U.S. Treasuries Are Supposed to Be Risk-Free. Treasury Markets Are Definitely Not.

Treasuries occupy the role of a safe haven in public regulation and in protecting trillions of dollars in private credit. Financial firms are required to carry a cushion of Treasuries to keep themselves safe, and credit markets routinely rely on them as collateral. So when COVID-19 shocked the financial system in March 2020, investors invariably turned to the Treasury market – a risk-free and reliable source of cash — to remain solvent and navigate the turbulence.

The market did not act as intended. As large investors rushed in to sell, execution costs increased 50% – 500%, trading volumes shrank, and the price of Treasuries became worrying unstable. Disruptions like these are common to stock or corporate bond markets – yet they spell doom when their occurrence becomes more frequent in Treasuries – the one asset that public and private systems of financial regulation rely on to prop up markets in times of trouble.

“The underlying issue boils down to a core assumption by regulators and the market: the default-free nature of Treasuries means that they are also always perfectly tradeable at fair prices,” says Yesha Yadav, Associate Dean and Professor of Law. “This assumption is simply wrong.”

In their paper “The Failed Promise of Treasuries in Financial Regulation,” Yadav and her co-author Pradeep K. Yadav of the University of Oklahoma detail the fragile and broken system for distributing Treasuries as well for and supervising the Treasury market. It also offers some solutions to fix the dangerous vulnerabilities undermining the risk-free status attaching to US Treasuries.

One problem with intermediation: opacity and incentives

Primary dealers, consisting of 25 large banks and investment firms, act as intermediaries, buying and selling Treasuries to interested parties in what’s commonly known as “secondary trading.” They also connect players in the market for short-term lending between financial firms, aka the “repo market,” which allows firms to lend and borrow cash from one another, mostly using Treasuries as collateral. They are also routinely borrowing and lending on their own balance sheets to keep this market flowing.

The authors note that this market design – and its dependence on primary dealers – creates information gaps. For example, in the repo market, due diligence is abandoned in light of the risk-free Treasuries being used as collateral. “Primary dealers lack the tools and, importantly, the incentives to carefully monitor the default risk posed by parties with whom they contract,” they write.

A lack of reporting and monitoring in the system also makes it difficult to track Treasury ownership, creating the potential for a single Treasury to act as collateral across multiple loans.

Importantly, the system also depends on primary dealers’ willingness to trade through any conditions, including stressful ones, and to protect both the secondary and repo markets through turbulence. Primary dealers have no requirement to remain trading. “If the cost-benefit trade-off of intermediation becomes overly expensive, intermediaries will rationally withdraw,” the authors note.

Dealers may also favor one market over the other for profitability, relationships, or reputation. The repo market is multiple times larger than the secondary market for Treasuries by trading volume on any given day, creating the potential for dealers to favor the more profitable, active market in difficult circumstances.

“For public and private financial regulation to currently remain credible, Treasuries intermediation must be lucrative business for primary dealers,” the authors write.

Regulatory Challenges

The paper also details a fragmented regulatory structure for overseeing Treasuries. Oversight is shared by five or more agencies, with no lead regulator in place. Each regulatory group brings a different approach to their work, varying mandates and bureaucratic restrictions, adding to the challenges of rulemaking, monitoring, and coordination. The system creates blind-spots and leaves regulators unable to fully grasp the risks running between repo and secondary markets.

“Regulators are poorly placed to recognize the tension between a system of public and private financial regulation that is so deeply reliant on Treasuries to function,” the authors write.

A Path to Reform

The authors propose a three-pronged solution to regulating Treasuries.

The first is to increase the extent of market-wide, real-time reporting available to regulators, in both the repo and secondary markets. The authors note that pushback from different players in the market is inevitable, but “failure to understand the market and its dynamics carries not just financial costs but also implies larger damage from the standpoint of political economy.”

Secondly, regulators should explore tools to incentivize the primary dealers and market makers during times of crisis – namely, an affirmative duty to remain trading. This would apply to the largest dealers and most active traders. They note that with the designation could also come certain privileges and status.

Lastly, the authors push for stronger coordination between regulators to eliminate the type of regulatory fragmentation that creates dangerous blind spots in times of crisis. They specifically advocate to make the Financial Stability Oversight Council (FSOC) a coordinating supervisory agency for the Treasury and repo markets.

“Without real reform, the first steps to which we outline here, we worry that Treasuries cannot live up to their reputation, undermining their promise for regulation as the anchor in financial system stability,” the authors conclude.

The Failed Promise of Treasuries in Financial Regulation,” by Pradeep K. Yadav and Yesha Yadav, is forthcoming in Southern California Law Review.