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Non-fungible cash and financial risk

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Someone decided to give Zoltan Pozsar a hard time during the catastrophic announcement of the structure of the Treasury market.

Bank of America strategist Ralph Axel published an article on Wednesday saying the risk of liquidity problems in the $23 billion Treasury market – which has relatively standardized securities – is “the greatest systemic financial risk today. ‘today’. To the extent that the post-GFC reforms have all but eliminated the default risk of major global US banks, we suspect Axel might be right.

To support his case, he cites a July 2021 article from the Group of 30, which appears to be a non-profit organization funded by the financial industry and should not be confused with the Groups of 20 or 10. Axel also points out that Primary dealers are making a smaller share of Treasury trades even as this market has grown, a trend that has been covered here and elsewhere, at length, for years:

On a more interesting note, he argues that the relative decline in volumes happened after the financial crisis, but before the imposition of capital requirements. Banks have always been keen to blame these regulations for the (relative) withdrawal of their primary trader weapons in the Treasury market making business:

Clearly, a regime shift occurred immediately after the Great Financial Crisis – even before Dodd-Frank and Basel III came into force – during which primary dealer trading fell sharply from baseline. size of the market and have only declined since then. While Dodd-Frank and Basel III are generally blamed for this, it is important to note that it started long before the change in capital regulations.

Axel describes the Armageddon that would occur “if the Treasury market fails to trade for a while.” We won’t go too far here, because it is difficult to imagine why such a blockage would occur, unless there was an all-out strike by the primary dealers (which would surely have disastrous consequences for the primary dealers) or some sort of geopolitical crisis catastrophe or nuclear attack (which would have disastrous consequences for everyone).

Regardless of the likelihood of such an event, we agree that it would not be good for the Treasury market to go haywire for more than a few weeks, or to completely freeze for any significant period of time.

So Axel calls on a “dealer of last resort”, a position that Alphaville’s friend Zoltan has already entrusted to the Federal Reserve, to deal with this risk:

A dealer of last resort could have a number of different structures that we think could work. The most sensible would be a government sponsored enterprise (GSE) with a utility type structure. Such a GSE could be capitalized by banks and insurance companies (as FHLB is capitalized) and perhaps other institutions like clearinghouses, brokers, etc., and partly capitalized by the government. GSE capital expenditures could be offset by relaxing specific capital requirements in the banking system, for example by removing cash and treasury bills from all capital measures. In this way, the banks’ total capital (including the capital held in the GSE) would effectively remain unchanged but would be redistributed and would not create a new burden on the banking system.

Other structures are possible, but imply that the banking system comes together to capitalize an entity that would ensure the continuity of the markets in the most severe stress scenarios. The incentive for banks to do so would be 1) capital relief in other areas, 2) profit sharing with taxpayers in ongoing operations (buying in distressed markets is historically rewarding), 3) reducing the tail risks in their own market-making or market-facing businesses, 4) reducing the tail risk that market disruption might have on consumers who conduct the banking business. Like other GSEs, the concessionaire of last resort would be regulated by existing federal agencies, report regularly to Congress, and provide a social good.

We just need Congress to be proactive and create one! Easy, right?

Axel follows with a much less ambitious request to reduce the size of the Treasury market. And he doesn’t mean that in a fiscally responsible way. Rather, he argues that the problem could be solved by making it easier to substitute different Treasury securities for each other in accounting rules and other regulations:

Today, each bill, note and bond is treated as a separate item for accounting and risk. This is unnecessary, in our view, and leads to significantly reduced liquidity and broker capacity. One way to reduce the size of the Treasury market is to allow the fungibility of Treasury issues. This would allow for significant position netting and allow the dealer community to regain some of the buffer role it played before the 2008 crisis. If loans and short-term loans with close maturities could be treated as the same risk for accounting purposes, this would effectively make the Treasury market much smaller relative to venture capital. We think this could be set up in addition to a reseller of last resort to put the threat of major market disruptions behind us.

Forget non-fungible tokens: the future is in ultra-fungible Treasuries.