Washington, D.C. — In recent years, both the U.S. and U.K. Treasury bond markets have required central bank bailouts due to investment strategies of nonbank financial intermediaries (NBFIs) that went wrong. In March 2020, interest rates spiked in the United States, leaving the Federal Reserve purchasing large amounts of Treasury securities—effectively restarting the expansion of the asset-buying apparatus that was first implemented during the 2007 global financial crisis. In 2022, the United Kingdom faced similar bailout needs when U.K. private pension funds were forced to sell U.K. government bonds to raise cash and meet margin calls. A new Center for American Progress report examines how the United States can draw on these lessons to reduce the fire sale risk that hedge fund trading poses to the Treasury market and provides recommendations for how the Federal Reserve can use its authority over fixed-income trading platforms to do so.
Some key recommendations from the report include:
- NBFIs such as hedge funds are a potential source of large-scale market disruption that requires a solution. This risk can be mitigated if the Federal Reserve limits hedge fund leverage. It could do this by leveraging its Dodd-Frank authority over the central counterparties when large volumes of Treasuries are traded.
- The Federal Reserve should use its Dodd-Frank authority to mitigate hedge fund risks to the market for Treasuries. Imposing leverage limits on hedge funds will mitigate their ability to take large risky positions in Treasuries.
- Allowing global systemically important banks (GSIBs) to increase their leverage is unlikely to make the market for Treasuries less vulnerable. If Treasuries, which have market risk, and reserves are excluded from leverage calculations, there should be compensating increases in leverage requirements to cover other assets.
“As events in the U.S. Treasury markets and the U.K. gilts market have demonstrated, NBFIs pursuing complex, leveraged financial strategies can disrupt crucial financial markets,” said Marc Jarsulic, CAP senior fellow, chief economist, and author of the report. “The recent Securities and Exchange Commission proposal to require clearing of Treasury trades should itself be leveraged by the Federal Reserve to mitigate the fire sale risk these entities pose in the Treasury market.”
Read the report: “Regulatory Change To Enhance Treasury Market Stability” by Marc Jarsulic
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