is balance sheet as a zero sum game, then if you can increase the amount of balance sheet that's being passed around, the balance sheet capacity of banks, then you've addressed the problem in part. So there's a couple ways to do that. The first is you can just change the rules, right? And that's what the Fed actually did on a temporary basis in 20.

They made a temporary change to the supplementary leverage ratio that said if it's cash or its treasuries on balance sheet, which is an important distinction. But if it's cash or treasuries, it doesn't count anymore for at least a year. And the idea that was to create capacity, right? Because now the size of my balance sheet I use for that supplementary leverage ratio is just smaller. And certain things don't contribute to that number. So I can do more of them. In principle, that was the theory. That doesn't necessarily work that way in practice.

But, you know, it's a separate thing. So one way to do this is to change the rules, change the game. The other way you can do it is played a little differently. And so, you know, one thing that was proposed very quickly after the crisis in 2020 was to introduce a broad clearing mandate for the Treasury market. And the logic for that was on the one hand, it reduced settlement risk by having all of these transactions go through a central counterparty. So it would be less likely that securities, for example, I could not be found in time. We have less failures to deliver, which in principle has an impact on certain capital requirements and so forth. But the more interesting, from my perspective, impact of that was that in the repo market, if you were to clear all those trades, the impact of central clearing is, say, everyone's facing the same counterparty.

They're all facing FIC, which is the clearinghouse. It's the same way it works in derivatives markets where everyone faces the CME, right, because they're all their derivative exposures, all those contracts are novated or transferred to a central counterparty that serves as the other side to every trade. And so, like, they're naturally offsetting because the derivatives markets are, you know, definitionally zero sum. And so they have all the positions. They can match off trades and reduce the overall, sort of credit risk embedded in derivative contracts. So in the treasury market, the idea was, well, what if everybody just faced thick? And that has a couple of implications, but one of the most important is that when banks measure their balance sheet, one of the ways they do that in repo

markets is they say, am I facing the same counterparty? So if you borrowed with the left and lent with the right, you're kind of economically neutral, but if you do that facing different counterparties, then they both contribute, or one of them contributes to the leverage. And that's because those two trades can't see each other in principle. But if everyone's facing the same counterparty, then they can. And so the idea there was, well, banks will get balance sheet relief and elasticity, meaning they can grow their exposures as needed because there'll be lots of offsets in the way you measure leverage. And if you can count all your economic offsets in your regulatory exposure, then that ratio is less binding, which is like a lot of technical ways to say, you know, a central counterparty will reduce the

amount of leverage you have to show for your regulatory requirements. Why can't they just make those rules the one year? rule where they said treasuries are equal cash, why not just make that permanent, especially since other parts of the law indicate that, and as you mentioned, like, you can pay your taxes with treasuries. So why not just, if so many parts of the law say treasuries are cash, why not just have that be a permanent part of bank regulations? Well, people have made that argument. It's an ongoing debate as to whether treasuries should be excluded. It would be a little difficult in the context of international standards to exclude treasuries and not be a little

out of the mainstream, but certainly cash at the Fed is one of those things that people argue shouldn't be included. And one way to think about that is if you get a lot, how am I going to a line of credit? Right. And you take $100,000 out. And you take that $100,000, you put in a bank account and keep it there. Don't do anything with it. So you always have cash in the bank to pay down the loan, but you still have the loan. Has your credit gone down? Are you less credit worthy now as a consequence of doing that? Because if you're, if you're, if you want, if you have a new liability and you have cash to back it, you're sort of not really necessarily reducing your credit quality as a borrower, right?

And so should you have to hold more capital against that position is kind of the question? And a lot of jurisdictions or some jurisdictions have said, well, you shouldn't, right? You're not less safe or sound as a consequence of having more cash. On the treasury side, you know, people have argued, well, that has interest rate risk associated with it. It's not purely fungible. It's not purely cashless. Look what happened in 2020.

you might have a market functioning issue. But this is like an ongoing debate, which is what's the proper measure of size for a bank? Because the need to think about size constraints in general is something that the Basel Committee is very focused on and regulators are very focused on after the 2008 crisis. But how you measure that size, what actually should contribute to that size measurement, how big are you really, how risky are you really is an ongoing source of debate. But the clearing question What's interesting there, I think, and important to note is it's not a matter of direction, meaning if you were to introduce a clearing mandate, the amount of balance sheet allocated to repo, like the amount of balance sheet size you'd show would go down.

The question is how much, and that's where sponsored repo comes in, which is clearing is available currently. And there's a decent chunk of the market that's actually cleared already. And so, you know, it's not obvious. And there's lots of reasons to think that it would likely not meaningfully improve. the leverage constraints that banks are facing, that that is a very, very mild self for what is otherwise a much more acute problem. So we don't necessarily have a clearing mandate in U.S. Treasury trading, the way we do for derivatives where trades have to go through a central counterparty, but we do have sort of some clearing going on in the market through, for instance,

FICC and other ways. Rather than just announce a total clearing mandate, is there a way to incentivize market participants to do more clearing voluntarily? Well, those incentives are there in the price. So at times, for example, if you're a cash lender, it's been advantageous to do that in a cleared format, to do that via sponsored. Like banks will essentially pay up a little bit to incentivize you to do that. And the same is true on the borrower side.

And so like this kind of balance sheet optimization work is something that the larger institutions have gotten quite good at. And they know how to price trades to sort of push people or nudge them in the direction that benefits their regulatory constraints. So that in that sense, like people are acting economically. The issue is not so much, you know, can we push people in that direction? It's more, you know, what direction do they want to face? And by that, I mean when rates are rising, right, for example, now, the way that hedge funds position for that is they don't do repos, which is a way to buy treasuries on using leverage. It's they do reverse repos, which is you're going short the market. That's how you position for rising rates.

And so that creates netting inefficiencies, which basically means you can't net off trades on the on the borrower versus the lender side because there are simply less borrowers out there. So, you know, the amount of netting you can do in your book goes down as a consequence of the positioning of the hedge fund and speculative industry, those who are trying to short treasuries. And so in practice, that actually makes a bigger difference than the availability of sponsored trade. So it's not about access to clearing as much as this is about, you know, do people think rates are going up or down, which is something you obviously can't control. Going back to the present tense, and, you know, obviously March 2020 was an extraordinary. situation, I mean, truly, you know, maybe hopefully once in a lifetime or once in a century. What we've seen more recently should not be that rare. And, you know, it's going to happen multiple times probably in our careers that people are surprised in a significant way by the direction of the

market, because that's what markets do. What are the lessons here? And what, you know, how bad is it that, you know, we saw, we have this lack of depth, that we have this gap between treasuries, that that are on the run versus off the run, treasuries, and so forth. And is it something that needs to be fixed? Is it something that, you know, when you look at this lack of depth, needs some sort of like policy or architectural solution? Yeah, I think it's important not to over-solve for the problem. So, like, as an example, if you have a plate and you think it's cracked,

and then you smash it on the ground and it breaks along the crack, you've confirmed that it was cracked, but that doesn't mean you should only have plastic plates. Right? So like that's not the right level of stress to solve for. And in a lot of ways, 2020 is the smashing of the plate. And that it's usually going to break it. And that's because it's extremely unusual. It is unique in lots of respects.

And yes, you could probably say that about any crisis. But it's important to recognize that like we should not be creating or designing a treasury market that is specifically calibrated to survive a once a century pandemic liquidity squeeze. That is not the right level of rigor. And I think it's likely we can't do that within reasonable constraints. Like there's a lot of reasons to think that even in the absence of leverage constraints, even in the absence of other issues, like 2020 would have been a mess in lots of ways regardless. So it's unclear that we could actually have avoided that fate. But the question is, do we want a more resilient treasury market?

I think there the answer is very much yes. It's important when we think about that, if we go through the list of reforms that have been proposed, to think more in terms of like what is the quantitative impact? Like, how much is this going to help, not will it help? How much will it help to reduce the fragilities in a system that under much less extreme circumstances has exhibited a lot of a lot of frailty? And that comes back to this issue of disincentivizing banks from taking on high leverage, low-risk positions, among those are repo and treasury intermediation. And to say that there's a lot of reasons, and this goes all the way back to the Fed Treasury Accord in 1950s, where the proper functioning of the treasury market is a matter of national importance. Like the economy requires it. And it needs to be robust to modest to modest shocks or even significant ones. And so, you know, the question is when we, for example, include reserves in the leverage ratio.

And the reason why I'm talking about cash and not treasuries is that, you know, capital is fungible, right? You have some capital requirement. And if you create more space relative to minimums, if you make sure the supplementary leverage ratio is really a backstop rather than a binding constraint, then you have space to do other activities that would otherwise consume. and balance sheet. And one of those is treasury trading. We have to think about, and the Fed has been quite clear that they are thinking about this, whether, no, the banking system is less safe and sound as a consequence of a higher reserve balance and whether that's the right way to think about capital requirements and safety and soundness. So that's on the regulatory side. And then on the market structure side, you know, there are certain ways in which you could reduce these pro-cyclical

tendencies. And one of the things I like to highlight is cross-martining. What is cross-margining? Back in 2020, VAL was very high. And in those basis positions, the two legs of the tray were margined separately. And by margin separately, I mean that the marginage to post against the futures leg was based on an outright exposure. The margin of the post against the cash leg, the security's leg, was an outright exposed based on an outright exposure. They couldn't see each other. So you could be, sort of well hedged, but still have to post margin on both sides of your hedge because those two hedges were margined independently. That sounds like a technical nuance. Why am I talking about that in the context of like changes to the overall structure of the banking system?

It's because that creates post-prosiclicality. Back in at that time, the futures margins increase by several times very quickly. And that naturally de-levers the entire financial system because if you have to post more cash against a position, you get less leverage. And And that might be desirable under normal times. I'm not going to say it's necessarily desirable. You might want less leverage in the system. You might want more. But reducing it rapidly during a period of stress is sort of de facto problematic,

both in practical terms because you've got to find that cash, but also like the signaling value that it's important to keep in mind if margins get tripled and no liquidations actually come as a result of that. No one liquidates positions. They find the cash elsewhere. You could still trade the market like there might be liquidation. And then it sort of has the same impact. And you can see that in part from the commodities experience in the past few months.

Right. Is there was this concern that margin requirements were going to be, we're going to force liquidations of positions and that just creates a whole mess. So, you know, one of the things you can do is you can say, look, if you're well hedged on an economic basis, you shouldn't have to post as much margin. And that just reduces the pro cyclical dynamic that the margin cycle introduces and makes the market sort of more resilient to volatility shocks. You mentioned how the Fed is thinking about these issues, and I think they've published a couple of papers on this topic. But why doesn't the Fed

feel compelled to intervene? Because clearly it's comfortable unwinding its balance sheet. This is just to play devil's advocate, by the way, but it's comfortable unwinding its balance sheet. It's comfortable, I don't want to say, abandoning forward guidance, but certainly surprising the market as it did recently. What do they see here that maybe market participants don't? Or where does the difference in opinion come from? Well, I think this comes back to the question of, is it illiquid or is it not functioning? And this is where I think the somewhat hyperventilating language that traders often use is not terribly helpful. So, like, the number of times anyone has been told their face has been ripped off is, like, probably not the right number of times relative to how, like, intense that image is.

And so things are not, I guess, in that sense, that bad because, you know, transaction costs are manageable. Like, if risk is clearing, if you can get the trade done, you can do it at a relatively tight bit offer, at least in the current issue that most recently issued bond. So, like, in that sense, the market is functioning. The high-francy traders have stayed involved, much more so. than prior volatility episodes. There have been some structural changes to the way these markets operate, and one of the big advancements since 2020 has been the rise of what are sort of called bilateral streams

or private central limit order books, where the issue with broker tech is when you put it in an order, everyone can see it, even if they don't know who put it in, whereas these bilateral streams and private order books allow you to stream prices directly to specific clients, so you don't have to tip your hand in the same way. And that sounds like a small change, but it makes the showing of bigger size in general much easier.

So markets are more resilient as a consequence. That's become a much more common way to trade inter-dealer that then was the case even a year ago. The question is, why are yields actually going up? And is that bad? And if you're the Fed, you want to tighten financial conditions, presumably. So rising yields are not prima facie problem. If you look at dealer inventories, they're pretty low. If you look at the way the repo market is trading, it suggests a scarcity of collateral.

It suggests not enough bonds in the system rather than too many. What's probably happening here is speculative investors are going short the market in the way I described through reverse repos, more so than real money and users of securities of treasury bonds are actually selling them. And so that's a lot less concerning, right? So on the one hand, you're kind of getting the macroeconomic outcome you want. And on the other, you don't have the outflows from the real firm hands in the market. at nearly the same scale you had in 2020. So the need of the Fed to take those bonds out of the system is a lot less because they're floating around in the levered complex anyways. It's not like you have long-term holders looking to liquidate and no one on the other side. You take that all together

and like, if I was at the Fed, would I be concerned? Absolutely. You know, low levels of depth, high levels of all, a very uncertain macroeconomic environment and policy environment are all reasons were concerned, but would I be convinced that not only are markets functioning poorly, but that they are not functioning to the point where this could create other contagion effects in the financial system and necessitates basically sucking the venom out, which is what those market functioning purchases were, we're definitely not there. I mean, we're very far away from that kind of thing. So, you know, in that sense, it's a familiar kind of stress, which is still no fun,

but it is not the kind of existential angst, creative. by the environment of 2020. Existential angst, that's a good way of describing it. Josh, we're going to have to leave it there. I feel like we could talk to you for another hour on this topic, but thank you so much for coming on all thoughts. That was great. That was great feedback.

Thanks for having me. Yeah, thanks, Josh. So, Joe, I feel like existential angst is a really good way of putting the experience of 2020, and that's when we did see some momentum towards actually addressing the problems that Josh was outlining in the world's most important market, but it does feel like absent a major crisis, these issues just kind of like limp along. Yeah, I think that's right. And, you know, some of this stuff, it's not the end of the world per se. It's not an imminent crisis, but because it is the world's most important market, there are reasons to be concerned when you see some of

these lack of liquidity or the fragmentation that he discussed. You know, the thing that gets me is it feels like there are so many different moving parts that work cross-purposes. So you have some laws that say Treasury should be cash. Right. You have other laws that say banks can't get too big. You have other situations in which expansive Fed balance sheet helps liquidity. On the other hand, the Fed feels it needs to shrink its balance sheet for its monetary policy purposes, which are all of, so you have all these different things that each individually may have some logic, but it's the confluence of all of them that see where the problem seem to create. I think that's That's exactly right. Also, something I didn't know up until recently. Do you know repo contracts are apparently exempt from the automatic stay of bankruptcy? That was something Paul Volker did.

What does that mean? So it means if a company goes bankrupt, their like repo assets don't automatically get frozen and then distributed to creditors. So like, you know, if you want to treat treasuries like cash, but on the other hand, if someone has a treasury that they've used as repo collateral, in a bankruptcy, it wouldn't necessarily be distributed. Sorry, I'm getting really into the weeds. No, it sort of speaks to like the issues. That's exactly right. Yeah. Do we want to treat them like cash or do we not? And should we actually have a holistic approach towards the market? They have to all, all the regulators and policy authorities just have to get in the same room.

And it's like, let's just get on the same page with this stuff. That's the trick. Yeah, okay. Well, we'll make that happen, I'm sure. Should we leave it there? Let's leave it there. This has been another episode of the All Thoughts podcast. I'm Tracy Alloway. You can follow me on Twitter at. Tracy Alloway. And I'm Joe Wisenthall. You can follow me on Twitter at The Stallwork. Follow our producer, Carmen Rodriguez, on Twitter. She's at Carmen Armin. And follow all of our podcasts at Bloomberg under the handle at podcasts. Thanks for listening.