The Failed Promise of Treasuries in Financial Regulation

Abstract

U.S. government bonds (Treasuries) anchor financial stability. Public regulation mandates that financial firms maintain deep buffers of Treasuries that can be sold for cash in a crisis. In private lending between financial firms – running into trillions of dollars daily – Treasuries are the preferred form of collateral, designed to make debt fully resistant to default.

But this unquestioned reliance on Treasuries in public and private self-regulation has created a financial system that rests on fragile foundations. The first fundamental problem – so far unnoticed in the literature – lies in the system-wide tension that is present where both public and private self-regulation depend on the same scarce Treasuries/cash for survival.

This tension plays out in the common system of intermediation that supports both public and private self-regulation. Crucially, financial regulation places its trust in the competencies of 24 large financial firms – primary dealers – that uphold both the buying and selling of Treasuries as well as the supply of Treasuries to lending markets for use as collateral. This intermediation is deeply imperfect. As we show, primary dealers confront incurable information gaps when allocating cash and Treasuries between private lending and public trading markets. Further, facing scarcity, primary dealers must choose whether to devote resources to one space over the other. Finally, as for-profit actors, primary dealers have no reason to continue intermediating if the cost-benefit trade-off turns sour. As it stands, for financial regulation to remain resilient, its intermediation must also be lucrative.

The second problem lies in the fragmented system of supervision that governs an interconnected public trading and private lending market for Treasuries. Multiple regulators are in charge. But they lack coordination mechanisms, complementary regulatory approaches and institutional mandates. It follows that regulators have failed to spot shared risks to Treasuries intermediation and to develop mechanisms to correct them.

This Article sets out a three-part solution to fix the mistaken reliance on Treasuries in financial regulation: (i) enhancing transparency across trading and lending markets; (ii) developing consolidated oversight; (ii) and mandating that primary dealers maintain intermediation during crises. With Treasuries anchoring public regulation and trillions in private contracting, their fragility represents a danger that policymakers can ill-afford to ignore.

Keywords: debt, fragility, financial regulation, Treasuries, fixed income, dealers, systemic risk, repo, repurchase markets.