Is the global market of critical value malfunctioning?

When America was in a difficult financial situation in 1790, with debt-servicing costs surpassing revenues and government bonds trading at twenty cents, Alexander Hamilton, the first treasury secretary, wanted a reliable market for secure government debt. He was aware of how instrumental investor faith was and, thus, proposed that all debts be respected, including those of the states, and suggested that pre-existing debt be exchanged for new bonds with a lower interest rate at face value. This idea was met with resistance; should speculators who acquired cheap debt in the secondary markets not receive a lower price? Hamilton refused to budge, asserting that "when the credit of a country is in any degree questionable, it never fails to give an extravagant premium, in one shape or another, upon all the loans it has occasion to make."

 Two centuries after Alexander Hamilton's principles came to light, current American politicians are acting in opposition to them. The debt-ceiling debate has led to an almost technical default, and the result of increasing interest rates and uncontrolled spending is a total debt of $26.6trn which is 96% of the GDP, compared to the $12.2tn in 2013, which was 71% of the GDP. The cost of servicing the debt makes up a fifth of the spending of the government. As the Federal Reserve reduces its holdings of Treasuries under quantitative tightening and increases its issuance, investors have to take on more and more bonds.

 The Treasury market has been put under enormous stress lately, and its past record is troubled. American government bonds are a significant part of the world's financial system, as their yields are the benchmark for all other investments. But these yields have become extremely unpredictable, and the liquidity in the market appears to be low. This has led to a heightened concern from government officials, who are worried about the growing presence of leveraged hedge funds, instead of more secure players like foreign central banks. An event such as the 2014 "flash crash" and the 2019 rise in rates in the repo market first alerted us to the issue. Then, in 2020, the market was flooded with distressed sales as long-term holders sold off for cash, until the Federal Reserve stepped in. Lastly, a cyber attack on a Chinese bank in November caused a long disruption of Treasury settlements.

 In an effort to prevent future issues, authorities and lawmakers are seeking ways to limit potential risks. The Federal Reserve has established new facilities for the repurchase market, so they can interact with the private sector. Weekly reports on secondary trading have been swapped out for more thorough daily reports, and the Treasury is pondering the possibility of providing more data to the public. However, these alterations pale in comparison to the reforms proposed by the SEC, which were detailed in late 2022. The SEC has asked for opinions on these plans, and may begin to enforce them from the beginning of next year.

 Ferocious debates have ensued about the magnitude and causes of issues in the Treasury market--and the degree of action regulators should take for rectification. Making a sweeping alteration to the Treasury trading process carries its own potential perils. Detractors claim that the proposed modifications would needlessly add to the Treasury's expenses. Is this an accurate assessment?

Mending the repository

 The Treasury market is a complex network that involves almost every financial institution. The government issues bills and bonds, some with coupons or linked to inflation, which are sold to primary dealers, and then to different customers including foreign investors, hedge funds, and pension funds. These buyers often raise money to purchase Treasuries through the repo market, with high-frequency traders employing algorithms to match buyers and sellers. Large asset managers often opt for Treasury futures which require less capital than an outright bond purchase. Each link in the chain is a possible source of vulnerability.

 One of the most significant proposals of the SEC is to require centralized clearing, in which transactions in the Treasury and repo markets are carried out through a central counterparty, instead of being conducted bilaterally. This would make market positions more apparent, get rid of bilateral counterparty risk, and bring about an "all to all" market structure, taking away the burden from dealers to mediate trades. Nate Wuerffel of BNY Mellon, an investment bank, believes that central-clearing regulations will be set up in the near future.

 The SEC's most contentious plan involves the basis trade, which links the Treasuries trade to the futures market. When purchasing a futures contract, investors must post only a fraction of the face value of the Treasury, which is a simpler process than financing a bond buy through the highly regulated repo market. This disparity between the cash and futures markets of Treasuries leads to arbitrage. Hedge funds take advantage of this by going short and selling a contract to deliver a Treasury in the futures market and then buying the same Treasury in the cash market. They then often repo the Treasury for cash and utilize this money for additional basis trades, sometimes even so far as to become levered fifty times their initial capital.

 Usually, this type of trading is quite low-risk. However, during times of market instability, such as in 2020, when Treasury prices changed drastically, futures exchanges demanded more margin from hedge funds. If these funds were unable to secure cash quickly, they had to liquidate their positions, causing fire sales. This unwinding of basis trades in 2020 may have increased market volatility. As a result, the SEC proposed that hedge funds active in the Treasury market should be classified as broker-dealers and be subject to stricter regulations, rather than the minimal disclosure requirements that they currently must adhere to. Additionally, the agency is contemplating regulations that would put a cap on the amount of leverage hedge funds can obtain from banks.

 The people who profit from this practice have been enraged. In October, Ken Griffin - the head of the world's most prosperous hedge fund, Citadel - claimed that the regulator was just "seeking out a problem". He pointed out that the basis trade lowers the financing costs for the Treasury since the demand in the futures market can drive the prices down in the cash market.

 Are policy makers going to remain steadfast? It seems like there is a disagreement between the SEC and the Treasury since Nellie Liang, an undersecretary of the finance ministry, recently suggested that the market may not be as bad as first thought and its issues may be due to the current situation rather than any structural issues. It is true that market liquidity and rate volatility are interrelated. Low liquidity can create more extreme rate fluctuations because even a small transaction can cause prices to change, and high volatility can also reduce liquidity as it becomes more dangerous to act as a market maker.

 Volatility has been known to be caused by external factors in recent years. Whether the chaotic British gilt market, resulting from pension fund derivative bets, or the sudden shock of March 2020 could have been avoided by an alternate market structure is highly uncertain.

 The Treasury has taken action to improve the functioning of the market by collecting data and increasing transparency, as well as by launching buybacks. This involves exchanging older, less liquid debt securities, like 10-year bonds issued six months ago, for newer and more liquid 10-year bonds commencing in 2024. Ms Liang has expressed that leverage practices that enable basis trades should be investigated, but acknowledged that this kind of trading can bring benefits such as enhanced liquidity.

Alexander Hamilton, the creator of the Treasury market, would not have been able to imagine its current form. He did, however, understand the part that speculators played in providing liquidity to the market by buying Treasuries when bondholders had lost confidence or required liquidity. He would have been much more worried about politicians potentially defaulting and the increasing amount of debt than about the participation of intermediaries. Despite the popularity of modern ideas such as buybacks and central clearing, it is important to bear in mind Hamilton's anxiety about disregarding those looking to trade.

 Is it possible that the world's most significant investment market is not working correctly? This is the question that many have been asking, and it has become increasingly relevant in the year 2023. People have been analyzing the current situation of the asset market and assessing if it is broken or not.