Imitation Is the Sincerest Form of Flattery, Treasury Dysfunction Edition

Kashyap, Stein, Wallen, and Younger have attracted a lot of attention with their recent Brookings paper, “Treasury Market Dysfunction and the Role of the Central Bank.”  Their pathbreaking findings: (a) Treasury basis trades are systemically risky; (b) the rapid growth in the amount of US bonds and notes outstanding increases this risk; and (c) Fed intervention is required to prevent the systemic risk in basis trades from crystalizing.

Wow! Who knew?

Oh, right. I did. Five years ago. (First draft, 7 August 2020). (The lack of a citation is very bad form, guys).

A year and a half ago I provided an answer to a question that most analyses of the basis trade begged: why does it exist in the first place? My answer: constraints on money managers ability to buy cash Treasuries directly, especially leveraged purchases. They achieve implicit leverage through futures, which is mirrored by the explicit leverage of basis trading hedge funds.

Kashyip et al tart up their paper with a simple model. The most important component of this model is money managers’ demand for long futures, but that is really assumed, not derived from a model that specifies the underlying constraint. They merely say: “In our model, asset managers pay the basis for the convenience of holding Treasuries off balance sheet.” Whence that “convenience” arises is left to our imaginations. (They also say “there are specific stories we have in mind” but apparently they’d have to kill us if they told us).

The only real contribution of the paper is their proposal that the Fed engage in hedged bond buying to absorb a (margin induced!) unwind by hedge funds. But that’s just a particular way of doing this: “As a consequence, the soundness of the U.S. financial system continues to depend on the prompt and effective intervention of the Fed as lender of last resort, with all the attendant moral hazard problems.” (They do discuss the moral hazards inherent in their proposal).

By way of faint praise, I do acknowledge that they don’t advance clearing as a nostrum. But I am somewhat startled by this statement: “Although clearing may have significant benefits, these benefits are largely orthogonal to the issues of concern here.” Especially since they also acknowledge that “when volatility increases margin requirements can increase as well, potentially triggering forced unwinds.”

Orthogonal? Hardly: margining, of both the futures and repo legs of a basis trade, is THE source of instability. It is at the heart of these issues. “Can increase”? Does increase. “Potentially triggering forced unwinds”? That’s exactly what triggers forced unwinds.

Their proposal–again, not really novel–that the Fed intervene is necessitated by two things: clearing, and the constraints that induce money managers to launder leverage via futures, rather than take leverage on their balance sheets. Meaning that they let off clearing and regulation far too easily.