Introduction
In March 2020, as the COVID-19 pandemic ripped through the economy, the then-$17 trillion market for U.S. government bonds (“Treasuries”) was brought to the brink of failure. Because investors rely on Treasuries to keep them safe during crises, the potential collapse of Treasuries presented an unthinkable doomsday scenario for global markets and the U.S. economy.
With the Dow Jones index plummeting by 2,000 and 3,000 points in a single day, the Treasury market was supposed to be the safe haven for investors that needed to sell Treasuries to raise cash or buy them as protection.
Instead, as panic took hold and investors tried to cash out, the market faltered to a crawl. Waves of orders went unfulfilled.
Treasuries prices—a benchmark against which virtually all other financial assets are priced—whipsawed wildly.
Facing the possibility that this unshakable market could fail, the Federal Reserve (the Fed) stepped in with over one trillion dollars of immediate stabilizing support.
Yet despite this intervention and additional aid to help revive capital markets, the quality and reliability of the Treasury market struggled to regain its footing.
This decline could not have come at a worse moment for the U.S. economy. Treasury borrowing outpaced records, adding almost $3 trillion to the national debt over spring 2020 alone as Congress enacted far-reaching stimulus measures in response to the COVID-19 pandemic.
Just as the need for Treasuries has grown existentially urgent, the Treasury market has revealed itself to be fragile.
This suddenness notwithstanding, the ill-timed collapse in “risk-free” Treasury markets is unsurprising and overdue. Despite their singular importance, Treasuries have evolved under a regulatory framework that lacks effective supervisory and administrative power. Treasury markets have therefore failed to adapt to emerging risks and technological change while operating under a system of supervision that is far less intense than what exists for equity or corporate bond markets. The result is a market structure in which the regulatory guardrails are minimal and outdated, leaving it pervasively exposed to failure.
This Article makes two descriptive claims. First, public regulation of Treasury markets is characterized by excess fragmentation among supervisors, resulting in a lack of coordination as well as a sparse and bureaucratically costly-to-change rulebook. This institutional framework is fragmented by design. Whereas equities or corporate bonds are overseen by a primary regulator (the SEC), Treasuries are supervised by five or more major agencies, none of which has lead status. The Treasury writes the rules, the Federal Reserve Bank of New York (N.Y. Fed) facilitates debt auctions, the SEC and the Financial Industry Regulatory Authority (FINRA) supervise securities firms that trade Treasuries, the Fed monitors banks, and the Commodity Futures Trading Commission (CFTC) oversees the derivatives markets linked to Treasuries.
This shared oversight is not necessarily unusual. As Professors Jody Freeman and Jim Rossi observe, fragmentation is a common feature of the administrative state.
This arrangement highlights the market’s significance for the financial system and has the advantage of pooling regulatory expertise and experience. But it also creates high institutional barriers to action
through information gaps, turf battles, inconsistent regulatory approaches between agencies, and the need to coordinate to fulfill basic objectives.
Perhaps the most problematic downside to this system is that no single agency possesses a full picture of the Treasury market with which to craft an optimal supervisory strategy, should it decide to take the initiative.
The widespread view that Treasuries are a risk-free security can also engender a lack of urgency to develop an administrative framework capable of heightened vigilance. Reflecting these hurdles, agencies have faltered in exercising joint oversight in recent years.
Information sharing has required regulators to enter into complex agreements with one another just to pool and transfer data.
And even straightforward, commonsense rulemaking has required time and mobilization, only to result in reforms that are partial in their coverage.
Perhaps most worryingly, these high administrative costs have produced a rulebook for Treasury markets that is noticeably sparser than that applicable to participants in equities or the corporate bond market, limiting the levers available to regulators to monitor and discipline traders. According to one expert, out of the thousands of rules prescribed for equity brokers and dealers, only about forty-six apply to those in Treasuries.
Indeed, there is doubt even among regulators about which rules are in fact applicable to Treasury markets, leaving a question mark over the enforceability of otherwise mainstay prohibitions (such as uncertainty over rules governing brokers trading ahead of client orders).
Further highlighting the limited tools available to regulators under this hands-off approach, trading platforms that only host Treasuries trades are exempt from the usual panoply of regulations that apply to securities trading platforms.
While major equity trading exchanges like the New York Stock Exchange (NYSE) must provide regular disclosures about their operations and comply with fairness and good governance standards,
venues that only trade Treasuries can avoid these regulations altogether.
This Article also argues that, in light of modern technological advances, private self-regulation in Treasury markets lacks structural incentives to fill the gap left by weak and fragmented public oversight. Historically, the purchase and trade of Treasuries have largely been intermediated by a cohort of top-tier banks and investment banks designated as “primary dealers” for the market.
Currently numbering twenty-four firms, primary dealers are designated by regulators to oil the machinery of Treasuries trading by providing liquidity to the market.
Because of their access to new issues, primary dealers are also the key conduits for investors looking to buy or sell Treasuries.
Primary dealers are chosen for their capacity to regularly purchase government debt (and are expected to do so), and they are also usually networked banks and investment firms capable of connecting with investors worldwide in the secondary Treasuries market.
Importantly, the secondary market for Treasuries features an additional significant aspect: the interdealer market, in which dealers transact with one another to manage their inventories.
If one dealer has clients needing Treasuries that it does not have, it can tap into this interdealer space to purchase the securities from another dealer and satisfy investor demand.
Traditionally, trading in both markets took place through telephones, faxes, and computer displays of orders, giving the market its reputation as an uncomplicated and ultrasafe corner of the financial system.
Over the last decade, however, the Treasury market has experienced a fundamental shift away from relying on just primary dealers and analog trading mechanics. It is now largely automated, populated to an increasing degree by high-speed algorithmic traders known as “high-frequency traders” (HFTs) that use preset computerized programs to trade in milliseconds and microseconds.
At least in the interdealer market, primary dealers have ceded their dominance in competition with expert, automated firms that are more agile because they are smaller—and generally much less regulated.
High-speed automated trading now drives as much as 50% to 70% of Treasuries trading volume between dealers.
Such trading is familiar in equities markets, and regulators have adopted a bevy of rules to mitigate negative externalities there.
But the advent of HFTs in Treasuries poses challenges within a lax regulatory environment characterized by patchy reporting, fragmented oversight, and weak levers to collect information on traders and platforms.
Without informational insight into the real-world effects of new traders and their strategies, regulators lack the knowledge and authority to effectively tackle the resulting risks.
This lenient regulatory regime contributes to the limited private incentives for market actors to self-regulate. Professors Georgy Egorov and Bard Harstad observe that firms can either come together to self-regulate in the absence of an active regulator or they can do so in order to preempt oversight by a strict one.
But because the regulatory landscape is so fragmented, the impending prospect of strict government monitoring is an unlikely motivating factor for Treasuries traders.
Even if market participants wish to police themselves, private incentives fostered by modern Treasury trading relationships undermine effective self-policing. The self-interest that might once have pushed primary dealers toward promoting protective market behavior has diminished with the ascendancy of rival, less-regulated automated securities firms. Primary dealers traditionally had much to lose if the Treasury market performed poorly, but the economic bonds that used to keep them in line are fraying as they compete with new automated traders for market share.
Thus, an overall picture emerges: The asymmetric distribution of regulatory burdens between primary dealers on the one hand and high-speed securities firms on the other limits opportunities for private cooperation and mutually reinforces risk-taking behavior by both sets of players. Unwieldy public monitoring, combined with a light-touch rulebook, allows all firms to take risks or trade opportunistically with little chance of detection and discipline. Traders can also cheaply exit the market if something goes wrong, limiting how fully they must internalize the costs of their risky behavior. For the less-regulated, nonprimary dealer firms, the regulatory constraints are even weaker, further increasing their financial incentive to seek risk in Treasury markets. Faced with diminishing profits and a less lucrative franchise, primary dealers are also incentivized to take risks and shirk self-discipline. So, not only is the task of private oversight logistically harder as the number of traders proliferates and diversifies, but it is also problematic when self-policing would result in primary dealers imposing added costs on themselves in a period of fierce competition and lower profits.
The consequences of this regulatory neglect in Treasury markets were apparent even prior to the March 2020 COVID-19 crisis, as a number of disruptions over the years pointed to unaddressed fragilities at the heart of this supposedly failure-proof market. Famously, on October 15, 2014, the price of Treasuries surged well in excess of what would have been normal for the time.
Just after 9:30 am, the market was roiled by some of the highest trading volumes in its history, and prices seemed to fluctuate at random.
Despite the absence of any significant news, this abnormally rapid rise—and subsequent correction—caused Treasuries to suffer some of their largest price moves since 1998.
The only three other occasions with greater price shifts have been in response to news of major policy changes,
but this “Flash Rally” came out of nowhere, and attempts to explain it delivered little by way of firm conclusions.
Jamie Dimon, the Chairman and CEO of J.P. Morgan, hyperbolically remarked that such price movements were so rare as to happen only once every three billion years.
Despite Dimon’s optimism, however, a similar incident occurred only a few years later in June 2018, sending Treasury prices into a short and inexplicable tailspin.
Even outside of these flash events, other disruptions also revealed the less-than-perfect operation of Treasury market infrastructure: The major trading platform for interdealer trading saw an hour-long shutdown in June 2019, slowing activity across the market.
To be sure, flash crashes, slowdowns, and platform malfunctions occur in other markets as well (like equities).
Nonetheless, scant regulatory attention and limited levers for intervention leave Treasuries exposed to the possibility that traders come to see the market as a space where risk-taking is much less costly and detectable than elsewhere in capital markets.
This Article concludes by outlining two proposals to begin remedying the deficiencies underlying Treasury market regulation. First, it suggests mechanisms to foster stronger interagency cooperation and help fill the gaps in public regulation. As an initial step, Treasury regulators can benefit by developing a more systematic memorandum of understanding (MOU) to formalize cooperation, information sharing, and enforcement.
To institutionalize pathways for interagency cooperation, this Article also proposes that regulators harness the coordination mechanism offered by the Financial Stability Oversight Council (FSOC), a post-2008 reform body that offers preexisting organizational expertise to map the connections between Treasury markets and the larger financial system.
Second, to mitigate currently misaligned incentives for private self-regulation in the high-frequency trading (HFT) era, this Article suggests creating a Treasuries clearinghouse—an industry mechanism that forces major participants to be more responsible for risk-sharing and mitigation, requiring each to have skin in the game in order to maintain the resiliency of the market.
Common to nearly all major markets, clearinghouses are a private solution to the risk that traders can renege on their bargains with counterparties. By supplying the clearinghouse with sufficient funds to make good on promised transactions, participants subscribe to a mechanism wherein their pocketbooks are at risk in case of another firm’s failure.
As Professor Darrell Duffie also argues, a clearinghouse for the Treasury market could introduce a stronger focus on risk management and bring a more organized approach to protecting its safety and soundness.
To be sure, clearinghouses are not a comprehensive solution; as in March 2020, market participants may still flee when it no longer suits them to trade, and algorithms could always go haywire. But a clearinghouse would provide a recognized bulwark that would anchor Treasuries trading to systematized risk sharing and management, motivating even rival traders to cooperate more fully in self-monitoring and discipline.
This Article proceeds as follows. Part I establishes the importance of the Treasury market to the national economy, especially in the wake of COVID-19, and demonstrates that much of the vulnerability is a function of the uniquely fragmented and light-touch regulatory structure overseeing Treasuries. Part II outlines the market structure of Treasury markets and traces their evolution from a relatively simple structure dominated by primary dealers to one populated by high-speed automated traders. This Part also observes how the changing composition of Treasuries traders undermines effective private self-regulation. Part III analyzes the risks of weak public and private regulation in Treasury markets. Part IV suggests pathways for reform.