Transcript: A radical change for the US Treasury market

This is an audio transcript of the Behind the Money podcast episode: ‘A radical change for the US Treasury market’

Michela Tindera
Think about the last time you were at the beach on a warm summer day. Sitting on the sand, you look out at the ocean and it’s blue as far as the eye can see. Massive. And it’s one of those days where the water looks tranquil, inviting and calm. Now the FT’s capital markets correspondent, Kate Duguid tells me that the way I’m describing the ocean is sort of also how you can think about the US Treasuries market.

Kate Duguid
The Treasury market is the biggest and most liquid market in the world.

Michela Tindera
And like the ocean’s waters, the influence of the market for US government debt is spread around the world.

Kate Duguid
They’re also held by nearly every investor on Earth. They’re held by foreign central banks, by foreign governments. And the market is also the way that the Federal Reserve executes monetary policy.

Michela Tindera
But under certain circumstances, if something goes wrong, those calm waters can quickly turn into a storm. [THUNDER RUMBLING] One of those hit four years ago in March 2020.

Kate Duguid
Usually in moments of crisis, people buy Treasuries. But at the start of March 2020, when Covid was sort of spreading around the world, we saw this massive dash for cash where people were selling off their Treasuries.

News clips
We are shredding, shredding levels and history in the bond market . . . Well guess what? There was zero stability in the bond market, and the volatility in the bond market is at levels where it should never even be close to.

Michela Tindera
Because of how important the Treasuries market is, this chaos flooded into other markets.

Kate Duguid
We saw ripple effects in the corporate bond market as well as in the stock market, and the Federal Reserve had to step in and buy a bunch of bonds to calm everybody down.

Michela Tindera
The fact that the Federal Reserve had to intervene was a big deal. And the thing is, this wasn’t an isolated incident. There have been three separate times over the last decade where a crisis in the Treasuries market led to mayhem. But now there’s a major change coming. And the goal? Well, it’s to set the market back on a path towards smooth sailing.

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I’m Michela Tindera from the Financial Times. Today on Behind the Money: a massive change is coming for the US Treasuries market, the biggest and the most liquid in the world. But will it work?

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Hi, Kate. Welcome to the show.

Kate Duguid
Hey, how are you?

Michela Tindera
Pretty good. Thanks. OK, so we’ve had multiple different crises that have happened in the Treasuries market over the last decade. What happened in 2020 was just one of them. So what’s made this market so vulnerable to these sorts of issues in recent years?

Kate Duguid
So there are two big themes here. One is that the Treasury market has grown dramatically in size in the last 15 years. In 2008, the Treasury market was worth 5tn. Today, it’s just under 27tn. When a market grows that much, there are going to be some shenanigans.

Michela Tindera
Sure. So then what’s the second theme?

Kate Duguid
So banks were really the main players in the Treasury market before 2008? And they’ve taken a big step back since then. That role has kind of been taken over by hedge funds and high speed traders, both of whom use more leverage. So that means using borrowed money to buy or fund something. And it introduces a lot more risk into the market.

Michela Tindera
And so then that level of leverage is what makes it riskier now than it used to be maybe 20 years ago.

Kate Duguid
Yeah. So it means that there can be big swings in price. And the thing that we kind of know about these high-speed traders and these hedge funds is that they sometimes pull back in times of stress. And so if you pull back in a moment of stress, liquidity disappears. It becomes much, much, much harder to buy or sell Treasuries. If the main players in the market are taking a step back.

Michela Tindera
OK. And that’s basically what happened in 2020, right? Some hedge funds with big positions and Treasuries pulled back.

Kate Duguid
Kind of. Hedge funds had built up a big leveraged trade in the Treasury market prior to March 2020. And when the crisis hit, they had to exit that position, which meant selling a lot of Treasury bonds. It was hedge funds and others who were selling. And this led to a big dip in prices and a spike in yields. And that meant that, you know, because the Treasury market is just at the centre of the financial system, that price move really kind of rippled out into other markets. We saw it affect the stock market as well as the corporate bond market.

Michela Tindera
Yeah. So all the volatility freaked out everyone else in these other markets. So what are regulators doing to try to address this, to stop this from happening in the future?

Kate Duguid
There’s been a lot of discussion about what to do. And not a ton of action until recently. Certainly there were important things that were instituted by the Fed. The Treasury department has made some efforts to improve transparency in the market. And then we have these two big rules from the Securities and Exchange Commission in the past couple months. There’s the dealer rule, which will bring more of these leveraged players under regulatory scrutiny. And then we have this really big one, which is the central clearing rule, which will force most Treasury trades to go through a centralised clearinghouse.

Michela Tindera
All right. So a lot going on here. But the centralised clearinghouse, as you said, is the big one. And before we dig into what the rule is all about and how it works, can you just tell me a bit more? You know, what even is a clearinghouse? Help me picture it.

Kate Duguid
So a clearinghouse is this sort of low profile, not really sexy, but very vital piece of financial market plumbing. And it sits in the middle of a Treasury trade. So between the buyer, between the seller. And it takes collateral from both of those parties in order to guarantee that they will deliver the cash or the securities that they owe. Because people have to put up cash in order to make these trades, that means that there’s going to be a little bit less leverage in the system.

Michela Tindera
So how common are these elsewhere in other markets?

Kate Duguid
They exist in most other financial markets. You know we had them in the stock market. We have them in derivatives markets. but until now there exists a central clearinghouse in the Treasury market. But very, very few Treasury trades go through it at the moment. It’s only like 13 per cent. So this rule reimagines a much, much bigger role for that clearinghouse.

Michela Tindera
And so what exactly will this new role look like?

Kate Duguid
There’s still some logistics to be worked out. What we know is that, currently the rollout plan is that from December 2025, all purchases or sales of Treasuries with broker dealers will have to be routed through a clearinghouse. And then by June of 2026, all repo trades, which is another part of the market, will be routed through those clearinghouses.

Michela Tindera
Now if the US Treasuries market had had a mandatory clearinghouse when all that chaos began with the hedge funds in 2020, just wondering, how might that have changed things?

Kate Duguid
I should say here that there are things that happened in March 2020 that regulators could not have prevented. There would have been a dramatic reaction in the market to Covid, regardless of what safeguards were in place. But this clearinghouse proposal does do a couple things. And one of the things it does is it probably reduces the overall amount of leverage in the Treasury market.

Michela Tindera
Right. Like you were saying, people have to put up collateral in order to make trades. So that leads to less leverage.

Kate Duguid
Yeah. It also guarantees that people make good on their trades. And that’s a huge, you know, that’s like something really reassuring for a market in a moment of crisis. So people would probably be able to trade with more comfort and ease, a little bit more security. And, it also sort of ensures that everybody gets their money, even if a hedge fund or a bank fails, which can happen in moments of crisis.

Michela Tindera
So would it be fair to say that this having a clearinghouse, it’s kind of like having insurance on your trade?

Kate Duguid
Yeah, it is it’s a way of ensuring that these trades happen.

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Michela Tindera
After the break. What will this new clearinghouse look like in practice? And what do critics say? So Kate, right now the idea is that when it becomes mandatory to use the centralised clearinghouse, there’s this group called FICC or Fixed Income Clearing Corporation, and they’re going to be the group to manage all these trades in the US Treasuries market. FICC currently manages some trades, but not very many. As you said, about 13 per cent of all Treasury trades pass through there. So tell me more about them. Who are they and what do they say about these new rules?

Kate Duguid
Yeah. So the existing central clearinghouse it is . . . So it’s a non-profit. Its constituents are members of industry, and it currently serves as the one clearinghouse in the Treasury market. We interviewed Laura Klimpel, who is the general manager of FICC. And she described this as a sacred duty of running this kind of clearinghouse. And she said that they will do anything they can to ensure the smooth functioning of this transition and, I think, ensure the smooth functioning of the market as well.

Michela Tindera
So obviously, the SEC is a proponent of all this, and it sounds like FICC is taking it pretty seriously. But what are critics saying?

Kate Duguid
What people are you on the other side of things is that there are trade-offs, right? That people will have to pay more to make Treasury trades. And so for a hedge fund that is used to not paying very much at all, they may trade less in the market because of this, or they may trade in a different part of the market to try to avoid some of this. I would say maybe like a way to frame it is to think about it as sort of like operational friction. It just makes it slightly harder. It adds a step in trading Treasuries.

Michela Tindera
So you explained how having a clearinghouse would help in situations like with what happened in 2020, but are there any other practical examples of where a clearinghouse would have been useful?

Kate Duguid
So my colleagues and I in November of last year reported on this ransomware attack at the financial services arm of China’s largest bank, which disrupted trading in the Treasury market by forcing clients to sort of reroute trades elsewhere. It took the bank completely offline. The way to think about it maybe was sort of a mattress on the highway. People did find a way around, but there was a big disruption in the flow of capital in the Treasury market that day. And the way this sort of relates to the Treasury market now, and especially to the central clearing proposal, is that there are some people who say that central clearing will prevent this sort of thing from happening. People also worry, though, that a cyber attack, if it was aimed at this central clearinghouse, could present huge problems. Right? Like you are creating some concentration risk by housing so many of these Treasury trades in one place.

Michela Tindera
So this clearinghouse FICC, they’re going to be getting a lot of new business soon when this rule goes into effect. How do they say that they’re preparing for this?

Kate Duguid
So they’ve said that they’re adding sort of extra hardware and they’re making processes more streamlined. They’re incrementally ramping up their capacity so that they can handle more volume. So I think that there is a lot of work there being done in order to accommodate this big sort of surge in business that they’re expecting. There are many people in the industry who are cautious about FICC, but we are kind of waiting to see what the final sort of the details that they come out with, say. And so I think people are kind of holding off on judgment until they see those.

Michela Tindera
So what do you think? Is there a risk of putting too many eggs in one basket here?

Kate Duguid
Yeah. I mean, I think that concentration risk is something that we should really be talking about, right? That you’re talking about a clearinghouse for the most important market in the world. Any sort of concentration risk, you know, routing, all trades through that or most Treasury trades through something like that is going to make it extremely important. And yeah, that does increase risks.

Michela Tindera
Kate, as someone who covers this topic day in and day out, how are you thinking about the future of this new rule?

Kate Duguid
Certainly the central clearing proposal is not the silver bullet, but it will go a long way to helping prevent some of these crises that we’ve seen proliferate over the past ten years from occurring again. It is an integral part of making the market safer and more resilient, especially in these moments of crisis. The thing is, like, these crises happen in markets, right? Like March 2020, the market was going to have a reaction to Covid. The SEC can’t stop Covid, nor can it stop a market reaction to Covid, but it can help build a market that is much more resilient when those shocks occur.

Michela Tindera
Well Kate, thanks for being here.

Kate Duguid
Thank you so much.

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Michela Tindera
Behind the Money is hosted by me, Michela Tindera. Saffeya Ahmed is our producer. Topher Forhecz is our executive producer. Sound design and mixing by Sam Giovinco. Cheryl Brumley is the global head of audio. Thanks for listening. See you next week.