Streetwise Professor

Former Treasury Secretary Timothy Geithner–better known as Timmy! to loooooongtime readers of this blog–is back, this time as Chair of the Group of 30 Working Group on Treasury Market Liquidity. The Working Group was tasked with addressing periodic seizures in the Treasury securities market, most notoriously during the onset of the Covid crisis in March 2020–something I wrote about here.

This is a tale of two reports: the diagnosis is spot on, the prescription pathetic.

The report recognizes that

the root cause of the increasing frequency of episodes of Treasury market dysfunction under stress is that the
aggregate amount of capital allocated to market-making by bank-affiliated dealers has not kept pace with the very rapid growth of marketable Treasury debt outstanding

In other words, supply of bank market making services has declined, and demand for market making services has gone up. What could go wrong, right?

Moreover, the report recognizes the supply side root cause of the root cause: post-Financial Crisis regulations, and in particular the Supplemental Leverage Ratio, or SLR:

Post-global financial crisis reforms have ensured that banks have adequate capital, even under stress, but certain provisions may be discouraging market-making in U.S. Treasury securities and Treasury repos, both in normal times and especially under stress. The most significant of those provisions is the Basel III leverage ratio, which in theUnited States is called the Supplementary Leverage Ratio (SLR) because all banks in the United States (not just internationally active banks) are subject to an additional “Tier 1”leverage ratio.

Obviously fiscal diarrhea has caused a flood of Treasury issuance that from time to time clogs the Treasury market plumbing, but that’s not something the plumber can fix. The plumber can put in bigger pipes, so of course the report recommends wholesale changes in the constraints on market making, the SLR in particular, right? Right?

Not really. Recommendation 6–SIX, mind you–is “think about doing something about SLR sometime”:

Banking regulators should review how market intermediation is treated in existing regulation, with a view to identifying provisions that could be modified to avoid disincentivizing market intermediation, without weakening overall resilience of the banking system. In particular, U.S. banking regulators should take steps to ensure that risk-insensitive leverage ratios function as backstops to risk-based capital requirements rather than constraints that bind frequently.

Wow. That’s sure a stirring call to action! Review with a view to. Like Scarlett O’Hara.

Rather than addressing either of what itself acknowledges are the two primary problems, the report recommends . . . wait for it . . . more central clearing of the Treasury market. Timothy Geithner, man with a hammer, looking for nails.

Clearing cash Treasuries will almost certainly have a trivial effect on market making capacity. The settlement cycle in Treasuries is already one day–something that is aspirational (don’t ask me why) in the stock market. That already limits significantly the counterparty credit risk in the market (and it’s not clear that counterparty credit risk is a serious impediment on market making, especially since it existed before the recent dislocations in the Treasury market, and therefore is unlikely to have been a major contributor to them).

The report recognizes this: “Counterparty credit risks on trades in U.S. Treasury securities are not as large as those in other U.S. financial markets, because the contractual settlement cycle for U.S. Treasury securities is shorter (usually one day) and Treasury security prices generally are less volatile than other securities prices.” Geithner (and most of the rest of the policymaking establishment) were wrong about clearing being a panacea in the swap markets: it’s far less likely to make a material difference in the market for cash Treasuries.

The failure to learn over the past decade plus is clear (no pun intended!) from the report’s list of supposed benefits of clearing, which include

reduction of counterparty credit and liquidity risks through netting of counterparty exposures and application of margin requirements and other risk mitigants, the creation of additional market-making capacity at all dealers as a result of recognition of the reduction of exposures achieved though multilateral netting

As I wrote extensively in 2008 and the years following, netting does not reduce counterparty credit risk or exposures: it reallocates them. Moreover, as I’ve also been on about for more than a fifth of my adult life (and I’m not young!), “margin requirements” create their own problems. In particular, as the report notes, as is the case in most crises the March 2020 Treasury crisis sparked a liquidity crisis–liquidity not in terms of the depth of Treasury markets (though that was an issue) but liquidity in terms of a large increase in the demand for cash. Margin requirements would likely exacerbate that, although the incremental effect is hard to determine given that existing bilateral exposures may be margined (something the report does not discuss). As seen in the GameStop fiasco, a big increase in margins in part driven by the central counterparty (ironically the DTCC, the parent of the FICC which the report wants to be the clearinghouse for its expanded clearing of Treasuries) was a major cause of disruptions. For the report to ignore altogether this issue is inexcusable.

Relatedly, the report touches only briefly on the role of basis trades in the events of March 2020. As I showed in the article linked above, these were a major contributor to the dislocations. And why? Precisely because of margin calls on futures.

Thus, the report fails to analyze completely its main recommendation, and in fact its recommendation is based on not just an incomplete but a faulty understanding of the implications of clearing (notably its mistaken beliefs about the benefits of netting). That is, just like in the aftermath of 2008, supposed solutions to systemic risk are based on decidedly non-systemic analyses.

Instead, shrinking from the core issue, the report focuses on a peripheral issue, and does not analyze that properly. Clearing! Yeah, that’s the ticket! Good for whatever ails ya!

In sum, meet the new Timmy! Same as the old Timmy!