On Friday, June 5, 2020, Darrell Duffie joined the Princeton Bendheim Center for Finance to discuss redesigning the U.S. Treasury market after COVID-19. In his presentation, Duffie argued that the current design of the U.S. Treasury market creates moral hazard. He outlined a new proposal for transitioning the market from one that runs through dealer balance sheets to one with broad central clearing.
Duffie is a Professor of Finance at Stanford’s Graduate School of Business.
n March 2020, the U.S. Treasury market “choked” with the demand for liquidity, requiring the Fed to intervene. Duffie noted this is the fourth time in the last century that the Fed has had to intervene in the Treasury market. Ultimately, the Fed purchased $1 trillion of treasuries in only three weeks’ time, followed by more purchases.
The Treasury market failure resulted from overwhelmed dealers. Because the market is dealer-intermediated, dealer’s balance sheets became over-stuffed. A pipeline effect overwhelmed dealers, even though they were performing their role and expanded intermediation. See chart of total Treasury market trade volumes.
We can expect this market failure to happen again—and perhaps more often. U.S. debt-to-GDP is growing enormously, resulting in more Treasury securities that need to be mediated by the market. See chart of growth in marketable treasuries.
Duffie’s proposal: Treasury market structure based on broad central clearing is preferable. It’s inefficient to run the entire Treasury market through dealer balance sheets, Duffie argues. Broad central clearing would 1) improve the safety of settlements in the market and 2) through netting of purchases against sales, reduce the amount of dealer balance sheet needed for a given volume of trade, and 3) allow for the possibility of all-to-all trade in the future. See illustration of current and proposed structures.
One barrier to reform is private sector preferences. Dealers prefer the current set-up and are unlikely to support a transition on their own. There’s a clear role for the official sector. Duffie argues mandating central clearing in the Treasury market is a public good.
There are three roles for the Fed to play in this new market structure. First, they should always be available to restore liquidity. Second, and perhaps more controversially, they could provide last-resort intra-day liquidity to the CCP for Treasury collateral, similar to the discount window for banking. Third, the Fed or the SEC can supervise and regulate the new facility.