What are the implications for Treasuries trading of the increasing risk in the market as the Fed begins to tighten policy and sell off much of its Treasuries portfolio? A partial remedy is to expand retail merchants’ access to cash runaway treasury bond market. The market for experienced treasuries is less liquid and less useful to retail risk managers, especially hedgers on the sell side of the market.
The long-term issue of Treasury market liquidity is the withdrawal of brokers from active market making. This conservatism of traders stems from post-financial crisis regulations requiring treasury traders to increase the capital backing their treasury stocks. The new regulations introduced an additional leverage ratio, increasing the amount of capital brokers must set aside.
The logical response to this reduced participation of dealers in state securities in the internal market is to broaden access to retail dealers without direct dealer intervention. However, providing easy retail access to the Treasury market will require additional safeguards. The article considers a way forward.
The Coming Cash Shortage in the Treasury Market
Withdrawal of the dealer from the market making of treasury bills. The current Treasuries market is starting to show stretch marks as the Fed prepares to raise the key rate, read here and here. The articles warn that lower liquidity in the Treasuries market will cause rates to explode higher as Fed stocks fall. The chart displays recent increases in volatility.
End of LIBOR. The regulator’s decision to end LIBOR compounds the problem of rising volatility. The three-month index that risk managers have used for the past 40 years to price non-traded financial instruments and hedge risk in the short-term unsecured credit market will disappear from market use at the end of of the year.
The alternative to LIBOR put forward by market regulators is the Secured Overnight Funding Rate (SOFR). The chart below shows the problem of using SOFR to replace LIBOR during a period like the present when an inflation-induced increase in credit risk dominates the pricing of short-term debt.
As the chart indicates, when credit conditions become more difficult, the spread between credit risk debt and credit risk free Treasury debt increases. The risk-free SOFR fails to capture the additional credit risk.
LIBOR Markets provided retail access through the CME Group Eurodollar Futures Market. With the end of LIBOR, there will no longer be any liquid index or debt instrument providing market access to retail traders.
The logical fallback is retail access to the internal Treasury market for short-term Treasury bills. Such access does not exist today.
A three-month liquid retail market for Treasury term debt along the way still fails to capture rising credit risk, but it does capture forecasts of future market conditions in the short term, unlike the term SOFR. .
SOFR and LIBOR. So far, the short-term debt market has reluctantly accepted the government-regulator-inspired LIBOR replacement, SOFR 3 months behind. The well-known disadvantages of 3-month SOFR in the role of LIBOR are
- SOFR is a risk-free rate with no credit adjustment.
- SOFR is an overnight rate and has no yield curve from which to predict the future cost of credit.
To form a three-month credit risk rate, users make ad hoc adjustments or rely on SOFR’s deeply flawed arrears adjustment methods. In other words, there is no objective market measure of the cost of credit risk of term credit.
Direct retail access to the Treasury wholesale market.
Retail access to the race market. Most high volume markets have an inside market and an outside market. The Treasury bill market is no exception. Retail clients can submit orders to dealers to get a dealer share of a new issue, but they have limited direct access to the more liquid on-the-fly market.
Runaway markets are the most liquid markets for treasury bills. This is a market for the delivery of Treasury bill futures during the week following the announcement by the Treasury of its intention to deliver a specific note on the date of issue. A more detailed description is here. Runaway Treasuries trade without margin or other protection against counterparty default, because traders with government securities broker status enjoy the implicit assurance that the Fed will step in if the broker fails.
Is it possible to expand the population of internal traders in the Treasury market beyond the small community of government securities traders? The answer is yes only if we can design a retail market to meet the needs of retail investors without hurting the existing population of treasury brokers.
Retail investors’ unfettered access to a financial market has historically been the result of a futures market listing that trades at the domestic spot market price.
In the case of short-term Treasury instruments, short-term instrument futures have existed historically, primarily the old Chicago Mercantile Exchange three-month Treasury bill futures. This market was a mixed success. It was very liquid until the more popular Eurodollar futures market knocked it out.
Protecting the integrity of the market on the sly. A downside of the Treasury bill futures market that may have contributed to its demise was government discomfort when the Chicago Mercantile Exchange listed its contracts ahead of the Treasury’s announcement of its intention to issue the deliverable spot instrument.
The Treasury felt that a decision not to issue a note with a commercial futures contract requiring the issue for settlement would have hurt the spot market as well as the futures market. This problem could be solved by simply listing a treasury bill outstanding only after the treasury announcement.
Lessons from existing markets for a retail treasury bill market.
Take the clues that the fly and futures markets provide.
A lesson of the market on the sly. The need to hold inventory is a burden that drives up the cost of market making. The on-the-fly virtual market is more liquid than the seasoned show market. This advantage of the running market is particularly important at the moment. The weight of expensive stocks of seasoned issues had a negative impact on the price, driving a premium for runaway Treasuries. Better retailer access to current prices would improve the price quality of the Treasury market. The chart displays the current discount on off-the-run Treasury issues, around three basis points.
Second, futures markets offer few traded instruments, concentration of traders’ interest in a few issues to increase liquidity.
Third, each futures contract trades through a single clearing house. This reduces the importance of the informational advantage that wholesale brokers possess, all together eliminating the possibility of a separate internal market. There is no advantage for high frequency traders in algorithmic arbitrage between markets. Arbitrage between the running market and the retail market will exist, but the most important part of the retail running market would be visible to all.
The attached PowerPoint file displays intra- and inter-market transaction details for a hypothetical retail market.
Retail traders could gain access to wholesale Treasury prices through the creation of an exchange that uses the properties of the fly and futures markets to create a retail-friendly spot market. Direct access to current prices through an exchange capable of filling retail orders at wholesale prices would be a big step forward in ensuring market depth for treasury bills.
The upcoming liquidity crunch in the short-term silver market suggests that now is the time to introduce this market.
Regulators have created chaos in the short-term credit markets by heavily insisting on SOFR to replace LIBOR. Market participants – broker-dealers, retail investors, purchasing institutions, retail borrowers and real estate agencies – will pay a heavy price for this regulatory hubris. Commercial banks and other financial institutions will struggle to provide basic credit through mortgages, student loans and credit cards.
A thriving market for short-term Treasuries will not replace LIBOR because it will not provide an industry-wide consensus on the cost of risky credit like LIBOR did. But if successful, it will provide a blueprint for creating a true LIBOR replacement.