The Consequences of Regulatory Failure in Public Debt Markets
63 Pages Posted: 4 Apr 2019 Last revised: 16 Aug 2019
Date Written: April 4, 2019
This Article shows that the regulation of U.S. public debt is flawed, risking the operations of the $16 trillion market in government bonds (“Treasuries”) and the global economy that depends on it. It identifies three factors that create structural barriers impeding the effective delivery of regulation, monitoring and enforcement to the all-important Treasury market.
First, regulators suffer from information asymmetries owing to a minimalist supervisory approach that all but assumes that little can go wrong. Until 2017, Treasuries lacked a systematic reporting regime for trades, placing high costs on regulators seeking insight into the market’s workings. The rules that apply to traders and platforms are markedly lighter than those applicable in other markets like equities. Regulators cannot easily acquire information from otherwise commonplace levers like eligibility assessments, regular reporting and disciplinary proceedings. Unsurprisingly, this rulebook is now also out of date. Over the last decade, Treasuries have moved from an analog market dominated by a small group of repeat-player banks and investment banks (“primary dealers”) to one that is highly automated where nimble, lesser regulated algorithmic securities firms are in the ascendancy. This shift creates new risks that regulators lack the information to map, understand and tackle. Secondly, oversight of Treasuries is fragmented by design. Regulatory authority is shared between five or more major agencies, with none having lead status. While this structure harnesses the expertise of multiple regulators, it also raises the costs of taking action. Information gaps, turf conflicts, varying enforcement cultures and differing bureaucratic priorities contribute to apathy in monitoring, rulemaking and enforcement. Thirdly, private self-regulation is unlikely to fill the gap. Whereas a dominant small network of primary dealers might once have had the incentives to monitor themselves and each other, the arrival of algorithmic competition shifts industry incentives against self-policing. Automated securities firms are subject to an asymmetrically lighter regulatory burden, increasing the competitive threat they pose to primary dealers. Moreover all traders gain from being risky. With limited chances of being detected and punished, while facing rising costs, traders gain by being privately risk-seeking, making Treasury markets more conducive to disruptive behavior than others (e.g. equity).
Recognizing the near-existential significance of the Treasury market for the economy, this Article concludes by offering two concrete, workable proposals for review and reform. For one, it proposes pathways for more effective co-ordination between public regulators. In addition, it suggests creating greater economic skin-in-the-game for traders as a way to encourage active self-policing and commitment to maintaining the resilience of Treasury market operations.
Keywords: Treasuries, Financial Stability, Exchanges, Fragmentation, Manipulation, Fraud, Self-Regulation, Public Debt, Interest Rates, Macroeconomy, Too-Big-to-Fail
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