Yesha Yadav on Treasury Market Turmoil and Potential Solutions for Reform

Yesha Yadav is a law professor and associate dean of Vanderbilt Law School. Yesha works on banking and financial regulation, securities regulation, the law of money and payment system, and is a returning guest to the podcast. She rejoins Macro Musings to talk about recent developments in the Treasury market and the prospects for reform. David and Yesha also discuss the future of CBDC in the US, the recent economic crisis in the UK, and a lot more.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Yesha, welcome back to the show.

Yesha Yadav: David, thank you so very much for having me back. It's such a thrill to be back in the podcast studio with you. And I should say that we're sitting here in Nashville, Tennessee, and I can see you in 3D, so it's extra special to be here today.

Beckworth: Yes, this is probably the first time we've been back recording a podcast in person. Typically, we've been doing them through Zoom because of the pandemic. We've had a few in the studio in Arlington. But I should mention in the past, pre-pandemic, we would travel to places and interview people, so you're the first one where we're doing that again. We're going out and we're visiting people, so hopefully more like this, but great way to start off our-

Yadav: I feel very special.

Beckworth: Indeed. We're going to talk to you today about the Treasury market. A lot's been going on there. A lot of talk about Treasury liquidity problems and need for reforms. Even some talk about Secretary Yellen doing Treasury buybacks. We want to get into all of that. But you've been busy working on CBDCs and bond market issues. Maybe catch us up, what have you been up to since we've chatted to you last?

Yadav: David, this is just an unbelievable time to be a law professor. It's an unbelievable time to be a person researching market micro structure. And that seems bizarre and crazy to say, because that sounds like just one of the most freaking boring things that you can possibly have. But thinking about the Treasury market and thinking about the plumbing of the Treasury market, as well as the plumbing of other securities markets like bonds, just reminds us of how important these mechanisms are for transferring value and making sure that they work efficiently and properly to maintain these markets. I've been doing a ton of work and actually having so much FOMO because there's just so much to do here. But several things that I've been up to. Obviously, the Treasury markets. I have a paper with co-author Pradeep Yadav of looking at the impact of a fragile and weak Treasury market structure on financial regulation more broadly. When our financial regulatory structure depends on Treasury so heavily, what happens when Treasury markets themselves are fragile?

Yadav: That's one line of research that's currently ongoing. In addition, I'm pretty obsessed with the bond market, and in particular why our corporate bond market structure is just so crappy. Why it sucks, why it's so inefficient, costly, why it's subject to so many delays. I have a paper there with one of my wonderful co-authors, Jonathan Brogaard, looking at the problem of a really troubled and problematic bond market structure and why that's the case. In addition, of course, is crypto. Super obsessed with crypto obviously like everyone else, and in particularly looking at crypto market microstructure. There, a bunch of my work is thinking about the role of exchanges in crypto markets, and in particular how we can think about these exchanges as potential SROs, self regulatory organizations of the future, as a way to regulate these exchanges themselves, but also as a stepping stone towards more comprehensive reform. And also, like you mentioned, David, there's the CBDC angle, which is just so cool and interesting at present, so much going on there. I have a paper with Barry Friedman that's coming up looking at some of the governance and privacy issues in relations to CBDCs. Just so much going on. And I don't want to bore your listeners with everything, but it's just so much to do here. It's just an exciting time to be in the field.

Beckworth: I have to ask on CBDC, and we'll get back to the Treasury issues in a minute. But what do you see happening in the US? It's been my impression that the Federal Reserve is not terribly excited about CBDCs, at least retail versions of it. They've seemed more positive on the wholesale side. Where do you see this going in the US?

The Future of CBDC in the US

Yadav: I think it's a wait and see approach, and I think they're taking it seriously, which is important to see, because the rest of the world is too. The BIS did a survey recently looking at different countries and there is enormous amounts of experimentation in the CBDC world. I think around 90% of the countries that they surveyed were experimenting with some form of domestic CBDC. In certain countries, we've seen CBDCs launched in pilot stages already. Thinking about Sweden for example, with the E-krona in which they have a real use case. They've been worried about, essentially, overuse of digital cash, private money, essentially, bank issued money. And they are worried that creates a certain systemic risk for their marketplace. And so, there's a real CBDC use case there, to the extent that they would want state central bank money, central bank backed money more freely circulating in the market.

Yadav: And so, they're pretty far along in their E-krona pilot. Other countries like the Bahamas, for example, they have the sand dollar. Their pilot's ongoing, as a way to build financial inclusion, for example. And obviously, China is pretty far along as we know. And so, that creates of different thought processes for the US as well, as for the EU and others, in terms of thinking about monetary competition, as it were, where a big player like China is well on the road to a CBDC. What's going to be the response of the US as well as the EU? The EU recently came out quite strongly in favor of thinking about their own Euro CBDC. So, again, the ball is pretty firmly now in the US's court to think quite seriously about what to do here.

Beckworth: Do you think one of the big obstacles to CBDC coming to the US is privacy? Is that the biggest one or are there other hurdles?

Yadav: Well, I think there's a bunch of hurdles that are involved, but there's also a lot of opportunity. But thinking down the line, how a CBDC is going to be governed is going to be key to whether or not it'll be accepted. Obviously, David, as an economist, money is only as valuable as what we believe it to be. And so, to the extent that we are willing to buy into the CBDC concept, we have to be comfortable with it. Comfortable with the fact that this is a digital currency, likely on our phones and our smartphone apps. How well it is governed, how well our data's protected, whether or not we're tracked – these are all things that are going to be really important for Americans to think about as they decide whether or not to opt into a CBDC model. And our capacity and appetite to opt into it is obviously going to be key to creating those network effects that make this, essentially, a believable currency that we can all rely on as a part of our everyday lives.

How well it is governed, how well our data's protected, whether or not we're tracked – these are all things that are going to be really important for Americans to think about as they decide whether or not to opt into a CBDC model. And our capacity and appetite to opt into it is obviously going to be key to creating those network effects that make this, essentially, a believable currency that we can all rely on as a part of our everyday lives.

Beckworth: I bring up the privacy concern because you mentioned China as being one of the leaders, the avant garde of digital currency. And you look to China and it's not the most reassuring use of it. They definitely use it a way to track people, part of their monitoring by the state. But it can be done in a more benign, friendly form, right?

Yadav: It's all about the governance. And we have a very developed public and private monetary framework that has grown a bunch of rules about how we keep our data safe, our privacy safe when using the banking system. For example, having confidentiality with respect to our data when we're using cash that is incredibly private, when we're transacting in that form. And so, trying to build in these governance protections that give us faith and confidence in using that currency is going to be essential to making sure that the CBDC concept works. One of the things that a lot of countries are realizing is that they're competing with private money. And so, in that context, when we see the rise of various types of crypto, for example, that is really being an impetus for public entities to think seriously about how to digitize their own central bank liabilities in the form of a CBDC.

Beckworth: Yeah. We could spend the whole show talking about this.

Yadav: We could.

Beckworth: Maybe we'll come back and do another episode with you, Yesha, on this.

Yadav: That sounds awesome.

Beckworth: But let's move to the Treasury market, because it's a hot topic right now and something that's really been piquing my interest is this Bloomberg Treasury Liquidity Index. And it shows that there's decreased liquidity, that there's more and more strains. And my understanding of how it works is it looks at where yields should be on these treasuries, relative to some kind of fair value model, and the idea is that since they're not aligning, there's a lack of arbitrage, there's money being left on the table. And so what we're seeing is that liquidity, the demand is not where it should be. It's alarming. I mentioned earlier that Janet Yellen has proposed the Treasury do Treasury buy backs. So, they would buy less liquid treasuries and then fund them with more liquid treasuries. You basically swap a highly liquid treasury for a less liquid one, which is interesting in its own right, things going on. But what do you make on these developments of the Treasury market being less liquid?

The Declining Liquidity in the Treasury Market

Yadav: David, the cracks in the US Treasury market have been there for a while. The US Treasury market has been struggling with liquidity for a while, but these cracks are really showing up under conditions of extreme stress and strain. That became very obvious in March 2020 when our Treasury market essentially ground to a halt, needed fed support to come and save it. And it's becoming incredibly obvious now, as the US Treasury market is really struggling under a bunch of pretty apocalyptic pressures from a number of different fronts. When I think about it, the Treasury market is facing its own Helms Deep. And for those of you who don't do Lord the Rings, that's like when our heroes are confronting their big battle. And this is Helms Deep for the Treasury market because there's several forces that are really, really, really tough for the Treasury market to navigate.

Yadav: The first is the institutional one. Some really unprecedented levels of pressure. Firstly, the institutional side. Some of the key backers of the US Treasury market that have maintained the function of the US Treasury market are having to pull back significantly. On the private side, the US Treasury market depends on these primary dealers, as you know. These are 25 big banks, investment banks, financial firms that are responsible for purchasing treasuries at auction. And obviously, with that role, they're also key in intermediating the secondary trading of treasuries, making sure that clients are able to buy and sell treasuries smoothly, and they themselves are then able to modulate their supply and demand of treasuries. These primary dealers have been essential to the market for as long as we can remember.

Yadav: But these banks are pulling back. They're pulling back, they've been pulling back for a while, for a couple of years, but that movement has accelerated over the last couple of months given the larger pressures in the economy. So, The primary dealers are pulling back. But the big, big, big problem here is that the Fed has to pull back. And we can talk about this, but the Fed is being incredibly constrained in its ability to support the Treasury market. The Fed, extending the Lord of the Rings analogy, are a great Gandalf. It's really struggling to help the Treasury market because for two reasons.

Yadav: One, the Fed has been one of the biggest buyers of treasuries, if not the biggest buyer, obviously. And now it's having to offload its supply of treasuries. That's creating liquidity pressure on the market as is, because it's offloading around $80 billion a month of treasuries. In addition, we're now doing QT, quantitative tightening. the Fed's ability to step in there with expansive support as it's done historically over the last couple of years, if not longer, to help the Treasury market function, that is also constrained, and the Fed is institutionally constrained in its ability to do that. Some institutional forces, the primary dealers are pulling back. The Fed is constrained.

Yadav: And number three, our traditional buyers of treasuries are not there with the same degree of enthusiasm and a alacrity. We've had, for example, Japan is our biggest holder of treasuries. It's $1.2 trillion worth of holdings. Japan is not buying as much. In fact, they're having to sell. And that's not just a Japanese issue, it's around the world as central banks are trying to manage their own problems, and they're doing it by offloading their treasuries. We've seen a lot of foreign selling of US treasuries rather than buying. The actors that have traditionally held treasuries are pull pulling back, so we're trying to find who's going to be the next marginal buyer of treasuries. These are all forces, institutionally, the Treasury market is dealing with.

Yadav: And then, obviously, as you know, David, there's just life. The Treasury market is there to help us live, and life is hard right now, as you know. We're dealing with inflation rates, the war in Ukraine, all sorts of issues that are really putting funding pressures or normal market actors, as well as just the need for the Treasury market becoming strong. But it is obviously a market, as you note, that's really struggling with liquidity. The ability of traders to come in there, be able to buy and sell treasuries, blocks of treasuries, as easily as they would like without affecting prices, that is not happening today because the actors that we rely on, the Fed, the primary dealers, and others, are really pulling back.

The ability of traders to come in there, be able to buy and sell treasuries, blocks of treasuries, as easily as they would like without affecting prices, that is not happening today because the actors that we rely on, the Fed, the primary dealers, and others, are really pulling back.

Beckworth: All those factors that you mentioned, they've always been a potential issue or have been issues, right? I wonder to what extent, if I can put those to the side, the high interest rate, high inflation environment by itself is also putting a strain on liquidity. Fixed incomes in general take a hit when rates unexpectedly go up and inflation goes up. The Fed's tightening, the other traditional banks are following, they're tightening too. In fact, this Bloomberg Liquidity Index... Someone showed me for Germany, France, and the UK, you've seen strains there as well for their government securities, as well. I guess, to what extent is this a sign or a reflection of the incredibly tight monetary policy, independent of quantitative tightening and lack of balance sheet space from primary dealers and other people in the market?

Yadav: For sure that the macroeconomic environment is exacerbating the pressures, there's no doubt about it. But at the same time, the Treasury market has been subject to a lot of liquidity pressure and fragility. This became obvious in March, 2020, but it was there before, that primary dealers and high frequency traders who are the key liquidity suppliers in the market have pulled back in times of strain, and it's easy to see why.

Yadav: This is a market whose market structure has changed quite dramatically over the last 15 years. It has automated. We have these very competitive high frequency traders that are bringing a lot of liquidity, but that are also putting competitive pressures on primary dealers, as well as increasing the competition for margin within this space, to be able to provide liquidity within this space. And so, we've seen periodic disappearances of liquidity under stress, and that has meant that the US Treasury market is always subject to these strains that result in disappearances of liquidity when we need them the most. I don't think it's specific, necessarily, to this moment, though the moment obviously exacerbates the pressure. These underlying fragilities have been visible for a while.

Beckworth: Yeah. We had you on a while back, and others, and you were talking back then along with them about the need to reform the Treasury market before we got into this high interest rate environment, so these weaknesses have been there. And I think one way to think about this is we're really putting the Treasury through a stress test right now. I mean, I imagine banks, too. Banks get stress tested by the Fed. Probably very few people had in their plans 4, 5, 6% interest rates. This is a true shock and a stress test that's exposing the weaknesses and fissures in the Treasury market. Maybe if there's a silver lining here, it's giving us more momentum or eagerness to address those reforms.

Yadav: Absolutely. And I think there has been a flurry of activity on the reform side, to try and address the fact that we're dealing with this gigantic elephant in our capital markets that is having a tough time. And I think policymakers on all sides are thinking very hard about this and have been. So, definitely it's given us that momentum. I think private actors, too, are on board to try and figure out solutions to thinking about how to reform this market.

Beckworth: And we're going to talk about those reforms in detail in just a minute. But before we move on, I want to talk about the United Kingdom and its recent crisis it went through with the former Prime Minister, Truss, and her mini budget that created a panic in the markets over there. And some people are saying this is an example or a wake up for the bond vigilantes, the bond vigilantes are back. And I'm not sure, maybe, I really know, what is a bond vigilante versus just a normal market reaction? When I say bond vigilante, what comes to your mind? What's the textbook bond vigilante?

Bond Vigilantes and the Recent UK Crisis

Yadav: The textbook bond vigilante might be one of the big investors. I think we had George Soros with the UK in the 1970s, I believe that resulted in extreme disciplining of the UK's fiscal policy owing to the actions of government bond traders in that market. And so, the traditional view of the bond vigilante is this external disciplinarian that's using government bond markets, potentially selling them or engaging in trading strategies that result in a significant disciplining effect on the government's fiscal policy and its fiscal direction.

Beckworth: I bring this up because it is an interesting question, and the case of the United Kingdom is, I think, a good case study in this. Was it the markets that reacted and forced the hand of the British government? Or was it the Bank of England and what it did or didn't do? And I just want to read briefly an Op-ed from Narayana Kocherlakota today, came out in the Bloomberg opinion. This is October 26th. It came out, I guess, yesterday. But the title is, *Markets Didn’t Oust Truss. the Bank of England Did.* “The way the UK government fell should worry all who support democracy." He goes on to make a case that we should worry about financial dominance, which is a term I'm seeing more and more used as well.

Beckworth: But his point is that the Bank of England fell asleep at the wheel in terms of the pensions and some of the plumbing issues in the British economy, which is a fair point. And again, going back to the stress point we talked about, there are certain things we're going to see with this pressure added, and the case of the pensions in the UK is one of them. But he argued that the Bank of England should have stepped in and kept rates low. "We wouldn't have had these losses on balance sheets," and it didn't, and it allowed things to fester, and then the government fell from power. Even if you don't agree with that government per se, it was a democratically elected government. And the Bank of England has so much power to make or break governments. Someone else, Jon Sindreu, he works for the Wall Street Journal, he made this claim as well, which is an interesting claim. He noted that when the Bank of England stepped in and bought up the gilts, that the pound actually went up in value. It'd been falling during the crisis. And he says this is evidence that it was more of a technical issue versus a fundamental.

Beckworth: The fundamental view is this budget deficit that the Prime Minister was proposing was going to create more spending, more inflation and the bond vigilantes were striking as a result. Jon Sindreu’s argument was, "It's a technical thing. The Bank of England should have been buying up these bonds to help support. It wasn't that there's too much liquidity." Or as he put it, "It's not that there was a lack of fiscal capacity or fiscal space." And his evidence is that the pound shot up. He argues that if they'd been out fiscal space, the pound would've collapsed even more and you would've imported more inflation. I think there's still an open question, open debate, but what is your sense? I know I'm throwing a lot at you here.

Yadav: And I should warn everyone, I'm a lawyer, not an economist, so everyone be fairly warned about that fact. I think what it points to is, stepping back 10,000 feet, is the incredible interconnectedness of government bond markets in today's marketplace, and I think we cannot forget that. We cannot forget the fact that our government securities, whether they be gilts or whether they be treasuries, play an extremely significant role in supporting the financial markets and different types of financial market actors. And we need to be aware of that when certain macroeconomic and policy actions are being undertaken. Now, in the UK's case, there's a great Odd Lots podcast with Toby Nangle, which folks should listen to, which details the machinations with the pension schemes and so forth. But what it makes clear is the fact that that treasuries are used as collateral or gilts are used as collateral. They are designed to be sold in a crisis. And when that selling happens, there's going to be massive amounts of pressure on the plumbing of that government bond market, resulting in all sorts of unintended consequences and pressures arising for policymakers as a result that we have to deal with.

We cannot forget the fact that our government securities, whether they be gilts or whether they be treasuries, play an extremely significant role in supporting the financial markets and different types of financial market actors. And we need to be aware of that when certain macroeconomic and policy actions are being undertaken.

Yadav: Similar things are going to happen here. The US Treasury is the safe asset for the entire global economy, for the entire financial system, not just of the US but also international financial systems. These are securities that are designed purposefully to be sold in the case of a crisis. And so, we should expect that when we're dealing with the fallout as we saw in March 2020 with mutual funds and others, central bankers rushing to get cash, that is exactly what treasuries are supposed to do and the plumbing is meant to withstand that. There's that side of it, which is the fact that treasuries play an extremely important public role in supporting the systemic stability of institutions across the market.

Yadav: There's also a very protective private role that they're playing in the repo market. They are the security to support the repo market, and we don't regulate the repo market per se in this kind of hugely technical way. We rely on collateralization to support the repo market safety and soundness, and treasuries are the backstop for that. We have $4 trillion worth of bilateral repos outstanding. I think about 68% of that is treasuries backed. And so, thinking about that level of dependence, systemically, we should not be surprised that when times are tough, for example, in the case of whatever triggered the UK's fallout as well as here, that we should expect selling pressure, enormous degree of constraint on balance sheets to respond to that, and the Treasury market is supposed to react in a way to absorb the impact.

Yadav: But given these balance sheet pressures, from primary dealers and others, it may be constrained in its ability to do so. Quite apart from the discussion about bond vigilantes isn't exactly what they do, the market's response here is unsurprising to me because of the pressure it came under, as well as the fact that it's supposed to come under that pressure because gilts as well as treasuries are performing a protective role for many different types of institutions in the market.

Beckworth: We need to get to the reform part of these discussions, because this can be exciting. But one more point on this, do you think the incredible surge in the amount of the US federal debt... You're really accumulating, in fact, $5 trillion during the pandemic, so it's really gotten large. At the same time that many of those primary dealers and other financial intermediaries’ balance sheet capacity has shrunk because of Dodd-Frank and other Basel III legislation that's increased capital requirements and such. So, you had growing need in issuing more government debt, at the same time less capacity due to increased regulations. That's a part of the story, right?

The Impact of More Debt and Regulations

Yadav: There's definitely a story there because we had around $6 trillion worth of debt in 2007, I believe, and now we're at almost $24 trillion. Our marketable Treasury security supply has absolutely expanded. And so, we have needed balance sheet space to be created in order to absorb that supply. I think what is also interesting to see is what happens next. We have $24 trillion in these marketable Treasury securities that are currently outstanding. We need balance sheet space in order to be able to absorb that supply. In addition, looking forward, we're expected to see, according to the Treasury Borrowing Advisory Committee, the TBAC, a reduction in the future issues of treasuries going forward. Most issues now are being cut in terms of how much is going to be issued going forward, at least that's anticipated. And so, what we're seeing is that future Treasury issues are going to be cut. We have this big supply here, and so we have an aging supply of treasuries, potentially, going forward.

Yadav: In other words, we are going to have a lot of off the run treasuries going forward without necessarily the same refreshing of the treasuries supply in the future. And so, it's interesting to observe that because off the run treasuries are more illiquid, they're harder to sell, they are transacting in markets that are very primary dealer dominated, the dealer to client markets. And so, it will be interesting to see what that dynamic does for primary dealers going forward, because they will be dealing with securities much more that are likely to be illiquid, off the run treasuries, without the fresh supply of treasuries being generated at the same pace going forward. At least, that's what's being anticipated.

Beckworth: That is very interesting because I just looked at the average maturity for US treasuries and it's going way up.

Yadav: It's a record, I think.

Beckworth: It drops months dramatically and then it's even higher than it was pre pandemic. And I don't know, maybe, the reason behind it. I imagine maybe some of that was locking in low rates during the pandemic, but it's growing rapidly. And so, if the maturity is getting longer, that means they're going to be holding less liquid bonds that aren't going to be rolled over anytime soon because they-

Yadav: Because they have a longer duration. I think we're at a record weighted average maturity at the present, which is 74 months. I think it's the highest it's ever been. And so, we've obviously had new types of Treasury securities coming to the market, a 20 year bond for example. These are interesting dynamics and it will be particularly tricky for primary dealers to have to deal with the fact that these maturities are quite long. They will turn into off the run treasuries. We are having potentially a less active supply of new and super liquid treasuries coming in. And so, coming back to your very first question about the bond buyback program, I think we can see the logic behind that, which is to try and create a potential valve for the Treasury to essentially refresh old and sad, clunky treasuries with new, super electric, super fun, self driving, super liquid treasuries. We can see the kind of minds at work that are trying to create this liquidity in this way, by transforming what would be really clunky off the run treasuries and replacing them with newer refresher issues.

Beckworth: You must be someone who reads the Treasury Borrowing Advisory Committee a lot, the reports. You're probably a big fan of the reports when they come out and you read them. The quarterly reports.

Yadav: Do I fess up to this? I'm not sure it does my street cred any good, but I'll say yes.

Beckworth: I mention that because I read the last one preparing for the show and they get into this question about the bond buyback. Apparently last meeting it came up and they talked about its advantages. There's also some risks as well that go with it, that you issue more and more debt, you may lose some liquidity premium. So, the buyback program is going to be fascinating to watch if it happens. I was reading an article in Bloomberg recently titled, *Yellen Flags Potential for Buybacks of Treasury Securities,* “Treasury chief notes relative illiquidity in 20 year bonds” and notes that other nations could also do buyback operations. It will be interesting to see what that means, and apparently we'll find out soon in November 2nd. The next meeting, they'll report that on their debt management policies. And this report suggests maybe early 2023 before we see anything happening. That would bond buyback is kind of a temporary fix, right?

Yadav: It's a plaster. It's not fixing the structural issues that are impacting why treasuries are becoming so illiquid and the structural deficiencies in the market. It's not what it's designed to do. It's designed to just provide a little safety valve to give a little bit of relief and balance sheet space to dealers who are transacting in off the run treasuries.

Beckworth: Yeah. And that's one of the things that was brought up in that Treasury TBAC report, was that this is something we need to use carefully and not overuse because it could at some point eliminate the liquidity premium on treasuries if we abuse it. Let's move on, then, to the fundamental reforms that have been suggested and that could be done. And let's first start with a reform that has already happened, or at least it's in the stages of happening, and that has increased central clearing. And I'm looking at another Bloomberg article here titled, *Hedge Funds Facing Tighter SEC Clearing Rules for Treasuries.* And what the article highlights is that Chair Gensler of the SEC is wanting to do more central clearing. What are your thoughts on this development?

Central Clearing as a Treasury Market Reform

Yadav: It's super interesting. I think it's worthwhile stepping back and trying to figure out what a clearinghouse actually is. A clearinghouse is an institution that is designed to make sure that bargains that happen in capital markets are executed exactly as agreed. So, if there is a potential earthquake or some entity collapses and fails, that that bargain is still going to be unaffected. The clearinghouse steps in the middle. It makes sure that it's the buyer to every seller, the seller to every buyer, and it provides the securities and the cash depending on which side you're on, and make sure that this bargain gets fulfilled. That's the function of a clearinghouse. It's this incredible stabilizing institution that underlies all of our sort of market function today. Super, super important function. What the clearinghouse does, in short, is eliminate counterparty risk. The risk that your counterparty is going to fail, that your bargain is going to be destroyed as a result. That's what the clearinghouse does.

Yadav: The question is what's the role of central clearing in the US Treasury market? Now, the US Treasury market has operated in accordance with this weird secondary market structure, which has been heavily dependent on primary dealers, these big banks. This is a secondary market structure that comes in two parts. One, the dealer to client market, where say if you're a government central bank, you might interact with a primary dealer to buy and sell securities. That's a dealer to client market. Then you have this other part of the secondary market called the inter dealer market, where the dealers are interacting with each other in order to modulate their supply and demand of treasuries. That inter-dealer market is where you have a ton of hyper frequency trading activity.

Yadav: Now, the US Treasury secondary market today has very patchy clearing. About 13 to 20% of this market is cleared and it's cleared through this clearinghouse called the Fixed Income Clearing Corporation. We're in a situation in which we're in the worst of all possible worlds. There's no full clearing. And in fact, what clearing is there, it's very patchy. Which means the clearinghouse, the Fixed Income Clearing Corporation, does not get the benefit of an entire marketplace of central clearing. That's an existing problem with the clearing infrastructure in today's marketplace, it's the worst of all possible worlds. But let's think even more broadly, what's central clearing going to do in the Treasury market? When we think about counterparty risk in the Treasury market, the reason why the Treasury market has survived so long without central clearing is because the entities that have been intermediating it, the primary dealers, have traditionally been quite safe. These are some of the best capitalized institutions, generally, within our financial markets, and so they have the buffers to make sure that they are able to go through on their bargains.

The US Treasury secondary market today has very patchy clearing. About 13 to 20% of this market is cleared and it's cleared through this clearinghouse called the Fixed Income Clearing Corporation. We're in a situation in which we're in the worst of all possible worlds. There's no full clearing.

Yadav: And moreover, it's been like a club, and so they trust each other and so it's not in their interest to renege on bargains. That is the reason why central clearing has not been implemented in the way in which it has in the equity and other markets. Now, obviously we have a new argument, we have a ton of high frequency traders that are smaller, less capitalized firms, so maybe thinking about bringing central clearing in here. And we can debate the pros and cons of doing that. However, there are a couple of issues to think about. One, solving for counterparty risk is not going to deal with the liquidity problems. Even if we say that we have a central clearing house in this market, it doesn't negate the fact that primary dealers and high frequency traders can just leave the market whenever they want and stop trading whenever they want.

Yadav: Solving for counterparty risk is not going to deal with that problem in any direct way. Sure, you can have arguments to say that, for example, because people feel safer now, maybe they'll trade more often, so there is that argument. Alternatively, some folks have argued that because the cost of central clearing will be higher, some folks may not actually want to come into the market. There are all these indirect effects on liquidity, but it does not deal with the fundamental, structural problem that market makers can disappear from the Treasury market whenever times get tough. That's one issue with central clearing that we have to think about.

Yadav: The other issue that we have to deal with central clearing is that we're creating what is going to be the most insanely systemic institution in the market ever. The US Treasury market today, weekly trading stands at something like $6 trillion a week, and, I think, as of September, $627 billion a day. We have the repo market that's also going to be subject to central clearing. This is around $4 trillion worth of bilateral repos that are outstanding at any present point in time. And so, thinking about how systemic this institution can be, making sure the design of this clearinghouse is completely resilient to all sorts of shocks is going to be an incredibly important policy matter. How do we deal with that fact? The systemic aspects of this institution coming up.

Yadav: And the final point of this is, who's going to regulate this thing? The SEC has done a wonderful, wonderful act of creation, in putting these rules out there for discussion and deliberation. But the SEC cannot act alone in this respect. Yes, the SEC is a regulator for FICC, but this is a systemic institution like no other or will be. And the Treasury market itself is governed by a confluence of multiple different regulators that need to act together. In my opinion, the SEC cannot do this by themselves at all. It's incredible that they have come forward and done so much of the work, but the execution of this has to be a joint enterprise between multiple different regulators, as well as private actors, of course. And so, we're nowhere close to that kind of cooperation at present.

In my opinion, the SEC cannot do this by themselves at all. It's incredible that they have come forward and done so much of the work, but the execution of this has to be a joint enterprise between multiple different regulators, as well as private actors, of course. And so, we're nowhere close to that kind of cooperation at present.

Beckworth: For listeners, our previous show with Yesha dealt with this issue that there's many, many regulators that oversee the Treasury market and sometimes they're at cross purposes, they need better communication. And this would be one example, right? Where they need to get together, make sure they're on the same page and make it effective. And going back to this point, it really hit me that this Fixed Income Clearing Corporation, or FICC, it could be the mother of all systemic risk, all in one node, one part of the economy, and the Fed would clearly have to backstop it somehow. It would be almost like an appendage of the Fed, at least implicitly, the Fed would have to be there and say, "We will make sure this will not affect a broader economy." And people are talking about this, right?

Yadav: They have been talking about this. And David, it's really interesting because it has led to different conversations about what kind of model of clearinghouse we need. One model that's been put forward, it's a purely public model, recognizing the fact that the Fed is going to be a critical player in this, not just as a regulator but also as a market participant. Obviously, through these past years, the Fed has been buying a bunch of treasuries and now it's selling them. The Fed itself is a market participant, a big one, if not the biggest. And it will also have to be the provider of any liquidity support and thinking about what kind of liquidity support might be needed is pretty jarring, and remarkable, and shocking and you have to use your full imagination to think about what that could look like.

Yadav: One of the things with clearinghouses is that they do, of course, have a bunch of risk management tools to deal with the systemic risk that they need. They have to keep a bunch of collateral, of course. They have to do netting, which is you set off different obligations. If you have a debit, I have a credit, we can match them and set them off so we have a net exposure rather than the gross exposure. How will these mechanisms work in the context of treasuries trading and clearing and settlement? How much margin is going to be enough for a systemic institution of this scale? Can we actually net treasuries as easily as we might equity? Treasuries come in different flavors. They're not necessarily fungible in the same way. Can we net them with the same degree of facility and ease and fluidity that we might apply to other kinds of securities that we're used to transacting in? These are all important considerations for any future treasuries clearing model, and I think it's worthwhile, at least, tempering our expectations of what we expect from a clearinghouse. Don't expect it to solve the structural problems of the treasuries market, which are manifesting in these sudden disappearances of liquidity.

Beckworth: So, it's a complex problem. Keep our expectations low. The SEC's made a nice first step. And just to be clear, that first step is that hedge funds and high frequency traders have to participate in the central clearing as well?

Yadav: What the proposal is essentially saying is that members of a Treasury CCP, the Fixed Income Clearing Corporation, those who are the members of these Treasury CCPs, have to clear Treasury transactions in relation to the repo market as well as the inter dealer market. If you are a primary dealer, if you're a member of the FICC, then whatever transactions you get into, whether they be with a non participant in the Treasury CCP, in the Treasury clearinghouse, if they're with a high frequency trader, or if they were a hedge fund, you still have to centrally clear those trades. And that's not the case today. Today, only participants in the Treasury clearing house, primary dealers for the most part, have to clear transactions. If you are having a trade that involves a leg where the counterparty is not a member of a clearinghouse… So, If you're having a primary dealer transacting with a high frequency trader, for example, that doesn't centrally clear for the most part, so the default rule changes. As soon as you have a member who's transacting, you bring the trade into the clearinghouse.

Beckworth: So, a big takeaway about central clearing is it's not going to solve a liquidity problem by itself. It does something, but it doesn't fundamentally address this concern.

I think it's worthwhile, at least, tempering our expectations of what we expect from a clearinghouse. Don't expect it to solve the structural problems of the treasuries market, which are manifesting in these sudden disappearances of liquidity.

Yadav: Not in my view. And I truly, deeply, hugely love clearinghouses and I think they're extremely important institutions, and studying them is one of my life's passions. It’s sad to say. But they are designed for a very specific purpose, which is to solve a counterparty risk. And there is an argument for saying we do have counterparty risk increasing in this market owing to the prevalence of high frequency traders as well as other participants like hedge funds for example, that are in very important participants in the US Treasury market. Of course, we do have that counterpart risk that is growing in this market, and so we should think about ways to deal with it. But let's be clear, the clearinghouse is not going to sit there and solve your liquidity problems. They need to be addressed through a broader regulatory toolkit.

Beckworth: Well, let's go to the next one, then. Increased transparency has been proposed. What does that hope to accomplish?

Increasing Transparency in the Treasury Market

Yadav: Transparency is the hallmark for our securities markets, that we have very broad transaction reporting. We can see what trades are happening in real time. The equity market is just incredibly transparent from that perspective. We are pre-trade and post trade transparency for the most part, so you're seeing what orders are going into the market, you're also seeing what the prices are at the end. That's the traditional capital markets model, which is having a lot of pre-trade and post trade transparency. What's important to understand in the US Treasury market is that this transparency is largely missing. Some of it's by design, and some of it's by regulatory oversight in some form.

Yadav: Traditionally, the US Treasury market has lacked a secondary market reporting regime. In other words, that secondary market actors have not necessarily all had to report their trades in real time as they were happening. This was remedied in 2017, with an amendment in 2019, to ensure that all members of FINRA, the financial regulator, that they were reporting their trades much more systematically. And so, this brought in a bunch of securities markets participants who are now constantly reporting their trades. So, we've increased that reporting mechanism. And now the argument is whether or not to make that reporting mechanism much wider to bring in folks that are traditionally not included in FINRA's broker dealer membership. That would now mean high frequency traders and hedge funds, to make them report much more fulsomely. That's one part of this transparency. The other part is for this trade data to be disseminated much more broadly to the public domain. That doesn't happen in real time at all with treasuries. We get weekly aggregate statistics that are published to us. We don't get this granular picture in the public domain.

The clearinghouse is not going to sit there and solve your liquidity problems. They need to be addressed through a broader regulatory toolkit.

Yadav: Now, transparency is a really tricky issue for US Treasury markets. And the reason is that treasuries are systemic. There are these systemic asset that we hold onto in order to help us in times of trouble, which means that if you're a financial institution and you need to rapidly sell treasuries, you are sending a signal that you may potentially be in trouble. If you are a central bank that is holding onto treasuries and you need to offload them, suddenly that is also potentially sending a signal about your potential monetary policy at home or issues at home. To incorporate that systemic aspect into treasuries, we've traditionally had a degree of opacity built into this marketplace. In other words, that you have delays in reporting, not all the information is publicly available. And so, certainly I think there's an argument that for large block trades that reflect the transactions of institutions engaging in potential systemically relevant buying and selling, that these block trades have some benefit of opacity for their conduct. I think there's something to be said for that.

Yadav: At the same time, in the context of the inter dealer market where we have a much more, in some ways, traditional capital market, with buying and selling constantly in milliseconds, microseconds, the argument that we shouldn't have greater transparency is much weaker. Having stronger reporting in that case, having post-trade transparency happening much more fulsomely in that space, there seems to be a good case for it.

Yadav: The one final point I'll make, David, is that the lack of historic reporting in this market as well as the lack of transparency in this market has meant that regulators have unfortunately not had a full picture of how this market essentially works and what the deeper interconnections in this market are. This has come up on numerous occasions. The most vivid, obviously, is in 2014 when the Treasury had this flash rally, when prices went haywire suddenly and no one could understand why. It took a year of an investigation to figure out and still we don't have any answers. March 2020 happened and we're still trying to work out what exactly caused the problems. Hedge funds have been implicated in that, but we don't exactly understand how and why this happened. The lack of data here has some real, profound consequences for our ability to understand how this market works and, therefore, to be able to tailor solutions from the regulatory standpoint that can help deal with the risk.

Beckworth: That's interesting. So, a lot of work in that area. So, we have increased central clearing, our first reform. Increased transparency, our second one. Let's go to our third and that's all-to-all trading. What is all-to-all trading?

All-to-All Trading as a Treasury Market Reform

Yadav: The all-to-all concept is something that is being discussed much more widely. I think PIMCO for example, released a paper recently that advocated for all-to-all trading. The New York Fed released a paper, I think it was a couple of weeks ago, again, discussing the potential benefits and models that could be used for all-to-all trading. And what all-to-all trading broadly refers to is that we can essentially transact and buy and sell treasuries with one another much more directly, whereas today we're going through primary dealers. Today, if I want to buy a treasury, I'm going to talk to a primary dealer and they're going to give me the treasury. In an all-to-all world. If I want to buy a treasury from you, David, we're on a platform, I post what I'd pay for it, you post what you would sell it for, and then we have a bargain.

Yadav: We are bringing in a much bigger set of players into this market to be able to transact more directly with one another, and one version of all-to-all trading is going to look a lot like the equity markets with the central limit order book. You're posting orders, you're matching these orders and you are coming up with treasuries trades that are reflecting the transactions of a very big and heterogeneous, diverse cohort of actors. That is all-to-all trading. There is a lot to be said for it. The proponents argue that all-to-all trading should mean that we're no longer as deeply dependent on the primary dealer banks for liquidity, and it allows all of us to use our balance sheet space to provide liquidity into the treasuries market. That's the positive use case for all-to-all trading.

The lack of data here has some real, profound consequences for our ability to understand how this market works and, therefore, to be able to tailor solutions from the regulatory standpoint that can help deal with the risk.

Yadav: Of course, there's some big issues, too. When we think about the equity markets, there is a danger in looking at our lovely equity markets and thinking that we should make everything look like equity. Because treasuries are not equity securities, they are not equities. Treasuries are the most special security in our entire marketplace. They function as a buffer to protect us against all sorts of different ills. They function, as we discussed earlier, in multiple different capacities across the market. And so, when you are dealing in all-to-all trading, that all-to-all marketplace means that you have to live with pretty huge levels of transparency. Are we ready for that in the treasuries context? And I'm not sure, given the systemic function of treasuries, whether we can still afford to say that we are completely on board with that.

Yadav: Now, of course you could make the argument that if you're dealing with a systemic trade, that you can have a separate part of the market to do block trades. We have that in equities, too. We have dark pools, for example. So, that you have these treasuries, dark pools where you're able to transact and keep things more opaque. But the problem with having that kind of structure is that you are fragmenting liquidity in the all-to-all market. You’re taking away these big players, these central banks or these big financial actors that would bring liquidity to trading and you're fragmenting them away, so they're transacting in a separate part of the market. That's not what the intention is here. The intention is to have everyone pool their liquidity. That's one issue. The other issue here is that because we're bringing in all-to-all trading, I think we really need central clearing then. I think central clearing becomes non-optional. In other words, because we have a much more diverse cast of characters, we have firms, actors that are banks, investment banks, mutual funds, hedge funds, private firms, whatever, that we are exposing the market to some real significant levels of counterparty risk.

Yadav: I think a CCP in that context for treasuries becomes pretty much non-negotiable. Are we ready for that? That's an open question. I think there's some real plus points to think about all-to-all trading. It's a great conversation that we're having here. I think we, again, need to be thoughtful about what we're suggesting, which is making the Treasury market look a little bit more like equities. But are we ready for that full sum level of transparency? And if we believe that that transparency needs to be cabined, that we are then indirectly going to fragment liquidity in this all-to-all market. We will, I think, need, definitely, central clearing in this market for all-to-all trading. And I think we need to learn from the equity market, which is also not perfect, and that also needs a bunch of different protections to save it from disruptions. Equity markets are also subject to flash crashes, and disruptions, and disappearances of liquidity. They have evolved a lot of regulatory tools like circuit breakers and other protections to deal with them. When we do have a potential all-to-all model for treasuries, we need to also think about these other structural regulatory tools that would protect that market against the kind of problems we see in equities, because we cannot afford to take risks with treasuries.

Beckworth: Well, it sounds like in its best form, which may not exist, but in its best form, all-to-all trading would increase liquidity in the Treasury market.

Yadav: It could, but it could also fragment it because of the special function that treasuries perform. If I'm a central bank abroad and I need to sell a bunch of treasuries because I need to sell a bunch of treasuries, then I don't want to be in an all-to-all market. And there's a strong argument for saying that if I do come and dump a bunch of treasuries, that may strain the liquidity of this all-to-all market, too. In that context, you may want to have your relationship with a primary dealer, in order to be able to ensure that you can do the selling you need to do and to have a counterparty that will be able to come up with the cash to do it. I'm encouraged by the conversation, because it's cool to think about these creative things, but equally we must never forget that treasuries are really special and that specialness can mean that solutions that we are used to having in the equity markets may not translate wholesale into the treasuries market.

Beckworth: Okay. Let me just summarize two other reforms. I want to come back to you with another question. But we also have in the discussion, the supplemental leverage ratio, tweaking that so there's less demand to hold reserves, and banks would hold treasuries instead. Another item that had been suggested, and actually is now in place, is the standing repo facility. And I've had guests on the show, Bill Nelson, who've indicated that it's not working exactly as planned, so there's issues there, as well. But putting all those together, all those proposed reforms together, maybe there's others. If you could wave your magic wand to fix liquidity in the Treasury market, what combination of those would you use?

When we do have a potential all-to-all model for treasuries, we need to also think about these other structural regulatory tools that would protect that market against the kind of problems we see in equities, because we cannot afford to take risks with treasuries.

The Ideal Treasury Market Reform Package

Yadav: I actually have a new one, if I may suggest it, which is put forward in this paper I have with Pradeep Yadav which is dealing with the issues with financial regulation in treasuries. *The Failed Promise of Treasuries in Financial Regulation,* it's called. And what this solution seeks to do is to create formative market maker obligations. This is something that we have had in our equity markets before, which is essentially make market makers affirmatively promise that they will stay on the market in the event that there's a problem. They promise to use their balance sheet space in crisis to stay trading on the market and not disappear altogether. And that's a solution that is tried and tested in our equities market. And I think it's one that we may want to think about in the context of treasuries, having just caveated for equities is not treasuries.

Yadav: But notwithstanding that, it's a model which means that top high frequency traders, primary dealers commit to staying on the market in the event that there's a problem. And so, in order to implement that kind of solution, I think, obviously, we may have to think about others as well. For example, the SLR. I think there's a fair amount of agreement. There seems to be a degree of consensus coming around on the need for the SLR to have some level of comfort or refining to deal with the fact the Treasury's liquidity is stressed. That's a policy objective that we need to solve for, in addition to having bank safety and soundness. We have worked really hard to make our bank super safe, and so let's have a little bit of give for the treasuries to create some balance sheet space, compliance space for the banks, in order for them to be able to make markets as fully as they might be able to do.

Yadav: In order to have these affirmative market making obligations work, I think some level of balance sheet concession would arguably be valuable, I think, from the primary dealer standpoint. And then, obviously you mentioned the standing repo facility. Now, that's a facility which is now formalized in its early days. There are definitely issues with respect to that facility. For example, it's open to primary dealers and some banks. And as we just discussed, primary dealers are making markets much less actively in treasuries today. You have a facility that's designed for primary dealers that are pulling away from this market, rather than being open to a larger cast of characters who are constantly moving within this market.

We have worked really hard to make our bank super safe, and so let's have a little bit of give for the treasuries to create some balance sheet space, compliance space for the banks, in order for them to be able to make markets as fully as they might be able to do.

Yadav: One option that's been put forward for the standing repo facility, I think PIMCO's paper advocated for this, is to make it more broadly available with haircuts and other protections, but to make it more broadly available, recognizing the fact that market making in treasuries today is not just confined to primary dealers, but also obviously includes HFTs and, to some degree, hedge funds as well. So, we have different combinations of tools that could work to try and provide for ex-post help, standing repo facility, to a broader cast of characters, as well as more affirmatively allowing market makers to promise that they will remain in the market, and then providing some balance sheet space for them in order to do so.

Beckworth: If you had to rank all of these reforms, you'd put the affirmative market maker at the top, along with the needed institutional fixes?

Yadav: For me, I think the big problem right now is liquidity. And I think one fix is certain, not a complete one, for the liquidity issue, is to try and get these market makers to stay on the market when they really need to stay on the market. And the Treasury is designed to be a disaster proof market, is designed to work specifically at times of trouble. And so, if these market makers are disappearing exactly when we need them, they're not doing their job. And so, we need to force them to promise that they are going to do their job.

Beckworth: With that, our time is up. Our guest today has been Yesha Yedav. Yesha, thanks so much for coming back on this show.

Yadav: David, thank you so much for having me. It's been such an awesome conversation. I really loved this chance to talk to you.

Beckworth: Thank you.

Photo by Stefani Reynolds via Getty Images