Again in the course of the Nice Recession of 2007-09, it grew to become widespread for economists to speak about “financial plumbing” as a part of the issue. The metaphor of pipes and drains and valves was meant to recommend {that a} comparatively small blockage or capability limitation in a single a part of the monetary plumbing might result in a lot greater systemic results. In different phrases, the monetary plumbing would possibly work simply tremendous in bizarre day-to-day use, but when one a part of the monetary system got here below stress, issues might again up unexpectedly.
With that normal idea in thoughts, contemplate the overall quantity of US Treasury debt held by the general public. Again in 2001, it was about $3.5 trillion. By 2009, it had doubled once more to $7 trillion. By 2016, it had doubled once more to $14 trillion. By 2024, it had doubled yet another time to $28 trillion. The Congressional Price range Workplace forecasts recommend that by 2035, based mostly on present regulation (that’s, earlier than the passage of this 12 months’s funds and tax payments, which of their present kind would enhance the debt additional), complete US debt might practically double yet another time to $52 trillion.
So right here’s the query: How assured ought to we be that the monetary plumbing which dealt with the buying and selling of US Treasury debt when the market was one-eighth of its present dimension, again in 2001, is equally able to dealing with the a lot bigger quantity–particularly when the market comes below stress? Darrell Duffie rings some warning bells in “How US Treasuries Can Remain the World’s Safe Haven” (Journal of Financial Views, Spring 2025). (Full disclosure: I’m the Managing Editor of JEP, and thus predisposed to seek out the articles of curiosity.)
If it appears far-fetched that the US Treasury market ought to come below stress, then it’s value noting that it occurred in March 2020. Duffie explains:
When the World Well being Group declared COVID-19 a worldwide pandemic on March 12, 2020, … the sellers who make markets for Treasuries have been unable to deal with the flood of calls for by traders world wide to purchase their Treasury securities. Bond sellers have been requested on the similar time to purchase huge portions of mortgage-
backed securities and company bonds, amongst different calls for for liquidity. Complete customer-to-dealer bond-market commerce volumes immediately jumped to over ten instances their respective 2017–2022 pattern medians (Duffie et al. 2023). The bond market reached the bounds of its intermediation capability and have become successfully dysfunctional. Yields for Treasury securities lurched greater, whereas dealer-to-customer bid-offer spreads and dealer-to-dealer market depth worsened by elements of over ten (Duffie 2020). Amongst different steps to assist the market, the Federal Reserve bought nearly $1 trillion {dollars} of Treasury securities from major sellers within the first three weeks after March 12, liberating supplier balance-sheet area to deal with extra gross sales from prospects. Weak market performance persevered for a number of extra weeks (Duffie et al. 2023). Though liquidity in Treasury markets step by step returned to regular, many Treasuries traders presumably observed that within the coronary heart of the March 2020 disaster, they’d not benefited from the safe-haven requirement of a liquid and deep market. Even earlier than the COVID-19 disaster, the vaunted liquidity of the marketplace for buying and selling Treasuries had been exhibiting cracks below stress.
Potential difficulties out there for US Treasury bonds have massive implications. As Duffie notes, many monetary establishments and traders world wide view US Treasuries as their “safe” asset. Just about by definition, a secure asset holds its worth and might be bought when desired. The power of the US authorities to market its debt at favorable rates of interest is dependent upon this widespread notion. But when the marketplace for Treasury debt can turn out to be illiquid in a disaster, as occurred in March 2020, then Treasury debt is much less secure than it beforehand appeared. The upper danger implies that the US authorities would want to pay greater rates of interest when it borrows.
As Duffie explains the plumbing out there for Treasury debt, about $1 trillion is traded day-after-day, and most of that flows by means of 25 corporations which might be designated as “primary dealers.” Primarily, which means that when there’s a surge of sellers of Treasury debt, these major sellers must be financially capable of act as rapid consumers–though after all they are going to be planning to re-sell most of that Treasury debt later. However the complete quantity of Treasury debt is rising quick, a lot quicker than the monetary dimension of the first sellers. In 2007, earlier than the Nice Recession, the ratio of complete Treasury debt to the property of the first sellers was lower than 0.2; by 2023, the ratio was above 0.7. Briefly, the monetary plumbing for the US Treasury market is operating a lot nearer to its capability, and it has already gotten clogged as soon as.
In fact, one technique to make it simpler for the first sellers to ensure that they may purchase Treasury debt when wanted could be to have much less authorities borrowing and fewer Treasury debt. Now that we’ve all had a superb giggle over the implausibility of that taking place, what are the intense choices? Finally, the aim could be to maneuver past having the Treasury debt market movement by means of these 25 corporations, and as a substitute create an “all-to-all” market, extra just like the inventory market, the place consumers and sellers of Treasury debt can work together straight. However organising such a market is nontrivial, and it nonetheless would elevate the query of what occurs in world monetary markets if a wave of sellers of Treasury debt begin driving down the worth.
Duffie opinions numerous coverage choices, a few of that are being applied. You’ll be able to learn his article for particulars, however to provide a way of the chances:
- Require that trades for Treasury debt be carried out by means of a central clearinghouse, somewhat than as trades between two separate events: “The clearinghouse offers a guarantee: if one of the original counterparties fails to perform at settlement, then the clearinghouse will complete the settlement.”
- “Regulators are slowly moving toward a plan for improving post-trade price transparency in the market for US Treasury securities by publishing trade price and quantities shortly after each trade (Liang 2022). Post-trade price transparency will likely improve competition and allocative efficiency. … The efficiency with which dealers are matched to trades will improve, likely expanding the intermediation capacity of the market. Eventually, greater post-trade price transparency will also speed up the emergence of all- to-all trade.”
- The Federal Reserve might arrange preparations to ensure upfront that if/when US Treasury debt markets are melting down, they may prolong short-term credit score to key market gamers as wanted. Expertise has taught that when such backstop preparations are identified to be out there upfront, they’re much less prone to turn out to be vital!
- The US Treasury might purchase again US Treasury debt issued within the distant previous, which is tougher to commerce out there, and change it with newly-issued debt which is less complicated to commerce out there.
- Re-consider the particular financial institution supervision guidelines that strive to verify banks have adequate capital to face crises, and guarantee that these guidelines are usually not having the impact of discouraging banks from holding Treasury debt in a monetary disaster scenario.
Duffie says it bluntly: “The market for Treasury securities is simply growing too large to rely exclusively on dealers to intermediate investor trades.” Finally, the selection is whether or not monetary regulators will proceed with all deliberate pace to implement the mandatory modifications earlier than the following disaster hits the Treasury debt market, or whether or not the regulators shall be improvising less-considered schemes when the following disaster hits the Treasury debt market.
