Fragile Financial Regulation
66 Pages Posted: 9 Sep 2020 Last revised: 5 Aug 2021
Date Written: September 2, 2020
Public regulation and private contracting rely on U.S. government bonds – Treasuries – to maintain financial stability. Regulators mandate that firms maintain thick buffers of Treasuries that can be sold for cash in a crisis. Using similar logic, financial firms rely overwhelmingly on Treasuries as collateral when lending trillions of dollars daily to one another in the short-term credit market. The assumption is that Treasuries are risk-free – the U.S. will pay its debt – and that they can always be bought and sold in a reliable, crisis-proof market.
This Article shows that this assumption is incorrect. First, while the Treasury itself is risk-free, the market in which Treasuries trade is not. It relies on an imperfect and understudied system of intermediation characterized by opacity, conflict and complexity. Center-stage is a chosen group of 24 financial firms – primary dealers – that are responsible both for buying and selling Treasuries with investors and for keeping the multi-trillion dollar short-term credit market supplied with Treasuries and cash. In performing this dual role, dealers face incurable information gaps that preclude an understanding of interconnected risks in both markets. Conflict also arises where a finite supply of cash and Treasuries must be precisely allocated between these two markets without complete information. Given such costs, dealers can stop intermediating whenever the cost-benefit trade-off becomes unfavorable, leaving investors, firms and the financial system in the lurch. Secondly, regulators are poorly placed to mitigate the risks of fragile intermediation. Oversight is fragmented between multiple regulators, cementing information gaps. Differences in regulatory philosophy stymie cooperation and coordinated supervision. In concluding, this Article sets out a three-part solution to build resilience into the Treasury market: (i) enhancing transparency and reporting; (ii) developing consolidated oversight; (ii) and mandating that primary dealers maintain trading during crises. With the Treasury market anchoring public regulation and trillions in private contracting, its fragility is a systemic danger that literature and policy can ill-afford to ignore.
Keywords: debt, fragility, financial regulation, Treasuries, fixed income, dealers, systemic risk, repo, repurchase markets.
Suggested Citation: Suggested Citation