Should declining liquidity in the US Treasury markets push haircuts on UST repo up? We think there is a good case.

A February 1, 2015 article in Bloomberg “The Treasury Market’s Legendary Liquidity Has Been Drying Up” by Liz Capo McCormick and Daniel Kruger got us thinking about haircuts on HQLA. Is it time to re-think what the right level is given diminished liquidity?

We have read about dealer inventories in the corporate bond market that have fallen to a fraction of what they were. The result has been lack of liquidity & more volatility. A research piece by Will Rhode when he was at Tabb Group put it aptly, describing corporate bond liquidity as: “a mile wide and an inch deep”. The Bloomberg article tells us that US Treasuries may now suffer a similar fate.

The authors write:

  • “…How much depth has the market lost? A year ago, you could trade about $280 million of Treasuries without causing prices to move, according to JPMorgan Chase & Co. Now, it’s $80 million…”
  • “…JPMorgan, one of the 22 primary dealers that trade with the Fed, estimates the amount of 10-year notes available to buy or sell at one time without moving prices has fallen more than 70 percent in the past year….”
  • “…The shift reflects the unintended consequences of new financial regulations, which have made bond dealers less willing to hold inventory and facilitate trades, as well as the Fed’s debt purchases to shore up the economy…”
  • “…As Wall Street dealers offer fewer bonds at a given price to contend with the onslaught of demand, volatility has increased. Average intraday swings for Treasuries are the now most pronounced since October, data compiled by JPMorgan show…”

Repo dealers rely on markets to liquidate positions from defaulted clients. The less liquid and more volatile the paper, the more difficult this is to do. To protect from this risk, haircuts are taken. The more volatile the paper, the greater the haircut needs to be. If you can’t sell more than $80 mm 10 year notes without moving the market, that is a problem. What happens when someone needs to buy or sell $1 bio or more, especially in a repo liquidation that will probably be an open secret (read: fire sale). Is it time to re-think the very low haircuts — sometimes zero — taken on US Treasuries?

As the violent market rally on October 15th showed, there are risks in both directions. Shorts got hurt badly that morning. Often dealers don’t take haircuts when lending bonds, thinking the dealer has the high quality assets (cash) and thus limited exposure. That is not always the case.

Should haircuts on HQLA go up when liquidity goes down? Yes. But what is the appropriate trigger? Will we know it when we see it? Is small, frequent fine tuning better than infrequent big changes in margin — avoiding the kind of cliff risk that worries the regulators? Probably.

Listed and  OTC Derivatives CCPs take initial margin irrespective of the direction of the exposure (although it is subject to netting like repo), recognizing that markets can move both directions. And initial margin, while usually sticky, can move when markets move. (See our January 14, 2015 post “Fed’s Dec. 2014 Senior Credit Officer Opinion Survey (SCOOS): balance sheet tightening, margins and volatility” and the January 21, 2015 post “Leveraging CHF clients 200:1. We’ve seen this movie before.”)

Derivatives markets (and in particular listed derivatives markets) seem to be more nimble at adjusting initial margin than repo markets (and especially better than tri-party repo). Perhaps there are some lessons to be learned.


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