Odd Lots - Why Treasury Market Spasms That Shouldn't Happen Keep Happening

Episode Date: April 8, 2021

The U.S. Treasury market is the biggest, most liquid market in the world. Its smooth functioning is also crucial to the economy and the financial system. Yet it keeps experiencing bizarre, seemingly inexplicable bouts of volatility. We saw it in February. We saw it big time last March. And we saw it multiple times in recent years before then. On this episode, we speak with Yesha Yadav, a professor at Vanderbilt Law School, who argues that these episodes can be explained by the inadequate patchwork of regulations governing this market.See omnystudio.com/listener for privacy information.

Thanks for listening to OddLots. Follow the show on Amazon Music for more future episodes or just ask Alexa play the podcast, OddLots on Amazon Music. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a very big line. It's a lot. It's a firm. It's a lot. commitment to your clients. We're talking top grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com slash audio.

That's vanguard.com slash audio. All investing is subject to risk vanguard marketing corporation distributor. Hello and welcome to another episode of the Oddlots podcast. I'm Tracy Allaway. And I'm Joe Wisenthal. Joe, do you ever think about U.S. Treasuries? Yeah, every day. That's like unironically. First thing, get up in the morning, think about Treasuries. Absolutely. Yeah. I mean, treasuries are sort of the thing that the entire market is revolving around at the moment. Like, there's so many things that are correlated with yields. But I guess let me frame that question a bit differently. Do you ever think about what a treasury actually is? Yeah. I mean, I don't have as strong, like, intuitions about it, but I kind of feel that,

yeah, I do. But I, you know, I'm always up for learning more. Yeah. Well, that's what we're going to be doing in this episode. And I think it's an important topic. I mean, it's obviously an important topic. But one of the reasons it's worth, looking into is because I think most people tend to think of a U.S. Treasury as, you know, it's a bond issued by the U.S. government. It's unlikely to default. It acts as a sort of safe asset in the financial system. There's one other aspect of U.S. treasuries that doesn't get as much attention. And that's the fact that it's supposed to be this huge and liquid market that's really easy to trade. Yeah. I mean, so you ask like what?

what is a treasury and how I think about it. And on some level, I really do think it's almost like, it's like the fundamental building block of the entire global financial system. It is the deepest market. It is the most liquid market. It has no credit risk, you know, for the most part. And so the price, there's like a purity to the price. But as liquid as it is, every once in a while, and despite the fact that it should be like the simplest thing to trade, every once in a while, it kind of brings. breaks in this weird way and nothing ever good happened if the treasury market is breaking.

Yeah, that's right. So we've had these big moments of disruption in the treasury market recently. We had, well, the big one was the March mayhem in the market when a bunch of levered trades blew up. But most recently, we had the yield spike in February. And way before that, we had the repo madness in September, I think it was 2019. And then we had the flash crash in U.S. Treasuries back in 2014, although... I think it was 2015, but... 2015? No, maybe, I don't know. Something around there.

I should say upcrash because yields went down. Yeah, okay. But the point is that these sort of disruptions keep happening, and they're happening in a really important market, as you said, and in a market that's supposed to be liquid and easy to trade, and yet it seems to be seizing up every once in a while. So that's what we're going to talk about today. Great. I can't wait. No, it's a fascinating question because why the safest, most liquid asset in the world, which in theory, the Federal Reserve could, you know, stands ready to buy, you know, in theory at any moment, why it should ever seize up is sort of this, like, mystery to me. Like, I don't quite get why it should ever happen, but it clearly happens enough that something's going on.

A $21 trillion mystery. Yes. All right. Well, we have the, that's the size of the U.S. Treasury market, by the way. We have the perfect person to discuss all of this. Our guest for this episode is Yasha Yaddaf. She's a professor of law over at Vanderbilt Law School,

and she's done a ton of research on exactly this topic. So, Yasha, welcome to the show. Tracy and Joe, thank you so very much for having me. It's such a pleasure to be here. and particularly to get to talk to you about U.S. Treasury markets, what can be more exciting than that? Nothing. Exactly. Nothing could be more exciting.

I agree. All right. So maybe just to begin with, I mean, I just listed some recent, let's say, conyptions in the U.S. Treasury market. It feels to me like these are happening more often, but, you know, I haven't gone back and looked throughout all of the market's history. Is that right? Like, do you think this sort of random bouts of volatility is happening more often? It certainly feels that way, Tracy, it really does. I think one of the things that has been happening in the U.S. Treasury market is that this market

structure has changed really profoundly over the last decade or so. So this used to be known, I think, across the market as being a really super boring space. This was really the market in which the trading would happen over the counter by telephone using the screens, requests for quotes and so on and so forth. It was slow. It was this very steady market where nothing really seemed like it could go wrong. And it was essentially dominated by the primary dealers that were the key intermediaries in the space, both in the primary as well as in the secondary market.

And what we've seen over the last decade or so, and you and your colleagues at Bloomberg have reported extensively on this. It's really this change in market structure that is affected how this market is working, that has affected the risks that are impacting this market, as well as also the quality of the liquidity provision that is coming into this market and how resilient this liquidity provision is. And that change really has been this emergence, as it has been across the entire marketplace, pretty much, the emergence of high-frequency trading in the inter-dealer space in the secondary

market, which has really become the dominant form of liquidity provision. And what has happened here, obviously, means that primary dealers and HFT traders now are competing a lot more fiercely. There's a great deal of more technology that is coming to bear in the U.S. Treasury market. It's no longer the sleepy space full of telephones. This is a marketplace that is in motion all the time. And as a result of that, we have new risks. We have new dynamics that are impacting the space. But the essential point here is that none of this is really that new because it's been happening in the equities and derivatives markets for a whole hell of a long time,

similar disappearances of liquidity, flash crashes, mini flash crashes, and so on and so forth. But now these are happening in the U.S. Treasury markets exactly as we would expect, because we've seen it in equity and derivatives. But unfortunately, in U.S. Treasury's, we just haven't been focusing on it. And so it's really taken us by surprise. And so really it feels like this is happening more often. So I want to get in, you know, we want to get into obviously like what this new structure looks like and why it's not as resilient or robust as the old sleepier structure. But before we do that, why do we just zoom out for a second?

And why don't you tell us about your work and this sort of, you know, Tracy mentioned you're at the law school. what is the lens with which you come to this problem from and seek to sort of understand problems and solutions? You know, thanks for that question, Joe, because, you know, I wonder that myself sometimes because, you know, this is, this is, I'm a law professor. I'm a really boring law professor of a strategy market structure and the regulation of market structure. And for the longest time, folks have been very polyanish about U.S. Treasury market structure. In other words, that it will always work, that this will be the most resilient, most robust market structure anywhere in the world. As you said, Tracy, and Joe, that this is the deepest most liquid market in the world. That is a standard spiel that we see every single time.

We have a report from the regulators. This is the deepest most liquid market in the world. And so you might wonder why it is a law professor really would want to look at this, because what we do is look for problems. right, that's our job. The US Treasury market structure, when I started studying it, you know, I was bowled over. I was coming at it from the regulatory side. I wanted to understand how this market's regulated. I wanted to see if that regulation is fit for the job that is doing today, which is regulating this extremely important, as well as technologically advancing market. And what I discovered there was a complete shock. The paradigm by which this market is regulated is like

none other in our space. The regulatory structure, I think, deserves a conversation because it really feels like it does not work. It is just not set to work. This regulatory structure, the public structure, as well as the private structure in some sense, just leaves enormous gaps. And the reason for those gaps possibly stems from the belief that this market will be perfect and will always perform and is completely risk-free. And so regulators, I feel, have really taken their eye off the ball and that structure that we have in place today really just does not exist to function to regulate a marketplace and to match the marketplace that we have today. And so it should not be surprising that we're seeing some of these conyptions, as Tracy said, happening with ever

greater regularity because some of the guardrails that have been put in place in other markets just don't exist in treasuries, right? And so it should not be surprising to us that this is happening. You know, one of the things that you guys mentioned was in relation to the flash crash, the flash rally in 2014. And that's really set off this kind of regulatory circumspection, this reflection on U.S. Treasury markets. And I think that's when regulators discovered that this market actually has a whole bunch of risks that they never knew existed. And that they had to come to this space with a greater degree of deliberation and intention that they have done historically. But it also showed that the regulatory structure that we have today is really not set to do the job that we expect it to. And the reason for that is that this market structure for regulating the public structure for regulating U.S. Treasury markets is extremely fragmented.

Unlike every other market, like equities or derivatives, this market does not have a lead regulator. There is no one person that is policing this market. We have a fragmented loose association of four or five superstar regulators, the big top regulators for the marketplace. But none of them has a lead status, right? So the U.S. Treasury, the New York Fed, they are responsible in the auction space. We have the SEC and FINRA that are taking care of the securities market firms that trade in this space. We have the Federal Reserve, the Fed and the OCC that look after the banks that are the dealers in this space. And so everyone is sharing a little bit of the authority and that can be

great because they bring their expertise and their insights into the space. But equally, it means that no one person always has the incentive to come forward and take a lead and set an agenda and coordinate information costs. You have to share information. You have to develop a plan for enforcement and reform. And so we should not be surprised that rulemaking that is taken for granted in other markets just does not happen in U.S. Treasuries. It just hasn't happened in U.S. Treasury's. And perhaps the starkest example of that is the lack of information in this market, right?

So up until 2017, and you guys are, you know, you report on markets, you know this stuff, you are, you know, you are steeped in this stuff. It's shocking, I think, for all of us that do this, it discovered that up until 2017, there was no mandatory secondary reporting regime for trade in U.S. Treasuries, right? And that is kind of shocking. And what that means is that regulators have not had information to figure out what exactly is happening in secondary market

activity on a granular basis. And it, you know, comes as no surprise that it took a year to figure out what the flash rally was about. And even then, into the 2014 flash rally. And even then, they did not have a conclusion. We still don't fully know. know what caused March 2020, the blowout that you were mentioning, the March Madness, Tracy. And the reason for so much of that is that this market does not have comprehensive data. It does not have granular reporting, even today. Sorry, can I jump in there? Because this is something I wanted to ask you.

So given the lack of transparency in the U.S. Treasury market, you know, even though it's the sort of bedrock of the financial system, we don't quite know. what's going on with it at all times. How do we actually measure treasury market liquidity? Like, what do you look at in your research? I'm curious because everyone has different definitions of ease of trading. So what are you watching? And how has it sort of evolved over time? Yeah, I mean, that's a terrific question. It's a $21 trillion question. In fact, it's a $6 billion question on a daily basis because that's the liquidity that is coursing through the Treasury secondary market in a daily basis.

compared to around $500 billion in the equity space, right? So this is supposedly a market in which we have $600 billion on, I think that was March 2020, 2021 rather. You know, we have $600 billion worth of liquidity, of course, in this market every day. Liquidity is hard to measure, but the idea here is that you should be able to trade without causing price impact, right? Particularly in this market, you should be able to make large trades without there being a price impact in the market structure.

And that is exactly what we're not seeing. So in the context of the blowout in February, for example, we saw that the five-year and the seven-year tenor just incredible amounts of movement in the spreads in just a very short period of time, and that was due to liquidity concerns. In the case of March, we saw enormous prices locations that were happening because liquidity in the market.

market disappeared. And what that means is that the price changes are not happening because of fundamental informational changes, right? So of course we expect volatility to exist in the marketplace because information will affect how price changes happen. But in the treasury market, we should not expect these price changes to happen because the market is becoming illiquid because dealers are not there to supply trading opportunities constantly throughout the trading day. Liquidity in this market should be taken for granted so that the price changes that are happening are because of informational and fundamental issues rather than because of liquidity issues because there are not enough trading opportunities for buyers to have sellers and for sellers

to have buyers. So really that's how I understand it that we are that we are relying on a marketplace that is supposed to be responding to information, not a marketplace that should be responding to disappearances of trading opportunity. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy.

Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a commitment to your clients. We're talking top grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income.

So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com slash audio. That's vanguard.com slash audio. All investing is subject to risk vanguard marketing corporation distributor. So talk us through, because in theory, you know, you describe the old sleepy treasury market of the dealer community and a lot of it being done by phone. And now we have this sort of like, I guess, richer treasury ecosystem and HFTs and hedge funds and interdealer trading and all that stuff. In theory, you think, okay, more participants, different preferences that would make it more liquid. So what is the failure between theory and practice such that even though there is the sort of,

you know, a whole like flora and fauna of treasury participants, it doesn't translate automatically to greater liquidity. And we do seem to see this rise of dislocations. Like what are the leading theories for why, basically? Yeah, that's an awesome question, Joe. And, you know, I think it's one that perplexes regulators and perplexes market participants. Because exactly as you said, you look at the market and, you know, there's $300 billion worth of daily trading in the inter-dealer space, which is the super liquid space where dealers are trading with each other. And on a normal day, that liquidity seems so incredible. It seems so lush and robust because we do have the primary dealers still.

We do have these brand-new, high-frequency traders that are expansively providing liquidity throughout the trading day. Now, the HFT participation in the U.S. interdealer space is around sort of 70%, 65 to 70%. And of course, what that means is that we expect them to be available, and they are generally, to be providing liquidity robustly throughout the trading day. But what we have is a problem that liquidity can disappear just when we need it the most. In other words, that the market participants here, the automated traders, HFT traders as well as the primary dealers have no incentive to remain on the market when

conditions get stressed. Rather, these folks now are competing with one another, right? Whereas primary dealers dominated for much of the Treasury market history, right, recent history. Now the competition with primary dealers in the interdealer space means that they've been pushed out. Their margins are smaller. They're no longer the biggest players. They don't have as much skinning the game in this marketplace that they traditionally have done. And HFT experts, you know, these traders tend to operate which much leaner operations. Their balance sheets are smaller. They are more nimble. They are securities firms. They don't tend to be the banks, right? And so there is no incentive for folks to remain because aid is super costly to be there. They're

competing with each other. And when conditions get stressed, the algorithms may not perform as perfectly as they normally should. And so in those situations, it makes more sense to exit or reduce your participation or to reduce the market depth at which you participate or to reposition yourself to the back of the queue rather than necessarily be there to forthrightly provide liquidity. And that's what we've seen time and time again in these episodes. In March, for example, we saw 2020. We saw the HFT traders rather pull back quite drastically very sharply in the context of that that March episode. In this most recent episode in February, it was just a general pullback, right? In this case, the primary dealers too, the auction went

horribly. As, you know, one of your colleagues, Liz McCormick has written about so wonderfully recently, right, that the auction went horribly and it was just a general pullback in liquidity at that moment. And so the liquidity looks great on its surface on a normal date, it looks beautiful and wonderful. But when it's time for the rubber to hit the road and when it's time for stress, I think that's when we have the greatest fear that it might disappear, causing these illiquidity bouts to happen and causing for prices to dislocate. And I think what's really, really, really kind of horrifying for me as a person that studies this market and for all of us really that need this market is that the treasury market is supposed to

perform exactly during periods of stress. Right? This is the market that's a little bit countercyclical. In other words, that when everything is going clusterish in the normal market, this is the market that's supposed to stand up and to be there and to be resilient and to provide liquidity so that when we all rush in there in our flight to safety, we're going to have the trading opportunities we need either to buy or sell. So just on that note, can you talk a little bit more about the role of the primary dealers here? because in theory, they're supposed to be, you know, the big market maker in the treasury market.

And there's a suggestion that because of various post-crisis rules and trends, they've sort of retreated from the market. And then I guess my second question is based on what you just said about HFTs retreating from the market at precisely the moment where you would want to have them there to provide liquidity, is the answer that you somehow force. primary dealers and other market makers to intermediate, and how would you actually go about doing that? Yeah, I'm so glad you asked that, Tracy. I mean, on the first part, the role of the primary dealers here is super interesting, because as you said, they've been involved throughout these folks have been, they have relied upon in the auction space, as we know,

they have traditionally been relied on in the secondary market. And they do dominate in the dealer-to-client space. So there is one space which is where the clients interact with the treasury market. Well, we are able to go, when we have the big institutions and they're able to go and buy and sell treasuries, the mutual funds, the hedge funds, the foreign governments and others that are able to obtain treasuries through the dealer to client market. And that is still dominated by the primary dealers. And again, that's a market with around $300 billion worth of daily turnover.

So it is a solid component that we rely on for primary dealers to take care of, which is this dealer-declined space, which is still very much an OTC space, a bilateral space, in which primary dealers are the key players. Now, their retreat, as it were, competitively, has really happened in the inter-dealer space. And so, you know, one question to ask is,

what's their skin in the game in the market at present? And it's an interesting question because they are facing balance sheet pressures. You guys had a terrific podcast a couple of weeks ago with Zoltan Pozhar on the SLR issue and other issues. They discussed the balance. balance sheet pressures on primary dealers in the Treasury market. And certainly there has been a lot of commentary here that the post-crisis reforms following

Dodd-Frank have put pressure on primary dealer balance sheets. And the other thing to appreciate here is that primary dealers are also extremely active in the repo market, right? And they're extremely active in the much larger repo market where U.S. treasuries are now post-crisis, the preferred form of collateral. So these folks are facing tremendous pressures on a daily basis to maintain the function of the treasury market where trillions of dollars of treasuries are essentially locked up as collateral, as well as to have treasuries and cash available to intermediate in the dealer to client, as well as in the interdealer

space, as well as obviously in the auction space to the extent they need cash to purchase on a regular basis. So there are tremendous balance sheet pressures there. And as you discussed in the episode a couple of weeks ago, you do have the SLR issue that is now, we have an answer to that, but you also have other regulations like that G-SIP charge that mean that there is a constant balancing that is happening here, which can be a little scary sometimes during crisis periods because you don't know if primary dealers have the balance sheet space to come in there. and provide liquidity to come in there and provide cash if they need to. And that is something that we need to worry about when it comes to understanding the liquidity of this market under stress.

And so one thing you asked the second part of your question, Tracy, which I think is a really brilliant question on that policy side, which is, what do we do? Do we have what are affirmative market making obligations attaching to both the key HFT players as well as the primary dealers? And I think that should be an idea on the table. In other words, do we go back to the idea that was prevalent in the equity markets, for example, in the 80s and 90s that you have these affirmative market makers that always provide liquidity, that trade against the wind if they have to, that promise to stay on the market to trade, even during times of stress, do we do that today in the Treasury market because it's so important?

And I think it's a good idea to have on the table. The interesting question here is how it links back to your first question, which is this balance sheet space for primary dealers. As well as HFT folks who do have these thinner, smaller balance sheets in general, do these institutions today have the elasticity in their balance sheets to be able to perform in the event of a crisis and the event that they are subject to affirmative market making? because that is expensive, as you can imagine. Let me jump in there, because this brings to mind a question I've been thinking about. So you've talked about the sort of the fragmentation of regulation in this space. There isn't a single clear regulator. But something I've been thinking about and the sort of the tensions that led up to the SLR decision,

it was sort of around this, is this sort of like intersection between post-GFC regulatory decisions versus macro policy. So you have these determinations. It's like, okay, banks have to hold a certain amount of liquid assets and have a certain amount of capital and so forth. On the other hand, you have the Fed making non-regulatory macro decisions at a given time about the size of its balance sheet, asset purchases for, you know, broader hitting its dual policy goals.

How much is the tension emerge from the fact? that these regulatory decisions that were made about bank balance sheets didn't necessarily anticipate a decade of very expanded Fed balance sheet, multiple rounds of asset purchases, very heavy treasury issuance on a historical scale, and it's sort of essentially this sort of like collision course between two different priorities. It's a great question. And unfortunately, I'm going to, you know, I'm going to do with my law students, which is take a pass on this one because it's not, you know, it's such a tough one because I think, you know, what I think has been happening here and which your question really speaks to is that

we don't have the regulatory picture as fully as we want it to be there, right? So we're making decisions without necessarily seeing the full parts of the elephant. And so obviously we come in after the 2010 crisis, clearly wanting to make bank balance sheets as robust as possible, right? Of course we want to do that. Of course, we need to do that. And then, of course, we also want to make sure the repo market is as secure as possible. So we try and make this market as dependent on treasuries as possible with respect to the collateralization of this market. And guess what?

That's exactly what's happened. Right. So 67% or 68% of the market in the bilateral repo market is now collateralized by Treasury. It's even higher in the reverse repo market around 75%. So of course, you know, we've done a good job there to make these markets. On the other hand, we still require the nuts and bolts of intermediation to be provided. And so we need the primary dealers to have the elasticity in their balance sheets to be able to do that. And then on the other side, we have this incredibly dynamic macro picture in which, as you said, QE, Fed purchases, we just have this really interesting global picture also emerging with respect to the role of the U.S. and the role of treasuries

and the role of the dollar that is happening. We have so many factors to consider here, but what is missing is a regulatory structure that can do that job. The Fed, the Treasury, the CFTC, and others are all fragmented in the treasury space. The F SOC, the Financial Stability Oversight Council, created in the wake of Dodd-Frank, that could coordinate, doesn't coordinate in this space. So we're not having the conversation that you want us to have, Joe, which is being able to try and put these pictures together.

And so, you know, for that reason, I feel like I have to take a pass because there is no real coherence to the approach that we have, such that trying to find a narrative that can explain the interactions is really difficult. You mentioned the repo market there, and I wanted to get your thoughts on repo market reform, because it feels like this was on the radar immediately after the financial crisis, because so much of the 2008 housing bubble sort of emanated from trouble in the repo market, a lot of trades were collateralized with, you know, subprime structured finance, ABS and stuff like that.

And then it all went awry. But it also feels like the repo market hasn't changed all that much. Like the nature of the collateral has changed, but the actual functioning, if anything, seems to have become more concentrated on one or two key players. What are your thoughts there? And how does the repo market fit into? your overall research on treasuries? Great. So the repo market is mammoth. It's extremely important. And it's a market in which the daily consumption of treasuries and cash changes incredibly differently on a daily basis.

So the needs of this market on a daily basis diverge sharply from one week to the next. As we saw in the case of the September 19th incident, September 2019 incident, the repo market is liable still to sudden disappearances in its liquidity and its functioning. I have a terrific colleague at Vanderbilt Morgan-Ricks who's written about a repo market reform from the structural perspective to try and shore up some of the cash-like aspects of this market. But as you said, right, the attention on the repo market and on repo market reform has really disappeared, right? We have not been focusing on what we should do to make this market secure to deal with the fact that it's still fragile, that it does change in a week-by-week basis,

that the consumption of treasuries and cash does change. One of the proposals that's been on the table for both the secondary market as well as for the repo market is in relation to central clearing, right, which is trying to bring in a greater degree of clearing into the space. We do have some. We have the triparty repo market that does have some clearing arrangements and whether or not we should think about making clearing more systematically a part of this as well as the secondary market in Treasury. So that is one idea that has been on the table. But again, as you say, you know, the question is this market has become enormous. It is a market in which we are intermediating around $6 trillion worth every single day to meet the daily

financial needs or financial farms across the system. So trying to get this into a clearinghouse even is something that does feel slightly intimidating and daunting and scary, and possibly something that we could talk about in this conversation. But it does feel like it's become a problem from the structural standpoint that maybe has become a little too big to address at this point. So it feels like we're going on like we've done before and really using the fact of treasuries as being the preferred form of collateral to provide the safety that we need in this market.

In other words, we're going to be. We're looking to collateralization as the means of securing this market rather than structure reform, as my colleagues have talked about, or moving into central clearing as a way to try and protect this market against risk. You mentioned central clearing, and can you sort of just spell out the basic idea of what that would theoretically look like at the treasury market and what the, I don't know, drawbacks of that would be? Yeah, I'm so glad you asked that, Joe, because, you know, clearing is.

clearing is this amazing thing that we have in our securities markets, right? Clearing houses are, as I'm sure a lot of your listeners know, this is the fundamental structure in our market that protects all of us and that we hardly ever get to see and that's a good thing. So central clearing houses, they are the guardians of the market, they protect us against counterparty risk failure, that the counterparty are trading with will not provide the securities of the cash that you need. And in return, what clearinghouses do is that they have a whole bunch of things. that they put in place to keep themselves and the market safe. In other words, they make sure that the folks participating in the market

provide collateral margin, that they have procedures in place to share losses between their members. But the clearinghouse is well-resourced in case even their members don't have the resources that they need. So this is the structures that's designed to absorb and buffer risk. And for the most part, it works really well. But as you might expect, this is a structure that's also just incredibly too big to fail. And it's one that has grown in its footprint following Dodd-Frank as we rely on clearing houses much more systematically to protect the derivatives and swaps market.

So the idea here has been, and Darrell Duffy and others have thought about to try and bring central clearing into the U.S. Treasury's market. and I think it's a terrific idea. But I think if we take a step back, it's worthwhile noting that clearing does actually exist in the U.S. Treasury markets. Unfortunately, the clearing in this market as it does exist is a hot mess. So we do have central clearing in the U.S. Treasury market,

but it's a completely hodgepodge and confusing system. Central clearing does exist when you have, say, two dealers, two primary dealers, for example, that trade with one another. But it does not exist, or you will not get central clearing, when you have, say, an eight two HFTs trading with one another. So this is a patchwork of clearing that exists in the U.S. Treasury market. And unfortunately, that's a disaster, Joe, that is like the worst of the two worlds that we could possibly imagine. In other words, we have a clearinghouse that exists that partially clears U.S. treasuries. I think there was a terrific treasury market,

Treasury Practice Markets Group Report in 2018, I think, that dealt with clearing in the U.S. Treasury markets. And what it described was that approximately 75% of the thing the interdealer market is not centrally cleared, but 25% is. And so you can imagine the risks of that, that the clearinghouse does not have a full picture of what the risks in this market are, that market participants who are members of the clearinghouse don't have a full picture of what is happening in this market, what kind of risk the clearing house faces. And you don't get the benefits of central clearing for the market

as a whole. You don't have set off a netting across all these secondary market treasury transactions that could reduce the risk of the clearinghouse and individual members face. So this is a really confusing and just an unacceptable picture for central clearing and U.S. treasuries in the secondary market space at present. So, you know, the question is whether or not we bring central clearing in here. And I think it's a solution that needs to be on the table, because obviously it's one that has worked in other markets. But to do this, we need to be extremely careful because we are going to be setting up the clearing houses to end all clearing houses, right, for U.S. Treasury market function. And again, given the countercyclical aspect of treasury markets, that is that they have to

work when every other market is collapsing, that we really need to make sure that this clearinghouse over and above every single other financial institution in the whole wide galaxy world, whatever, is the one that is safe enough to protect us. Eating well shouldn't be complicated, but somehow it turns into recipes, prep, clean up, and half your Sunday gone. Factors solves all that.

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Visite CollegeslaC.a. D.M.C.A. D.M. An initiative of the consortium national of formation in health supported by Santee Canada. So I get the sense from this discussion that a lot of the problems

that are happening in the Treasury market and the weaknesses that you described. Like, a lot of those are the result of similar forces to what we've seen in other asset classes.

So stocks has gone through, you know, its own bout of electronification. people have had the same discussions about whether or not high-frequency traders actually provide liquidity in stocks in moments of stress. And to some extent, you know, corporate bonds are sort of going through this as well. But I guess my question is, like, is the problem that the Treasury market is encountering these issues that aren't necessarily specific to treasuries? But the difficulty is that regulatory fragmentation that you described before. Is that a fair way of thinking about it?

Like, this is not necessarily a treasury market specific problem, but the thing that makes it bad is the fact that no one's responsible for it and no one's looking at it in a holistic way. Exactly. I feel like you just wrote a lot of you article, Tracy. I think that was that was the perfect summary there. That's exactly what, you know, that at least. to me that seems to be the problem, that we have, exactly as you said, seen these phenomena before in other markets. Post-2010 with a flash crash, regulators went through an incredible

degree of investigation and research and the SEC and the CFTC did such a great job in collating a whole amount of research and doing the analysis, doing a bunch of rulemaking. So we saw systems compliance and integrity, for example, the SEC rule, direct market access, all of these different rules come into place to try and shore up the resiliency of a highly automated super fast market structure. And for the most part, these reforms have done a great job in making this market more resilient, more robust. I think, you know, we've gone through periods of volatility, we've gone through periods of extreme stress, and that market structure has held up. Unfortunately, the U.S. Treasury market, even these very, very basic reforms, just to safeguard

the resiliency of the trading infrastructure just haven't happened, right? They just haven't taken place. And the X factor that I that I put some of this blame at is this super fragmented regulatory model that we have in the U.S. Treasury market. It's unsurprising that regulatory updating in this market is so thin because we have to get a lot of regulators, big, busy regulators in the same room to talk about these issues, to share information, to come up with a plan, to coordinate. there are a whole bunch of costs that just don't exist for the regulators that are primary regulators and other markets. They can act essentially with enormous amounts of power, control, and deference given to their actions in the equity space with the SEC or in the jurisdiction space

with the CFTC. In the treasury markets, however, they have to come together to coordinate and there are barriers here to their coordination. So, for example, there have been difficulties between regulators and sharing information. There are institutional constraints that they have in providing fulsome information to each other. In addition, we're dealing with regulators that have very different approaches at times, right? So the Fed and the New York Fed and the OCC, these are prudential regulators.

They are designed to safeguard the safety and soundness of the financial system. In general, that doesn't mean that that means that they don't love the idea of a whole bunch of disclosure in the market to tell everyone what the skeletons in this market might be, as it might create some. conditions for a systemic run for a problem to happen in that market space.

On the other hand, we have the CFTC and FINRA that are the securities markets regulators. They are much more into creating these super liquid markets, just disclosure and transparency and these other factors. So we have differences in approach. We have differences in agency mandates. We have the need for all of these institutions to come together to develop a plan. and it should not be any surprise whatsoever that we just haven't seen the kind of rulemaking

that we have in other markets. So I'm not saying that we have, you know, a huge amount of regulation here. That's not what I'm saying. What I'm saying is that we at least need to have a regulatory structure in place that is geared towards providing even the most basic reforms

that are tried and tested in other markets, that work in other markets, but that are sadly missing in U.S. Treasury's, and that leave this market there for very vulnerable, the systematic fragility. Yesha, thank you so much for coming on. That was great. Thank you guys so much for having me. I just completely, I wish you could have seen me in my little room.

My arms are flailing everywhere. I was going to go crazy. You know, you have such great questions. And, you know, I could talk to you guys for like another hour. Like, this is, you know, this is so cool. We'll definitely have to do it again. Yeah. I would love it.

And thank you guys so. much. I mean, it was so cool. Your questions were just brilliant. You're writing. Some of the reporting that you guys do has been so important to the writing I've done. I could not have got the information and insights I did without that. And honestly, I just have so much fun. I just thank you so much. That's great. Thank you. So, Joe, I thought that was a really fascinating conversation and such an important one, because as you laid out at the very beginning, this is an ultra-significant market for, well, for the entire market. And it's sort of the thing on which everything else rests. It's the, you know, the benchmark risk-free rate. And there is this assumption,

I mean, you should touch on it. There is an assumption that in times of trouble, you should be able to liquidate a risk position and trade it for something considered safe, which, you know, would usually be a U.S. Treasury bond. And if the market can't serve that function, It seems like that's a bit of a problem. Yeah, absolutely. Like this idea that's like, okay, like in time, you know, normal times, treasury trading is fine. And higher volatility times actually, you know, victorizes treasury trading is still probably fine. But then this idea that's like you hit some new threshold where the volatility in last March was the clear example gets so high that this sort of like safety valve market that exists out there, even that starts to break.

then it becomes a real problem and can't sort of perform the, I guess, countercyclical function that you hope it would. And, of course, we saw the Fed step in last year. It definitely seems like if that level, whenever it is, we don't hit it that often. But we seem to hit it enough that it's, you know, that it's an issue that needs addressing. Yeah, absolutely. And it is kind of frightening that, as we discussed, we still don't know exactly why these. volatility issues keep propping up or you know why we are getting these moments of drama in the market and that's kind of I mean that's a little bit frightening

because it is this 21 trillion dollar market that kind of touches on everything else it seems weird that people aren't more dedicated to tracking it and sort of figuring out what's going on but I guess that speaks to the regulatory fragmentation that you show was describing it still seems like there's more that like, I don't know, maybe the Fed could do to treat treasuries as a true risk-free asset. And I know we talked about this a little bit in our discussion with Josh Younger, but obviously reserves are sort of like the ultimate, ultimate risk-free asset because they're all fungible, they're all identical.

And treasuries are close, but because they have different liquidity questions and different maturities and stuff, they're not quite the same. but still feels like perhaps there could be more done such that like a standing reverse repo facility, something such that at any time someone could be guaranteed by the government to get liquid cash for their treasuries. It seems like that could be part of the answer, but who am I? That's just that's just my two cents take. No, no, no, no. I think you're right. And I think it does feel like the Fed is taking more of an interest or I guess a more proactive approach to the Treasury. market overall. So I've said before that like I think the treasury like smooth functioning of the

treasury market is now a sort of unspoken priority if not target for the Fed. And I think that's right. And I think they're going to be looking at it more and more as these issues crop up. Yeah. No. And it should be. I mean, look, you know, the the entire yield curve as I see it should be understood as a policy instrument. And you have like the shortest, lowest duration assets are reserves and then the longest duration, like way out on the curve. But it all is an expression of policy. And I think this gets to the question that I asked about like this sort of intersection between macro policy and regulatory policy because, you know, it's like, all right, we're running large deficits because we're running countercyclical fiscal fiscal policy right now. We're running a

large balance sheet policy on the part of the Fed. So at some level, the regulatory regime has to acknowledge that the fiscal and monetary regime needs to use these tools from time to time and sort of recognize that. But again, I guess that gets to the answer of like, well, who is the individual regulator that's going to make that call and we still don't have that. Yeah. All right. Shall we leave it there? Yeah, leave it there. All right. This has been another episode of the All Thoughts podcast. I'm Tracy Allaway. You can follow me on Twitter at Tracy Allaway. And I'm Joe Wisenthal. You can follow me on Twitter at The Starwort.

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