The Myth of Risk Free Markets
63 Pages Posted: 4 Apr 2019
Date Written: April 4, 2019
As claims on the credit of the United States, government debt securities (Treasuries) are considered to be risk-free and easy to trade. Being default-proof and tradeable, Treasuries have become indispensable as safe assets that financial firms, foreign governments and everyday investors keep to protect themselves. The rates at which the U.S. borrows constitute the benchmark against which other risky financial assets are priced.
This Article contests the belief that the Treasury market constitutes a risk-free space despite the unimpeachable credit of the U.S. It argues that a uniquely deregulated and fragmented system of oversight has failed to keep pace with structural transformations in market design. Historically, Treasuries have been bought and sold using telephones, intermediated by a dominant cohort of big banks that have had economic stake in the market’s success. Newly driven by automation, however, Treasuries now trade in milliseconds, led by a class of smaller, lesser-regulated traders that can easily enter and exit the market. Weak regulatory constraints and limited reporting has left Treasuries vulnerable to traders engaging in risk-seeking and opportunistic behavior. Regulators possess few tools with which to understand the complexities of automation and to craft policies to control disruptive practices. Private oversight cannot fill the gap. Fierce competition between banks and lesser-regulated firms reduces incentives for traders to cooperate in peer monitoring and policing. Instead, it can encourage all players to engage in profitable risk-taking: exit is cheap and the chance of detection and sanction exceedingly low.
This Article details the economic harms arising from a Treasury market structure that is systemically susceptible to risk-taking and sudden exit by its traders. In the worst case, Treasuries stand to lose their reputation for reliability and stability, to the detriment of the taxpayer. The Article concludes by proposing pathways to foster meaningful coordination in oversight as well as to give traders real economic stake in the health of this singularly essential market.
Keywords: Treasuries, Financial Stability, Exchanges, Fragmentation, Manipulation, Fraud, Self-Regulation, Public Debt, Interest Rates, Macroeconomy, Too-Big-to-Fail
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