The Structure of the US Treasury Market (Primary Dealers, Fed, ETFs)
The Structure of the US Treasury Market (Primary Dealers, Fed, ETFs)
Source: Mohsen Fahmi and Elham Saeidinezhad on The Structure of the US Treasury Market
The Structure of the US Treasury Market
When we look at Treasury markets, one obvious fact is that Treasury debt has exploded in recent years. In the early 1960s, the amount of Treasury debt held by the public—excluding government entities—was about $260 billion. Today, that same measure is $26 trillion. So, there’s 100 times more debt in public hands today compared to sixty years ago.
Who are the most important players?
Primary dealers are essential in this ecosystem. In the US, “primary dealers” like banks and securities firms are authorized to deal directly with the Fed in bidding for auctions and buying and selling securities. Back in the 60s, the number of primary dealers was eighteen. By 1988, the number of primary dealers peaked at forty-six. The number of primary dealers fell back to seventeen in 2008 and has stabilized at twenty-four since.
What is the First Problem ?
One of the critical issues in the Treasury market today is that the size of the debt has exploded one hundred times, while the number of dealers has mostly stayed the same.
What is the Second Problem ?
Dodd-Frank said that banks and dealers should not take proprietary risk but only facilitate customer transactions. The idea was that if dealers focused on customer trades rather than proprietary trading, it would lead to a deeper market.
The unintended consequences of Dodd-Frank were that those banks no longer smooth out the price action in the market. A fewer number of dealers and less ability to take risks.Options
First Option:
Fed and the Treasury to intervene as the buyer and seller of last resort. When the markets stopped functioning in March 2020 during the Covid pandemic, the Fed came through with temporary measures to introduce liquidity to the market. But for most Western countries there are better solutions than this.
Second Option:
A preferable solution would be to allow and encourage nonbanks or non-primary dealers to take that risk(welcoming hedge fund participation or even private individuals). If we don’t want the public sector to absorb the risk, and we don’t want the banks to take that risk, then it has to be someone other than the banks. We need more hedge funds and private funds present, rather than less, in the Treasury market.
Third Option:
There is also a third option, which is to move away from the intermediaries. With new technology, We can connect buyers and sellers directly.
Why you think the first option is still less appealing compared to the third option?
The Fed promises low rates for a given period in the future. This is problematic because no one knows what the future will bring. Nonetheless, market participants generally believed those authorities. But sooner or later, the fundamentals changed: we had one or two percent inflation that subsequently exploded in a very short period of time, peaking at nine or ten percent. US mortgage rates have gone from 2.5 percent to 7. 5 percent. I think that is disastrous, and it could have been prevented if forward guidance hadn’t superficially pegged rates to 2.5 percent in the first place. They might have been 4 percent because the market needed to build a risk premium against the future. If you allow market forces to work, the process may be noisy in the short run, but that’s not bad. In the medium to long run, it will be smoother.
The passive money management, using exchange-traded funds (ETFs)
Additionally, over the last twenty years or so, there’s been an explosion in passive money management, using exchange-traded funds (ETFs) and so on. When a substantial percentage of the market is passive, the market size that gets traded is relatively small, destabilizing the market. So all of these factors together result in a less balanced market. That explains why the ten-year Treasury can go from 1 percent a couple of years ago to almost 5 percent.
The fewer dealers and more ETFs is reducing the diversity of opinion, which is a crucial aspect of the price discovery process in the fixed-income market.
Interesting Point
In the 1980s and 90s, you could buy and sell options on specific Treasury bonds. That market of Treasury options no longer exists. Instead, options trading has migrated to the futures exchanges. So you can buy options on bond futures but not on specific bonds. Without getting too much into the weeds, a “ten-year” note contract is actually driven by a seven-year treasury bond, which creates anomalies.
SVB
Why did they have such huge imbalances? Partly because the CEOs of those banks believed the promises of the various monetary authorities that rates would be low forever. And so, they were happy buying bonds at 1.5 percent, not realizing they would suffer a considerable loss when they went to 4 percent. But the imbalances are also partly because of their unwillingness or inability to deploy effective hedges. Banks have a held-to-maturity account, they have an available-for-sale account, and they have a trading account. And once you put bonds in one account, you’re not supposed to move them from one to the other. Otherwise, your accountants will not be happy. The IRS may be unhappy. Therefore, they put many of those bonds in a held-to-maturity account to avoid the unfavorable market-to-market. But by doing that, they got stuck with them. And so they couldn’t sell them after they fell five points. They had to wait until they fell thirty points, and in the process, they went bankrupt or got taken over for a nominal amount.
Engin YILMAZ (
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