US Treasury market structure is fragile — we urgently need to strengthen it

As small businesses clamored to access a fresh infusion of $310 billion in emergency support – after the $342 billion in funding from last month’s $2.2 trillion stimulus ran dry – Congress is already facing calls to increase federal aid to homes, businesses and states.

Thankfully, the U.S. possesses a superpower when it comes to writing checks: The market for U.S. government bonds (Treasuries). The U.S. Treasury announced that it expects to raise a record $2.99 trillion this quarter. But with pressure mounting to sharply ramp up capital raising, is the structure of the Treasury market strong enough to withstand this extreme level of stress?

After the Financial Crisis, tradeable Treasury debt has grown from around $5 trillion in August 2008 to $17 trillion in March 2020. With plans to borrow extensively, government indebtedness is forecast to rise in lockstep, with the national deficit projected to reach a record 10-13 percent of GDP in 2020. The Treasury market also generates enormous volumes of daily trading. Average daily trading volume stands at around $560 billion, compared to around $471 billion for equities.  

Viewed as risk-free, Treasuries are a fail-safe when stock and bond markets collapse. Investors – from foreign governments to grandma – pile into Treasuries. Those that hold a Treasury want to be able to sell it for cash; those desiring a safe investment offload stocks and buy a Treasury. Whenever money becomes expensive for everyone else, the U.S. can borrow at rock-bottom rates. As the coronavirus has decimated markets, interest rates on Treasuries have fallen to record-low levels. 

Despite its singular importance to American life and its risk-free reputation, however, Treasury market structure rests on far shakier foundations than we realize.

We have been caught off-guard by transformations in this market’s plumbing. It has rapidly become automated — populated by high frequency traders (HFT) that transact in milliseconds. These supersonic traders are competing with the big banks that have long supported the issue and trading of Treasuries using their pocketbooks to trade with investors and keep the market flowing. Facing more regulation than HFT firms, banks have less motivation to be diligent stewards of Treasuries. With pressure on balance sheets, banks and HFTs can stop or reduce trading when conditions become rough, raising the risk that markets will stall and prices go into a tailspin.

Regulators are not well equipped to deal with this landscape. This market is mysterious, even to them. The system for regulating Treasuries is fuzzier than that for shares or bonds. Instead of one lead regulator, like the Securities and Exchange Commission (SEC) is for equities, oversight of Treasuries is split between multiple bodies — the Treasury, the Federal Reserve, the Federal Reserve Bank of New York, the SEC, the Commodities Futures Trading Commission and the Financial Industry Regulatory Authority (FINRA). This fragmentation creates barriers to the information sharing and pooling of expertise needed to understand how Treasury market plumbing functions, new risks and its capacity to be resilient. It makes it harder to formulate rules designed to address problems. Until 2017, Treasuries lacked a systematic reporting regime for trades — and today’s regime still has gaps. Public reporting is restricted. FINRA started to publish weekly statistics in March that offer a glimpse into how Treasuries trade.

Problems in Treasury market structure have emerged under the stress caused by the coronavirus. As markets whipsawed, Treasuries became harder and more expensive to trade, suggesting that major Treasuries traders stopped or reduced activities. The Fed had to step in with a multi-trillion dollar support package, including a scheme to allow foreign governments to swap Treasuries for dollars, with the hope of dissuading countries from flooding the market with orders to sell Treasuries.

Despite these efforts, Treasury markets have become more volatile, more expensive and less liquid, causing worry about the stability of Treasury prices. Even before the pandemic, Treasuries trading had seen episodes when prices inexplicably went haywire. These fragilities point to cracks in the market’s plumbing. They cast doubt on the reliability of Treasuries as the one asset that protects when all else fails. If investors cannot easily buy and sell Treasuries when they need, they may think twice before lending the U.S. money. 

Congress must address Treasury market structure. It needs to interrogate the reliability of the market that enables lifesaving measures to be funded so cheaply. Policymakers must ensure that a fragmented and outdated system of regulation is updated to match the high-speed and interconnected modern Treasury market. Without reform, we may have to rely on the Fed to step in when a crisis strikes as a market-maker of last resort. 

It is a truism not to let a good crisis go to waste. We should not squander this one and fail to tend to the one market that we rely on to save us from crisis time and time again.

Yesha Yadav is a professor of law at Vanderbilt Law School.