Josh Younger Explains Why the Bond Market Has Been So Volatile

been it is volatile. Is cryptocurrencies? What they have been volatile? Now, wait a second, there was a day where they actually were more volatile than bitcoin at least, and I think it was It was earlier this month after the Wall Street Journal released that article saying that the FED might hike rates by basis points right, and suddenly we had this big move in bond yields and I think the tenure U S Treasury the yield on jump something like twenty eight basis points in a day, which was I know,

you love this a four standard deviation move and the kind of thing that's only supposed to happen based on normal distributions, Like once in a century have you ever seen that tweet about this seemed to leave breaking through the wall like the cool man? Have you? Like every time someone says standard deviation, I'm not surprised. I'll find it for you. Thank you. There's a really funny tweet about it. Anyway, I will say that was a wild day.

I remember that Nick timorrose at the Washer journals and they're gonna go instead of fifty and everyone believed them and right, and it was just this huge instant repricing of the entire curve, like really shocking, right, And so a four standard deviation move, make of that what you will. But bitcoins like move in the same period was something

like two point seven standard deviations. So we're talking about the market for US treasury debt, which is one of the most probably the most important market in the world. It's basically the risk free asset against which all other assets are judged, and it's supposed to be the most liquid market in the world as well, And yet it's having these big moves. And this isn't the first time, right, you know, I said a move that's only supposed to happen once in a century, But actually we see these

moves relatively often. And of course we had the big blow up in yields in March. We had a big rally in yields, and I think it was. We've had numerous other high profile incidents where the market just seems

to like go nuts in extreme periods of alatility. We do see this stress and it's it's not supposed to happen, right, Like, that's the whole idea here, which is that there are certain financial assets where yeah, it's supposed to happen, kind of with treasuries because they're theoretically risk free, and because say they can theoretically be you know, theoretically from an economic standpoint, be like equivalent to reserves or almost like

cash at some point, the ultimate safe haven asset, uh asset. They're supposed to just be that, like the one, the one predictable thing, the son of the you know, the sun, around which the financial universe revolves around, and everyone's in a while, it doesn't happen, and that's not good. Yes, not good is a good way of putting it. The other thing that's happening at the moment is the FED

has started to unwind its massive balance sheet, right yeah. No, So it's like I get another factor here, right, um, And that actually happened. I think they started unwinding in the same week where they raised interest rates by seventy five basis points, so of course no one actually noticed that this had started. But there's all these things going on in the market. It seems like we keep getting these dramatic events, so we really we need to dig into it, don't we do it? All right, we do

actually have the perfect person to discuss. We are going to be speaking with Josh Younger. He is currently a managing director and Global head of Asset Liability Management, Research and Strategy at JP Morgan. He was previously doing cell side research at JPM, writing about interest rates and money market. It's which I think was the last time we had him on and I didn't know this, but he was previously an astrophysicist, studying things like black holes and what

happens when large objects collide against each other. So maybe the perfect analogy for the bond market. Perfect, all right, Josh, thank you so much for coming on. All thoughts, Thanks very much for having it. It's great to be back.

So maybe just as a as a beginning question, I think people have probably heard that there may be liquidity issues in the U S. Treasury market, or certainly there are these bouts of volatility, but could you maybe give us some color of what exactly we mean when we talk about liquidity in the treasury market and what exactly happens on a day like the one we saw recently

where ten year yields made this massive move. Yeah, so I know it's it's always weird to see a four standard deviation event, but if people were around, we had a fifteen standard deviation event at least over a short time scale. So, pulling in my old education, that's not supposed to happen in the lifetime of the universe. So, uh, standard deviations have their place. But you know, the normal assumption, the Bell curve assumption, is not always necessarily the best one.

And for treasury markets in particular, you know what people like to say that there are lots of fat tails, like like unfrequent things happen at a much higher frequency than you or otherwise expect. That's true of all financial markets.

It's definitely true bond markets. But the question when we bring up liquidity is if we look at big changes in price, is that because things have really changed, or is it because there's some kind of market functioning or other issue that is causing the price change to be

exacerbated for reasons other than fundamentals. So, uh, this is a tough environment because you know the ft is actually raising rates by seventy five basis points in a meeting, So the outlook is truly changing rapidly, and so rapid price changes would be expected just because you know the fundamentals are shifting at the same pace. But we do want to figure out out and watch if the market is unable to transfer risk, because that's kind of what

the markets supposed to do. This was a lineup buyers and sellers and take care of those bonds that don't have an immediate buyer but have an immediate seller vice versa. Like they're supposed to smooth out these fluctuations by by having somebody in the middle. It's a market maker who's the buyer to the sellers and the seller to the buyers, and and can hold onto stuff that doesn't have an immediate home. It's just basically running a store, right like

you're running a candy store. You've got inventory, you have orders coming in, you've got customers coming in. You need shell space, but you also need to make sure you have enough customers to take out the inventory you're getting in so you need to line all those things up, and unfortunately, when you're a market maker, you can't really control your inventory right that someone else's decision as opposed

to the candy store. But there are different ways to to look at this um Usually we talked about the depth of the market, which is if you look at the screen. You're a trader on a desk and any given dealer and you looked at the screen electronic markets between dealers where they put up you know, I'm willing to buy this much at this price or sell this much at that price. How much size could you move near the current price in the market. That's the market

depth that's really low. So that's immediately concerning because if depth is low, that means if I go to sell something that's bigger than the size on the screen, presumably the price is going to change. And if that size on the screen is really small, then an incrementally larger trade still small in the grand scheme of things, is going to move the price a lot. And the implication is the market can't transfer risk without a big price impact.

So that's that's really important before moving on from that on market depth. So okay, like Nick Timorrose comes out and says they're gonna go. Of course you would expect to see a big move because there is fundamental news. There's a reason for the price of the curve to change. Is markets digest the sort of new thing about the fed trajectory. But as you say, it's like, okay, that's gonna happen. How do you measure depth? What would be sort of normal or healthy depth? Like, how would you

quantify that? And then what is the quantification of depth? Right now? When the when the dealers look at their screen. So we're data limited here because there's there's really two kinds of markets that exist in something like a hubb and spoke or a network. The first is the net the the end users, right, so the holders of treasury bonds. It could be a foreign central bank, it could be an asset manager, a hedge fund. But the non dealer, non bank end users of bond debt, so they just

hold it as an investment or a speculative asset. And then and that market faces the dealers because when you go to sell that bond or by another bond, you call up your dealer, right, So there's there's an interface there that is not particularly observed, but we don't really

know what's going on there. Usually people call that voice trading, which is really like in the institutional market, I would call up my dealer and say I need to sell you a billion of tenure notes like big trades, big institutional trades, and when retail gets smaller sizes, usually there's some institution standing between them and the dealers, and then there's the market between the dealers themselves. And in this

context dealer we'll talk about. I'm sure that the h f T component of this the high frequency component, but like the injured dealer, market is the way that dealers pass frists around between each other, and in some sense that's the more important market because if you think of yourself as buying whatever someone is selling, and selling whatever someone is buying, the amount of size you're willing to show that the size trade you're willing to do is

informed by how easily and cheaply you can hedge that. So the way I like to think about this, and I'll get to your question in a second, the way to think about this is you've got sort of risk coming in from the outside, and users selling a bond, for example, say they're selling a billion of those tenure notes, They're going to call one or two dealers, not gonna call everybody. Those one or two dealers are going to buy that debt at some price, and they're gonna try

to hedge it. And what hedging really is is socializing that slug of risk across the broader complex of dealers. So they're all going to keep a piece of it, but they're not going there. One dealer is not going to hold the whole billion outright, there's too much risk to hold as a market maker. Yields move a little bit, all of a sudden, you've run through all of your capital, and that's a problem. So the active hedging is the act of taking pieces of that and spreading it around.

And that's what the inter dealer market does. That's the electronic market that trades much more frequently. It's a decent chunk of the overall volume traded, but it's almost entirely concentrated in recently issued bonds. Broke a text by part of the biggest venue for that UM. And that's where we have good data because it's electronic, so we can see the screens, so to speak, UM and we can capture that data, and we can look at, say the the total number of bids and offers within say two

to three levels of the best price. This is the central limited order book. People call them CLOBs um, which is always kind of a fun acronym, but they can track that and say within three levels of the best price, there is x million dollars on the screen to trade on average during say the New York trading session. When you do that, on average something like a hundred and

fifty million. Over long periods of time, for the past ten years, that's averaged something like a hundred and fifty two hundred millions, so that would be sort of typical and bad times that can go down to five to ten that's what we had in Now it's probably around

fourty or fifty million on average. Now this fluctuates a lot over the course of the trading day, but this is like if you were to close your eyes and then you know, pick a time and look at it, you get something like forty million to trade within three levels of the best price. So that's low um. The reason why that's important again is because that's that's the liquidity available to the dealers themselves to hedge their risk, and so if that number gets higher, they're willing to

make bigger markets facing clients. If that number gets smaller, they're willing to get make smaller markets because they don't have confidence that they can hedge out of the risk. So that's low along the lines of different volatility episodes we've seen in the past. So if this was August, it would be probably a similar number. If this was June or July the Taper tantrum, you get similar numbers of that UM. March of twenty was much lower UM.

In November of two it was much lower UM. So you know, it's been worse, but it's definitely not not great out there. Can we talk a little bit about March because I think that was when we first had you on and we were talking about this big sell off in the bond market, which was exactly what people didn't expect to happen when we had a huge risk off event which was the global pandemic and equities sliding

and all of that. What exactly is the consensus around what happened in March of what was the issue that that whole incident exposed. So it's funny, I think if if memory stars I was supposed to talk about live or form. We talked about and I think we eventually did, like a few months later, but it like we did ye more interesting events intervened. Yeah, so this brings up a really important question, which is a liquidity versus market functioning,

Like what was so much worse back then? Because the FED is unwinding their balance sheet, like you said, they're not buying three trillion dollars worth of assets over a few weeks were three trillion rather, so there's clearly a lot less sense of urgency about the impact of this illiquid episode versus the events of and And that's where I think we should be very specific about what we mean by liquidity, because what we really mean we're always

feeling around. This is the different people feeling different parts of the elephant. But like once a trunk wins, one's of one's a foot, but they don't really know the whole picture. I think if we were to have the full the full picture of the market, all the participants and all of their risk tolerance and positioning, and we would really be asking this question, can I sell when there's more sellers and buyers? How much does it move

the price? Um and The implication there is can I turn my treasuries into cash at a reasonable cost in a reasonable period of time at scale. And that's not just part of the fact that the treasury market is perceived as risk free and is quite large. It's built into a lot of the law. The the liquidity coverage

ratio does not distinguish between treasuries and cash. I'm not a lawyer, but there's I believe a part of the I R. S Code that says you can actually pay your taxes in treasuries, which is the only financial asset you can directly pay your taxes in. So like a chart list would say, well then their money, right, And so treasuries have special status and lots of different ways. The reason they do is because it's supposed to be as close to cash as any financial asset can be.

And that means I can move large size at low cost because when you when you turn your bank account into physical cash, they don't charge you a fee, right, So so I need something that's convertible into into real currency.

The low cost and back in not only was depth low, but the bid esque spread in the market was a wide So what's going on now is the depth is low, but if you're able to trade, you're able to trade it roughly the biddest spread you were able to trade out a year ago, especially in benchmark issues like the tenure note back, it was three, four or five times wider. So there were no bids or offers within three levels

of that market price. In fact, the market price if you don't have bids or offers within one or two ticks of the market price, then it's not really the market price. We don't really know where the market price is. And so back then market the market was not functioning, it was not just a liquid and that's where the urgency comes in. So the question is what's different now versus ben What's going on now is a revision to expectations.

But more importantly, this is an environment that's served familiar in certain respects. You know, we've had inflation before, not recently, but we've had it before. We know what it is, we know why the Fed is raising rates, We have

reasonable confidence around the range of potential outcomes. Will argue about where the Fed is going to stop, but we know they're going to keep raising rates until inflation comes down, and we can say three four percent, five percent but I don't think anyone's out there calling for fun trade. So these are with thein the bounds of things we've seen before. Back in it's so easy to forget just

how crazy the set of uncertainties was. And like, for example, there was speculation they would just close the market for some indeterminate period of time. Right, so if the markets closed, the bidst spread is infinite because you can't transact, So if you need cash, you need to get it now. So like that creates a lot of urgency. So just going back to March for a second, and as you laid out nicely, like the law basically says treasuries are cash or very close to cash or cash like and

should be treated as such. But if I recall, like with Mar, part of the issue, and part of the reason we saw these sort of extreme widening of the spread is that even though there's theoretically free money on the table for someone to come in and close these spreads, that the demand for like pure cash was so strong that nobody, no actors in any any part of the ecosystem, whether it's edge funds or banks or whatever, wanted to deploy capital, deploy balance sheet to close these spreads to

take advantage of these opportunities at scale. And so is the problem or is there sort of like a core problem with Yes, we want to treat treasuries is cash, but the way we have the system set up is such that we still depend on the risk taking appetite of private investors to actually do that job in the end. Yeah, so this gets to, you know, what are these dealers actually doing? And I was I was referring to, you know, matching buyers and salaries is one function, and holding inventories

the other. I'm gonna reference the SLR, the Supplementary Leverage Ratio, because it's one example of a regulation that creates a very different set of incentives for dealers that are has within banks. And what the SLR does is it makes all balance sheet count the same towards your capital requirements.

It makes balance sheet to scarce commodity. And that's not necessarily a problem if it's not strictly binding, or or there's relatively too a flow meaning as many buyers as sellers, but in a one sided market where there's mostly sellers, and that's what you're referring to, the most people want cash.

They don't want securities. It makes it very difficult for a dealer that's housed within a bank to hold that inventory because what what what balance sheet constraints do, what leverage constraints do, is they turn that allocation of balance sheet into a zero sum game. So when the treasury desk, for example, wants to buy that billion dollars for the

tenure notes, and they are near their allocation limit. Because if you want to limit the amount of balance sheet of business uses, you just gave it everyone a limit like that's a plausible way to do it. So that that creates rigidities. And let's say they call up their manager, and they call their manager and it goes all the way up to chain. They say, I need another five

billion of balance sheet because there's so many sellers. And I'm the treasury desk, I'm I'm I'm processing the most important market in the world, right, so I need I need that extra balance sheet. The reaction as well. So does the prime business, so does the credit business, so does the front end business, the short term credit desk, so does the corporate lending business where you're drawing a revolvers.

So everyone's got their hand out, and that's a zero sum game in the sense that like there is a balancie allocation that the firm can use, and it it makes it very hard in practice, especially at a high frequency, like a high pace, things were moving quickly to get those allocations where they need to be when they need to be there. If you think back to that period of time, it's easy with hindsight to say, well, you know there wasn't that much selling, but you don't know that.

In the moment um. It's like driving a car three hundred miles an hour towards a towards the wall with your eyes closed and like it might work out, but like it might not, and that creates a lot of hesitation. So you have what's referred to as the dash for cash, but it's really about a relative urgency to find liquid assets, not securities, not long term securities, due to this concern that one you might need that cash for something, and

too they might close the market tomorrow. That's the background. I think the important thing to keep in mind as well, and I think we talked about this back. There was this push over several years to take those market making functions and in parts, split them into two parts, and

push them out of the banking sector. Now this wasn't purposeful, but that was the set of incentives ever created, so that when you think about matching buyers and sellers, high frequency traders took on a lot of that responsibility, and they did that by doing very very high frequency, fast arbitrage trades to try to spread the risk around really

quickly and go home with no inventory. So high frequency traders generally don't have inventory at the end of the day, so they're doing only matching like that's that's that's most of their function and they were of that on screen depth, so they were the majority of the market, but they can't operate in a high volatility environment, so they tend to The thing about h f T s it tends to actually back away if something big is happening, right like if there's a big data release, like often the

machines will kind of back away from making that market until things settle down a bit. Yeah, like that at the time, if you were to if you were to look at the way the market trades in the three seconds before the payrolls number drops on monthly Fridays, and look at any day any period of that two weeks span, and just how the market is trading like it felt like payroll Friday at eight thirty all day long for

two weeks. And the reason is because if you're a higher concentrator, you're trying to make those bit esque spreads. You need to sell for a dollar and and and buy it back for a little less and so like if if market markets are moving around a lot, it's really hard to monetize the spread. So there's a reason for this, but in making it more complicated and costly

for bank dealers to perform that market making function. In businesses like treasuries, the h f T s stepped in to fill that need like a life finds away moment. So they step and fill the fill the need. They do a great job until things get dicey, and then that business model does not operate well when vall is very high, so they tended to jump and and and

drop the size they're willing to show. Can you talk a little bit about the overall size of the treasury market as well, because we have seen the US deficit growing. I think the amount of treasuries outstanding is at something like twenty three trillion dollars at the moment, and it's gotten a lot larger in recent years. Even though the FED has been purchasing US treasuries up until recently, how does that impact ease of trading or the way the

market functions. Well, the FED helps a lot when they buy half of the net supply for the past two years. So there's been sort of two things going on there. The first is the FED is really there too absorb the supply, uh. And the second is the commercial banking sector, which I believe is the sixth or seven of the US commercial banking sector, which I think is the six or seventh larger largest holder of treasuries, has been the

second largest buyer over the past two years. And that's because when you grow the size of the banking system, which is what KILLI quantitative easing does, there's this natural need to find assets to support those new deposits. There's new liabilities, and so banks have stepped into to absorb a lot of supply, and there's a bunch of other components in the market that that do sort of take

on a decent share of it. But the question is more, is the market too big for the intermediation capacity offered? I would argue that's probably still the case it's certainly grown, if anything, and and bank appetites to market making treasuries is not concreased. But that introduced vulnerabilities. So just because that ratio is a little off doesn't mean the whole world is going to fall apart at any moment. But when the stress hits, which is what happened in twenty,

it really struggles to serve that function. And that sort brings up the second thing that that non bank dealers were doing, which is on the hedge front side. We probably talked in at the time about basis trades and and specifically holding securities levered with repo, so levered longs in treasury securities that were hedged with futures positions. There

was a big position that built up over time. Cause if balance sheet, again is a scarce commodity, it's a zero sum game, then you have to sort of use it or lose it as a client. And one way to do that is to have positions that utilize a repo line. You're sort of using your line of credit, but you're hedging the risk in the futures market, and so you're not actually taking any market risk, but you're using your allocation, which looks a lot like holding inventory.

What dealers tend to do is they tend to be long off the run securities off the run securities or bonds that were issued a little while ago. They're not the most recently issued security. That's what long term holders tend to have, like stuff that was issued a while ago when they sell it. Deals hold that inventory, and they hedge in the futures market. On the hedge fund side, there was a position that built up which was pretty passive, mostly designed to use it rather than lose it on

balance sheet, and that looked a lot like inventory. And so you have these two functions of matching trades performed by h f t s and holding inventory performed by hedge funds. That was a brittle arrangement because it was basically taking the market making capacity and allocating it away from banks to relatively unregulated institutions who are not subject

to the SLR, for example. And what happens in that whole system comes crashing down because of a variety of operational and market related concerns that basically make it untenable to hold those basis positions and very difficult to operate

a high frequency trading operation. And so you have all of this intermediation capacity that's in principle provided by non banks, all of a sudden disappears, and if when the banks are asked to take on the slack, they simply can't do it for a reasonable price, which is why this whole arrangement came to be in the first place, and so the market stops functioning. Can I just ask, is this sponsored repo? So this is just repo in general?

Some of it sponsored sponsored repo is definitely worth talking about in terms of some of the solutions that are proposed to this issue of intermediation capacity, But this is just repo funded positions in general, sponsor and otherwise, Okay, shall we talk a bit about sponsored repo in that case, because this is talking about dealer's ability to intermediate the market being perhaps too small or too constrained versus what's

going on there. And as you say, one of the solutions to this issue has been the idea of sponsored repo, which I think basically I wrote about this years ago, so I can't remember everything, but I think it basically allows banks to transact with counterparties like hedge funds without necessarily bumping up against balance sheet constraints, and I think they get it from the f d I C or no, sorry,

from the f I c C from Thick. Yeah. So if the issue is balance sheet is a zero sum game, then if you can increase the amount of balance sheet that's being passed around the balantie capacity of banks, then you've addressed the problem in part. So there's a couple of ways to do that. The first is you can just change the rules, right, and that's that's what the

Fed actually did on a temporary basis. They made a temporary change to the supplementary leverage ratio that said, if you're if it's or its treasury is on balance sheet, which is an important distinction, but if the cash your treasuries, it doesn't count anymore or for at least a year.

And the idea that was to create capacity, right because now the size of my balance sheet I used for that supplementary leverage ratio is just smaller, and certain things don't contribute to that number, so I can do more of them. In principle, that was the theory. That doesn't necessarily work that way in practice, but you know, it's a separate thing. So one way to do this is

to change the rules, change the game. The other way you can do it is played a little differently, and so you know, one thing that was proposed very quickly after after the crisis in was to introduce a broad

clearing mandate for the treasury market. And the logic for that was, on the one hand, it reduced settlement risk by having all of these transactions go through a central counterparty, so it will be less likely that securities, for example, I could not be found in time, have less failures to deliver, which in principle has an impact on uncertain

capital requirements and so forth. But you know, the more interesting from my perspective, impact of that was that in the repo market, if you were to clear all those trades, the impact of central clearing is, say everyone's facing the

same counterparty. They're all facing fix, which is the clearing house. Um, it's the same way it works in derivatives markets, where everyone faces the CME because they're all there, all their derivative exposures, all those contracts are novated or transferred to a central counterparty that serves as the other side to every trade, and so like they're naturally off setting because every derivative markets are definitionally zero sum, and so they

have all the positions they can. They can match off trades and reduce the overall through credit risk embedded in derivative contracts. So in the in the treasury market, the idea was, well, what if everybody just faced thick And that has a couple of implications, but one of the most important is that when they banks measure their balance sheet. One of the ways they do that in repo markets, as they say, am I facing the same counterparty? So if you borrowed with the left and lent with the right,

you're kind of economically neutral. But if you do that facing different counterparties, then they both contribute or one of them contributes to to the leverage. And and that's because those two trades can see each other in principle. But

if everyone's facing the same counterparty, then they can. And so the idea there was, well, banks will get balance sheet relief and elasticity, meaning they can grow their exposures as needed because there'll be lots of offsets in the way you measure leverage, and if you can count all your economic offsets in your regulatory exposure, then that ratio is less binding, which is like a lot of technical ways to say, you know, a central counterparty will reduce

the amount of letg. You have to show from your regulatory requirements. Why can't they just make those rules the one year your rule where they said treasuries are equill cash, why not just make that permanent, especially since other parts of the law indicate that, and as you mentioned, like you can pay your taxes with treasuries, So why not just if so many parts of the law say treasuries are cash, why not just have that be a permanent

part of bank regulations. Well, people have made that argument. It's an ongoing debate as to other treasuries to be excluded. It would be a little difficult in the context of international standards to exclude treasuries and not be a little out of out of the mainstream. But certainly cash at the FED is one of those things that people argue

shouldn't be included. And one way to think about that is if you get a lot of how might can re line of credit right, and you take a hundred thousand dollars out and you take that hundred thousand dollars you put in the bank account and keep it there. Don't do anything with it. So you always have cash in the bank to pay down the loan, but you still have the loan. Has your credit gone down? Are you less credit worthy now as a consequence of doing that?

Because if you're if you're you want, if you have a new liability and you have cash to back it, you're you're sort of not really necessarily reducing your your credit quality as a borrower, right, And so should you have to hold more capital against that position is kind of the lot the question, and and a lot of jurisdictions or some jurisdictions have said, well, you shouldn't write you are no longer, You're not less safe for sound as a consequence of having more cash on the treasury side.

You know, people have argued, well that that has interest rate risk associated with it. It's not purely fungible, it's not purely cashless. Look what happened in you might have a market functioning issue. But this is like an ongoing debate, which is what's the proper measure of size for a bank? Because the need to think about size constraints in general is something that the Bossle Committee is very focused on and and regulators are very focused on. After after the

two eight crisis. But you know how you measure that size, what actually should contribute to that size measurement? How big are you really and how risky are you really? Is an ongoing source of debate. But the clearing question what

what's interesting there? I think And an important to note is it's not a matter of direction, meaning you know, if you were introduced to clearing mandate, the amount of balantie allocated to tripo, like the amount of balanceie size you'd show, would go down questions how much, And that's where sponsored repo comes in, which is clearing is available currently and there's a decent chunk of the market that's actually cleared already, and so you know, it's not obvious

and and there's lots of ways, lots of reasons to think that it would likely not meaningfully improve the leverage constraints that banks are facing. That that is is a very very mild self for what is otherwise a much

more acute problem. So we don't necessarily have a clearing mandate in US treasury trading the way we do for derivatives, where trades have to go through a central counterparty, but we do have sort of some clearing going on in the market through for instance, um if I SEC and other ways, rather than just announce a total clearing mandate, is there a way to incentivize market participants to do more clearing voluntarily. Well, those incentives are there in the price.

So at times, for example, if you're a cash lender, it's been advantageous to do that in a cleared format, to do that via sponsored like banks will essentially pay up a little bit to incentivize you to do that,

and the same is true on the borrower side. And so like, this kind of balance sheet optimization work is something that the larger institutions have gotten quite good at, and they know how to price trades to sort of push people or nudge them in the direction that benefits their regulatory constraints, so that in that sense, like people are acting economically, the issue is not so much you know, can we push people in that direction? It's more you know,

what direction do they want to face? And by that I mean when when rates are rising? Right for example, Now, the way the hedge funds position for that is they don't do repos which is a way to buy secure

by treasuries on using leverage. It's they do rostary buds, which is you're going short the market, right, that's how you position for rising rates, and so that creates netting inefficiencies, which basically means you can't net off trades on the on the borrower versus the lender side because there are

simply less borrowers out there. So you know, the the amount of netting you can do in your book goes down as a consequence of the positioning of the hedge fund and speculative industry, those who are trying to short treasuries and so in practice that actually makes a bigger difference than the availability is sponsored trades. So it's not about access to clearing as much as this is about you know, do people think rates are going up or down?

Which is hothing you obviously can't control. Going back to the present tense and you know, obviously March was an extraordinary situation. I mean truly, Uh you know, maybe hopefully once in a lifetime or once in a century, what we've seen more recently should not be that rare. And you know it's gonna happen multiple times probably in our careers that people are surprised in a significant way by the direction of the market. Because that's what markets do.

What are the lessons here and what you know, how bad is it that you know, we saw we have this lack of depth, that we have this gap between treasuries that are you know, on the run versus off the run treasuries and so forth, And is it something that needs to be fixed? Is it something that you know when you look at this lack of depth needs some sort of like policy or architectural solution. Yeah, I

think the it's important not to oversolve for the problem. So, like, as an example, if you have a plate and you think it's cracked, and then you smash it on the ground and it breaks along the crack, you've confirmed that it was cracked, but that doesn't mean you should only have plastic plates, right, So, like that's not the right level of stress to solve for. And in a lot of ways is the smashing of the plate and and that it's usually going to break it. And that's because

it's extremely unusual. It is unique in lots of respects. And yes, you could probably say that about any crisis, but it's important to recognize that, like, we should not be creating or designing a treasury market that is specifically calibrated to survive a once in century pandemic liquidity squeeze. That that is not the right level of of of

of rigor. And I think it's likely we can't do that within reasonable constraints, Like there's a lot of reasons to think that even in the absence of of leverage constraints, even in the absence of of other issues, would have been a mess in lots of ways regardless, So it's unclear that we could actually have avoided that fate. The but the question is do we want a more resilient treasury market. I think they're The answer is very much yes.

It's important when we think about that if we go through the list of reforms that have been proposed, to think more in terms of like what is the what is the quantitative impact, like how much is this going to help? Not will it help? How much will it help to reduce the fragilities in a system that that under much less extreme circumstances, how has exhibited a lot of a lot of frailty. And and that comes back to this issue of disincentivizing banks from taking on high leverage,

low risk positions. Among those are RIPO and treasury intermediation and to to say that there's a lot of reasons. And this goes all the way back to the the Fed Treasury cord in I teen fifties, where like the proper function of the treasuring market is is a is a matter of of national importance, like the the economy requires it and so and it needs to be robust to modest shocks or even significant ones. And so you know, the question is when we, for example, include reserves in

the in the leverage rat show. And the reason why I'm talking about cashing out treasuries is that you know, capital is fungible, right, you have some capital requirement, and if you create more space relative to minimums, if you make sure the supplement or leverage ratio is really a backstop rather than a binding constraint, then you have space to do other activity that would otherwise consume balance sheet.

And and one of those treasury trading. You know, we have to think about and and the Ft has been quite clear that they are thinking about this. Whether now the banking system is less safe and sound is a consequence of a higher reserve balance, and whether that's the right way to think about capital requirements and safety and sound is. So that's on the regulatory side, and then on the market structure side. You know, there are certain

ways in which you could reduce these procyclical tendencies. And one of the things I like to highlight is cross margining. It was cross margining in back in the ball was very high and in those basis positions, the two legs of the trade were margined separately. And by margin separately, I mean that the tread the margin had to post against the futures leg was based on an outright exposure.

The margin had to post against the cash leg. The securities was an outright exposed based on raisin posed and they couldn't see each other, so you could be sort of well hedged, but still have to post margin on both sides of your heads because those those two hedges were margined independently. That sounds like a technical nuance. Why am I talking about that in the context of like

changes to the overall structure the banking system. It's because that creates post prosec locality back in and at that time, the futures margins increased by several times very quickly, and that naturally delivers the entire financial system, because if you have to post more cash against a position, you get less leverage. And you know that might be desirable under

normal times. I'm like, I say it's necessarily desirable. You might want less leverage in the system, you might want more, but reducing it rapidly during a period of stress is sort of the factor problematic, both in in practical terms because you gotta find that cash, but also like the signaling value that it's it's important to keep in mind if margins get tripled and no liquidations actually come as a result of that, no one liquidates positions, they find

the cash elsewhere. You can still trade the market like there might be liquidations, and and then it sort of has the same impact. And you can you can see that in part from the commodities experience in the past few months, is there was this concern that margin requirements were going to be We're going to force liquidations of positions and and and that just creates a whole the

whole mess. So you know, one of the things you can do is you can say, look, if you're well hedged on an economic basis, you shouldn't have to post as much margin. And that just reduces the pro cyclical dynamic that the margin cycle introduces um and it makes the market sort of more resilient to volatility shocks. You mentioned how the FED is thinking about these issues, and I think they published a couple of papers on this topic. But why it doesn't the FED feel compelled to intervene

because clearly it's comfortable unwinding it's balance sheet. This is just to play Devil's Advocate, by the way, but it's comfortable unwinding it's balance sheet. It's comfortable, I don't want to say abandoning forward guidance, but certainly surprising the market as it recently. What do they see here that maybe market participants don't or where does the difference in opinion come from? Well, I think this comes back to the question of is it a liquid or is it not functioning?

And this is where I think the the somewhat hyperventilating

language that traders often use is not terribly helpful. So, like, the number of times anyone has been told their face has been ripped off is like, probably not the right number of times relative to how like intense that image is, And so things are not I guess, And that's that bad because transaction costs are manageable like if if risk is is clearing, if you can get the trade done, you can do it at relatively tight but offer at least in the current issue that most recently issued bonds,

So like in that sense, the market is functioning. The high freaksity traders have stayed involved much more so than

than prior volatility episodes. There have been some structural changes to them, to the way these markets operate, and one of the big advancements since has been the rise of what what are are called bilateral streams or private central limit order books, where you know, the issue with broker techt is when you put it in order, everyone can see it, even if they don't know who put it in.

Whereas these bilateral streams and private order books allow you to string prices directly to specific clients so you don't have to tip your hand in the same way. And that that sounds like a small change, but it makes it makes the showing of bigger size in general much easier, so markets are more resilient. As consequence, that's become a much more common way to trade inter dealer that then

was the case even a year ago. The question is why are yields actually going up and is that bad um And if you're the FED, you want to tighten financial conditions presumably, so rising yields are not prima facial problem. I feel like a dealer inventory is they're pretty low. If you look at the way the RepA market is trading, it suggests a scarcity of collateral. It's just's not enough

funds in the system rather than too many. What's probably happening here is speculative investors are going short the market in the way I describe through reverse repos more so than real money, and users of securities of treasury bonds were actually selling them, and so that's a lot less concerning, right, So on the one hand, you're kind of getting the macroeconomic outcome you want, and on the other you don't have the outflows from from the real firm hands in

the market at the nearly the same scale you had in twenties. So the need of the FED to take those bonds out of the system is a lot less because they're floating around in the levered complex anyways. It's not like you have long term holders looking to liquidate and no one on the other side. You take it all together and like, what what if I was at

the FED way to be concerned. Absolutely, you know, low levels of depth, high levels of all, a very uncertain macroeconomic environment and policy environment are all reasons for concern. But would I'd be convinced that not only are markets functioning poorly, but that they are not functioning to the point where this could create other contagion effects in the financial system and necessitates basically sucking the Venomo out, which

is what those market functioning purchases were. We're definitely not there. I mean, we're we're very far away from that kind of thing, so, you know, in that sense, it's a familiar kind of stress, which is still no fun, but it is not the kind of existential angst created by by the environment of existential angst. That's a good way of describing it. Josh, We're going to have to leave it there. I feel like we could talk to you for another hour on this topic. But thank you so

much for coming on all thoughts. That was great, that was great feedback. Thanks for having yea. Thanks John so Joe. I feel like existential angst is a really good way of putting the experience of and that's when we did see some momentum towards actually addressing of problems that Josh's outlining in the world's most important market. But it does feel like, absent a major crisis, these issues just kind of like limp along. Yeah, I think that's right. And

you know, it's not some of this stuff. It's not the end of the world per se. It's not an imminent crisis. But because it is the world's most important market, there are reasons to be concerned when you see some of these lack of liquidity or the fragmentation that he discussed. You know, the thing that gets me is it feels like there are so many different moving parts that work cross purposes. You have some laws that say treasury should be cash, other laws that say banks can't get too big.

You have other situations in which expansive FED balance sheet helps liquidity. On the other hand, the Fed feels it needs to shrink its balance sheet for its monetary policy purposes, which are all those You have all these different things that each individually may have some logic, but it's the confluence of all of them that see where the problems

seem to create. I think that's exactly right. Also, something I didn't know up until recently do you know REPO contracts are apparently exempt from the automatic stay of bankruptcy. That was something Paul Vulker did. What does that mean? So it means if a company goes bankrupt, they're like repo assets don't automatically get frozen and then distributed to creditors. So, like, you know, if you want to treat treasuries like cash.

On the other hand, if someone has a treasury that they've used as REPO collateral in a bankruptcy, wouldn't necessarily be distributed. Sorry, I'm getting really interest, but speak to the issues. That's exactly right. Yeah, do we want to treat them like cash or do we not? And should we actually have it holistic approach towards the market? They have to all all the regulators and policy authorities just

have to get in the same room. And it's like, let's get on the same Yeah, okay, well, well we'll make that happen. I'm sure. Should we leave it there? Let's leave it there. This has been another episode of the All Thoughts podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy all the Way and I'm Joe. Why isn't though You can follow me on Twitter at the Stalwart. Follow our producer Carmen Rodriguez on Twitter She's at Kerman Arman, and follow all of our podcast is

Bloomberg under the handle at podcasts. Thanks for listening.