Streetwise Professor

The market for United States Treasury securities (notes and bonds) has been a source of concern for some years, dating back to the Treasury “flash” event of 15 October 2014, but especially in the aftermath of the “dash for cash” during the March 2020 Covid scare. The relentless selloff of Treasuries in the past year plus has contributed to the angst.

This has led the SEC to propose various changes to the structure of the Treasury market. The most important of these is mandated central clearing of most Treasury cash trades and repos. Well, since Gigi is back in the clearing saddle, I guess I have to mount up too.

The main justifications of the mandate come from Darrell Duffie and various collaborators at the New York Fed (notably Michael Fleming). The IMF has also produced an analysis outlining justifications of the mandating of clearing.

Just as with the Frankendodd clearing mandates, the case for Treasury clearing is very weak.

The basic argument is that Treasury market liquidity has eroded, and that clearing will enhance market liquidity. The supposed main cause of the decline in liquidity is that primary dealers face balance sheet constraints that limit their ability to intermediate the Treasury market.

In the Duffie paper and the Duffie, Fleming et al paper he cites, the main evidence of the deleterious effects of balance sheet constraints comes from the “dash for cash” in March 2020. Summarizing a variety of measures of market liquidity using principal components analysis, they show that liquidity usually varies inversely with market volatility, but liquidity declined far more than predicted by volatility alone in 2020. This was due, it is claimed, to the fact that dealers were not able to increase their holdings of Treasuries due to balance sheet constraints. Their ability to make markets was therefore constrained.

There is a big problem with this analysis. Dealers ended up holding far more Treasuries because Covidmania caused a sharp drop in the demand to hold Treasuries by hedge funds and others–they wanted to substitute cash for Treasuries. Part of the demand drop was accommodated by a price decline, but evidently dealers’ demands did not drop as much as the demands of non-dealers: thus, there was a major portfolio adjustment, with hedge funds etc. reducing their holdings and dealers absorbing as much of these sales as their balance sheets allowed.

Thus, this was a structural change in demand that led to major portfolio adjustments. Yes, the portfolio adjustments were accompanied by a decline in conventional measures of liquidity (bid-ask spreads, depth, etc.) but this decline in liquidity was a consequence of the underlying shock, and clearing of cash Treasuries or repos would have had little, if any, impact on this decline. Even if clearing increased dealers’ balance sheet capacity (something I discuss further below), given the underlying Covid-driven (and Covid policy-driven) demand shock it is highly likely that this incremental capacity would have been fully utilized as well and liquidity would have been about as bad.

This extraordinary shock that led to strained dealer intermediation capacity is different than the types of shocks that dealers typically intermediate. The role of Treasury liquidity suppliers–be they dealers or prop trading firms–is the same as the role of liquidity suppliers in any other market, be it stocks or currencies or commodities: to utilize inventory adjustments (balance sheet) to absorb temporary, temporally uncorrelated, and largely cross-sectionally uncorrelated investor (buy side) demand shocks. The dash for cash was a long-lasting shock highly correlated across major investors in Treasuries. It was a systematic shock that led to a long lasting adjustment in dealer portfolios, whereas market makers absorb idiosyncratic shocks that do not require long lasting adjustments to dealer portfolios.

That is, the kind of portfolio adjustments that occurred in response to Covid were fundamentally different in nature from the kind of portfolio adjustments that firms undertake to make markets. A long term transfer of risk rather than a short term transfer.

Therefore, using the dash for cash as the basis for policies intended to improve Treasury market liquidity is fundamentally misguided.

Be that as it may, it provides the underlying logic advanced for clearing mandates: improving liquidity requires increasing dealer balance sheet capacity, and clearing can supposedly do that.

How can clearing improve balance sheet capacity? The mandate defenders offer that hardy perennial as a justification: netting. For both cash Treasuries and repos, the argument goes, netting out offsetting exposures reduces the amount of capital and cash that dealers require to intermediate. For cash transactions, Duffie, Fleming et al estimate that netting would reduce daily settlement volumes substantially (70 percent in March 2020 according to their figures). This, and other factors, allegedly result in freeing up of dealer balance sheet capacity.

This analysis begs an important question: since dealers would internalize the benefits of more economical use of balance sheets that would result from clearing, why is it necessary to mandate it? Why don’t dealers and other market participants voluntarily utilize clearing more extensively in order to economize on the use of a scarce resource–balance sheet? After all, historically voluntary adoption of clearing in the stock market (e.g., NYSE clearing and CBOT clearing in the 19th century) was specifically intended to reduce settlement volumes by netting. In the case of the CBOT, the clearinghouse netted payment obligations but did not mutualize credit risk on derivatives transactions or impose margins (which were negotiated bilaterally).

The alleged failure of profit-motivated entities to reduce cost (from inefficient use of balance sheets) suggest that this does not come for free: at the margin there must be some cost for clearing that is greater than the putative benefit. That is, profit maximizers will balance marginal private benefits and marginal private costs. The benefits of netting from clearing are private, and thus the current degree of penetration in clearing likely reflects an efficient balancing of these marginal benefits and costs. The advocates of a mandate surely have not shown otherwise.

I further note that, as I wrote repeatedly during the Frankendodd era, netting redistributes default risk rather than reduces it. It is by no means clear that the distribution of default risk under central clearing/netting is more efficient than that under bilateral clearing.

Put differently, the advocates of clearing (both cash and repo) have not identified a “market failure”, e.g., a benefit from clearing that market participants do not internalize. Such a failure is a necessary (but not sufficient) condition for regulatory intervention such as a clearing mandate.

With respect to repo clearing, another supposed benefit is the disparity of margins (“haircuts”) in the repo market. Haircuts for some counterparties are low, but for others they are higher. Central clearing would impose uniform, value-at-risk (“VaR”)-based margins.

The operative theory behind central clearing is that the “loser pays”, namely the resources (margin, default fund contribution) posted by a counterparty is sufficient to cover any losses in the event of that counterparty’s default. Ideally, counterparty credit risk in central clearing is zero, though in reality some always remains.

Well, this begs another question: is the optimal amount of counterparty credit risk/default risk zero (or close to zero) in all transactions? Relatedly, is it optimal not to permit the pricing of counterparty credit risk, where the price varies by the creditworthiness of counterparties, with high credit quality entities paying smaller haircuts than lower quality credits? Central clearing makes pricing independent of creditworthiness, whereas bilateral arrangements that advocates of clearing dislike allow pricing of credit risk that reflects assessments of creditworthiness of counterparties.

Since credit risk mitigants (including margins/haircuts) are costly, and since market participants trade-off the costs and benefits of credit risk and its mitigants, allowing choice and competition on this dimension has strong justifications. Certainly the advocates of mandatory Treasury clearing have not identified a “failure” in this market that justifies regulatory intervention in the form of clearing mandates.

Put differently, clearing mandates force market participants to a corner solution–clear everything, and impose margins that make counterparty credit risk de minimis. The existing state of the market, where market participants can choose to clear with a CCP or not, reveals that they strongly do not prefer the corner solution. Furthermore, the advocates of clearing have failed to identify any market failure that implies that the interior solution/equilibrium is inefficient and can be improved by mandating the corner solution.

And the advocates have yet again failed to recognize the trade-off inherent in clearing: that is, the trade-off between counterparty credit risk and liquidity risk. This despite the fact that the reality of this trade-off has been made abundantly clear (no pun intended) repeatedly in the past–and including in particular the Treasury market basis trade turmoil during the dash for cash.

The real issue in Treasury markets right now, and the real threat to their stability, is the massive deficits in the United States, and the resultant increase in Treasury security issuance and Treasury securities outstanding. It is deficits and issuance that are driving the massive increase in the size of Treasury markets, and the consequent strains on the ability of dealers and others to intermediate the swollen market.

This is a challenge that no rearranging the market structure furniture on the deck of SS Treasury Titanic will fix. Furthermore, the economic case for mandating clearing of Treasury cash and repo transactions is laughably weak even if one overlooks that fact that clearing does not get at the real problem. But it appears that Gigi (cheered on by the Fed) will mandate a corner solution that makes the market less efficient, not more.