FRB Governor Powell Addresses Risk of ”Outsized Volatility”; Considers Developments in Treasury Market Structure

Board of Governors of the Federal Reserve System (“FRB”) Governor Jerome H. Powell discussed variables and possible adaptations to the current market structure that could provide greater or more stable liquidity.

In his remarks at the 2015 Roundtable on Treasury Markets and Debt Management, Mr. Powell addressed the October 15, 2014 episode of “sudden, outsized volatility” in the Treasury markets. He pointed out that further episodes could cause more market participants to react in ways that reduce liquidity, and add to pressures for changes in market structure.

Mr. Powell explained that his preference would be to see changes emerge from a process of experimentation in the marketplace, including both dealers and proprietary trading firms, but noted that regulators and the industry will only be able to evaluate structural innovations if “traders actually use them.” Among the potential changes he discussed were a central limit order book and what he described as high frequency “batch auction” (auction that would take place every millisecond rather than continuously). He concluded that there should be strong evidence that any change in structure represents an improvement before implementing it on a wide scale.

Referencing a recent New York Fed event on Treasury market structure, Mr. Powell mentioned a panel he moderated (which included an asset manager, a broker-dealer and one of the triparty clearing banks) in which there was agreement that: (i) expanded repo clearing would be positive for the market, and (ii) the regulatory requirements related to capital and liquidity are proving demanding for the private sector. Mr. Powell stated that the FRB is open to new solutions that would satisfy regulatory requirements while bringing the benefits of central clearing.

Lofchie Comment: Since the regulators seem so determined to push the benefits of central clearing at every opportunity, it may be useful here to explain why central clearing could be more appropriate in some markets than in others, and why it may not in other markets serve the purposes for which it was supposedly intended.

As a starting matter, central clearing has an obvious benefit in securities markets as compared to swaps markets: in securities markets, there is an object to be delivered, and having a central clearing repository can reduce the risk of failure because it allows for the set-off of delivery obligations. That advantage does not exist in swaps (or other notional) markets, as there is nothing to be delivered. Secondly, as we have previously observed, central clearing works best (in fact, it only works) in markets where the underlying security is extremely liquid, such as U.S. government securities, and thus the market would be perfectly well able to close out transactions without a central pricing mechanism. This is not to say that central clearing is not useful in some situations; rather, that the government would be better off letting the market decide where it is useful.

Notably, and unfortunately, Governor Powell does not say much about “demanding [new] regulatory requirements related to capital and liquidity,” issues of dispute that are within the FRB’s control.

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