This guest commentary was written by Christopher Whalen. It was originally posted on The Institutional Risk Analyst. This piece does not necessarily reflect the opinion of Hedgeye.
As a primer, read that very popular post (“Fed Prepares to Go Direct with Liquidity”) and then buckle your shoulder harnesses. Many of the changes to the US Treasury and REPO markets that were predicted in our comment this past May are coming to fruition.
These changes to the structure of US markets arise because of growing concerns over the stability and liquidity of the market in US Treasury securities, fears that already led the Federal Reserve Board to hike the interest rates paid on bank reserves a month ago.
Notice, all you economistas, that the Fed has discontinued the series on interest paid on excess reserves but there is as yet no replacement series visible on FRED.
The new report published by the Group of Thirty last week contains a great deal of information about changes that are being put into place to address the growing liquidity problems in the market for US Treasury debt, changes we described earlier this year.
The report authored by former Treasury Secretary Timothy Geithner and a host of Wall Street luminaries states:
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“[A] series of episodes, including the “flash rally” of 2014, the Treasury repo market stress of September 2019, and the COVID-19 shock of March 2020, have created doubts about its continued capacity to absorb shocks and focused attention on factors that may be limiting the resilience of Treasury market liquidity under stress.” |
The report then goes on to describe why this is happening, namely a dearth of capital supporting market-making activity in Treasury debt.
And why has this deficit in terms of capital supporting the market occurred? Because of the Dodd-Frank legislation, particularly the Volcker Rule, Basle III and a variety of other factors.
The REPO market liquidity crises seen in December 2018, September 2019 and April 2020 are all self-inflicted wounds, the result of an incompetent national Congress and equally flaccid regulators, who mistake reducing and constraining market function with reducing risk. Again, the report:
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“The root cause of the increasing frequency of episodes of Treasury market dysfunction under stress is that the aggregate amount of capital allocated to market-making by bank-affiliated dealers has not kept pace with the very rapid growth of marketable Treasury debt outstanding, in part because leverage requirements that were introduced as part of the post-global financial crisis bank regulatory regime have discouraged bank-affiliated dealers from allocating capital to relatively low-risk activities like market-making.” |
The fact that we predicted this very eventuality several years ago in The Institutional Risk Analyst and Zero Hedge gives us little joy (“The Volcker Rule & the London Whale”).
The implementation of The Volcker Rule, added to the other restrictions contained in Dodd-Frank, had to result in reduced market liquidity.
We last argued this very point over lunch with the great man in Manhattan back in 2017.
In a practical sense, December 2018, September 2019 and April 2020 were caused by poorly implemented regulations that have actually made it impossible for large dealer banks to support the Treasury market in times of stress.
Can't make this up. The solution is to amend Dodd-Frank and the Volcker Rule, but Congress is far too dysfunctional for a solution so subtle.
The first step to be taken in response to this threat to the Treasury market is for the Federal Reserve Board to create “a Standing Repo Facility (SRF) that would guarantee to a broad range of market participants the availability of repo financing for Treasury securities,” the report states. H/T to George Selgin at Cato Institute and the folks at the FRB St Louis in this regard.
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“In addition, an SRF would limit demands for market liquidity under stress by allowing holders of Treasuries that want cash to obtain the cash by tapping the SRF rather than selling the securities. This would extend the logic behind the repo facility that the Federal Reserve provided to foreign and official monetary institutions at the end of March 2020.” |
Those standing Fed facilities for EU central banks are now essentially permananent, keep in mind. All this translated into English, the Fed is now going around the largest banks to provide liquidity to the markets directly.
Since the banks have been neutered by Dodd-Frank and the Volcker Rule, the central bank is now going to push JPMorgan (JPM) et al out of the way and disintermediate the large dealer banks entirely.
As we’ve said before, the Anglo-American model of finance is being discarded by the Fed in favor of a government-centric, European model a la Frankfurt.
The second major recommendation from the Group of 30 that is also being implemented is central clearing of Treasury trades. This marks a deliberate move away from dependence upon principal trading firms or PTFs for liquidity in the market for government securities.
Again, since Congress and the regulators have forced banks to remove liquidity from the Treasury markets via the Volcker Rule and Dodd-Frank, the Federal Reserve and the Treasury will fix “the problem” by ending bilateral trading in Treasury securities. The report states:
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“All trades of Treasury securities and Treasury repos executed on electronic interdealer trading platforms that offer anonymous trading by interposing an interdealer broker between buyers and sellers should be centrally cleared." |
What this mean in plain terms is that a great deal of the institutional trading in risk-free collateral is being pulled into the daylight, a change that could have significant implications for dealer banks and their prime brokerage customers.
The report recommends that all Treasury repos should be centrally cleared.
The report also goes on to say that “market participants and regulators should continue to study how dealer-to-client cash trades of Treasuries might best be centrally cleared, including via the sponsored clearing model, and assess the private and public policy cases for central clearing using whatever is the optimal model.”
As Ralph Delguidice alluded in our earlier comment, this change will greatly reduce the ability of bank-affiliated dealers to allow big leverage in client trades. The 100:1 leverage that is possible in offshore, bilateral transactions is not possible in the context of a centrally cleared transaction.
Lest we forget, excessive leverage led to a $5.5 billion loss for Credit Suisse (CS) in the case of the Archegos transactions. Such leverage involving Treasury collateral will basically not be possible.
This change has enormous implications for US based PTFs and the dealers that service their needs.
Simply stated, the rich rewards that big US banks have earned via the offshore dollar trade have been changed forever, a fact that will show up in capital markets results of the largest dealers.
ABOUT CHRISTOPHER WHALEN
Christopher Whalen is the author of the book Ford Men and chairman of Whalen Global Advisors. Over the past three decades, he has worked for financial firms including Bear, Stearns & Co., Prudential Securities, Tangent Capital Partners and Carrington. Currently, he serves as the editor of The Institutional Risk Analyst.
This piece does not necessarily reflect the opinion of Hedgeye.
