Sometime before the end of this year, at the intersection of Wall Street and the Washington swamp, a deal is going to have to be done about how the US government funds itself.
Into the mix will be a push for reforms to ensure that a rapidly rising pile of government debt can be traded without overwhelming the financial system.
Every side wants something. The Biden administration wants to improve the way the big banks and dealers interact with the Treasury, the Federal Reserve, their customers, and each other to keep the government’s debt machine working. The banks want regulatory relief for their dealing operations.
The sine qua non of a deal on Treasury market reform, raising (or, who knows, maybe abolishing) the debt ceiling will be negotiated between Senate and House Republicans and their Democratic counterparts, in concert with the White House. That will be a tense but familiar struggle, and almost certainly can only be settled at the last minute, probably in October and November.
In parallel, there will be negotiations on reforms for the secondary market in Treasury debt. That market has been put under considerable strain since the pandemic.
The major dealer banks have post-crisis regulatory limits and charges that effectively limit or overprice their ability to intermediate in the US Treasury market. In addition, one big bank, Wells Fargo, has been restricted from increasing its asset base in the wake of its fake accounts scandal.
“If the US financial system were a Boeing 747 flying through a fiscal storm, it’s been flying with three engines (JPMorgan, Citibank and Bank of America), and the fourth engine — Wells Fargo — has been offline,” says Zoltan Pozsar of Credit Suisse.
The Treasury market is also, prospectively, going to lose some dealer balance sheet capacity as new reporting rules go into effect for European banks, supposedly by 2023, but as a practical matter next year.
The Biden administration and congressional Democrats do not want to do any favours for banks, but it is absolutely essential for their programmes that there be a well functioning and highly liquid Treasury market.
That will take magic or the Swiss Army knife of bank reformers: the central clearing party, or CCP.
A CCP is a financial market utility, usually privately owned or owned by participant members, which acts as buyer to all sellers and seller to all buyers. It transforms the counterparty risk that occurs when one institution agrees a trade with another into the more credible and visible risk of the CCP, with all its capital, member support and implicit or explicit government backing.
CCPs have been around for a long time, but came to recent prominence in US political dialogue after the financial crisis. At the time it was noted that bank-to-bank “bilateral” trading had incurred more systemic risk than markets such as those operated by commodities exchanges like the CME or the Intercontinental Exchange, which used CCPs as risk intermediaries.
The post-crisis Dodd-Frank law and accompanying regulations strongly encouraged financial derivatives markets to shift from bilateral trading to CCP-based trading. There has been strong resistance, though, to moving the Treasury market on to a CCP.
Among the most persistent proponents of a Treasury CCP has been Darrell Duffie of Stanford University. His papers on the topic are cited by the most influential leaders at the Fed and the Biden Treasury.
I include Nellie Liang, who is on track to be approved by the Senate to be the under-secretary of the Treasury, and, effectively the boss of Treasury markets, along with her counterparts at the Fed, including Lorie Logan, manager of the System Open Market Account, and Lael Brainard, vice-chair.
However, the CCP sceptics are well connected and influential. They include Manmohan Singh of the IMF, who has written that the imposition of a Treasury CCP would “cram more of the most important market in the world into already too-big-to-fail institutions ultimately puttable to the taxpayer”. Singh added: “That would require greater scrutiny by the Fed and maybe the guarantee of further liquidity lines.”
I believe that after some argument, the banks will agree this year to work on a plan to move the Treasury bond market on to a CCP platform. During the years-long planning process, the major dealers will get temporary regulatory relief from balance sheet limits and charges on the current Treasury trading business.
CCPs are actually a cyclically recurring structure. They work well in medium-size crises, and are abandoned when hit with big crises. History will repeat.
