Why is the U.S. Treasury Market So Fragile?

Abstract

Post-2008 regulatory reform depends on U.S. Treasury bonds to anchor financial system stability. As a readily tradeable asset carrying negligible default risk, Treasuries have become the preeminent safe haven in troubled times. Financial firms must maintain buffers of Treasuries that can be sold for cash and insulate against insolvency. Treasuries also constitute the preferred form of collateral in the six-trillion dollar repurchase (or repo) market used by financial firms to fund their everyday activities. This Article shows that reliance on Treasuries in financial regulation rests on an assumption of stability that is illusory when viewed against the fragilities embedded in their market structure. It makes three claims. First, Treasury markets are subject to supply shocks arising from the unexplored interconnection between the Treasury-backed repo market and the market for trading Treasuries. The greater the volume of Treasuries collateral “trapped” in the repo market, the smaller the supply of Treasuries available to trade with investors in secondary markets. Secondly, intermediation is crippled by cost and diminishing incentives on the part of key intermediaries – the primary dealers – to keep markets resilient. Primary dealers confront opacity, unpredictability, and competition, reducing profits and eroding their incentives to invest in treasury market resilience. Finally, regulators are ill-equipped to fill the gaps and develop rules for the safe use and trading of Treasuries. Supervision of Treasuries rests on a system of fragmented oversight where regulators struggle to coordinate. Further, Treasuries trading and Treasuries-backed repo markets are subject to distinct regulatory approaches that do not reflect the interconnection between them. In concluding, this Article provides three pathways to repair the stability illusion in financial regulation: (i) greater reporting and transparency, particularly in the repo market; (ii) stronger private market incentives to invest in market continuity; and (iii) a coordinated approach to oversight that can harness agency expertise to protect the most systemically significant markets in the world.