When the world’s largest and most liquid market shows signs of stress, investors need to take note.
Earlier this month, major financial market participants listed on the US Treasury bond market struggled to meet collateral demands made by their counterparties.
The alarm bell was sounded in the Federal Reserve Bank of New York’s Primary Dealer Statistics, in the weekly “failure” report for U.S. Treasury securities. A “failure” occurs when a market participant breaks a promise to receive or deliver securities when obligated to do so.
In the week ending April 6, there was a total of $507 billion in outages reported by major distributors, a sharp increase from $358 billion in the previous week ending March 30. The level fell back to $275 billion in the following week and was well below the peak of $5.3 trillion failures seen in one week in October in the 2008 financial crisis. But this month’s jump was remarkable: the highest level of failures since March 2020.
During that March, you may recall, the financial markets were publicly paralyzed due to the Covid-19 lockdowns. This time, however, there was no particular visible trigger event.
Even in the normal course of business, some securities transactions will fail. As the New York Federal Reserve has noted: “Failures occur for a variety of reasons. One source of failure is lack of communication. Despite their best efforts to agree on terms, a buyer and seller may not identify to their respective trading departments the same details for a given transaction.
Or, as the New York Fed puts it, there may be “operational problems,” such as those that arose after the terrorist attacks of September 11, 2001. “Less extreme operational problems can also precipitate settlement failures, and they are not uncommon.” “, He says.
But the glitches reported this April go beyond a burned-out computer or a mumbled order or two. There are a number of disincentives to control the size and number of failures. After the massive liquidation problems of the financial crisis, a default charge of up to 3 percent of market value was introduced in May 2009. The charge was expanded from Treasury bonds to US agency debt and agency mortgage-backed securities in February 2012. That adds up when looking at tens or hundreds of billions of dollars.
Part of the issue for dealers in early April was a recent significant cut in short-term bill issuance by the US Treasury, particularly four-week bills that are the most liquid form of collateral for other securities. transactions. Those would include margin posts required by clearinghouses for commodities or forex transactions.
As the Treasury has borrowed less to cover stimulus payments and additional costs related to the pandemic, its debt managers have been rebalancing the profile of its securities issuance by selling fewer short-term bills. This is in line with “good practice”: the Treasury advisory committee has agreed that only 15 to 20 percent of the total issuance should be in the form of bills.
This prudent debt management, however, does not take into account the greater usefulness of Treasury bills as collateral because their prices are the least vulnerable in a period of rising rates.
Primary dealers can take advantage of their direct participation in Treasury auctions to obtain lots of bills. Smaller market players, such as highly leveraged private equity funds or giant commodity trading houses, can then lease the bills for a fee to be posted as margin with clearinghouses against volatile energy contracts, rate interest or foreign exchange.
Primary dealers require other collateral in exchange for lending Treasury bills, most often in the form of lower-rated or less liquid securities such as corporate bonds. This process is known as “collateral transformation,” a way of turning chicken droppings into chicken salad, if you will.
Unfortunately, sometime in the days leading up to April 6, a large amount of the lower-rated collateral apparently depreciated, based on my contacts in the market. When that shock was combined with the tightness in the supply of bills, it had a collateral squeeze.
As a 2017 New York Fed document puts it: “Large and prolonged settlement failures are believed to undermine the liquidity and smooth functioning of the securities market.” As one bond market expert tells me, “This is still not at the level of October 2008, when there were $5 trillion in bankruptcies. But something is broken.