Leverage, dealer capacity, and Treasury market fragility
In this paper, Anil K. Kashyap, Jeremy C. Stein, Jonathan L. Wallen, and Joshua Younger build a simple model to explain how leverage and balance-sheet constraints generate Treasury market fragility. The model includes three-agents:
- Broker-dealers who allocate their limited balance-sheet capacity between two competing uses: intraday market-making (earning bid-ask spreads) and overnight arbitrage trades (buying cash Treasuries while shorting futures to profit from price discrepancies).
- Hedge funds that run leveraged basis trades—they borrow heavily against cash Treasury purchases via repo markets, then hedge by shorting Treasury futures. This allows them to profit from small price gaps between cash and derivatives markets.
- Asset managers (pension funds, insurers, mutual funds) are the only agents bearing duration risk. They hold long Treasury exposure partly in futures to free up balance-sheet space for higher-yielding corporate bonds, creating structural demand for Treasury derivatives.
The model shows that as Treasury supply grows, asset managers’ derivatives demand forces dealers and hedge funds to hold more cash Treasuries to offset those long futures positions. This requires intermediaries to be compensated via a widening cash-futures basis, the spread between cash and derivative prices.
Stress mechanism & empirical validation
Under stress (e.g., a margin call spike), hedge funds are forced to unwind their levered positions simultaneously selling cash Treasuries and covering short futures. Dealers must absorb these fire sales, but their already constrained balance sheets lead to:
– A sharp widening of the basis between cash and derivatives
– A collapse in market liquidity (wider bid-ask spreads, lower trading volume)
– Spillovers into repo markets, where intermediation spreads spike
The authors validate this narrative using 2016–2024 data. They show that a $100 billion increase in Treasury supply correlates with roughly $5 billion in additional hedge-fund short futures positions, confirming the model’s predictions. In March 2020, they document a nearly unprecedented (9-sigma) basis blow-out, with hedge funds cutting $62 billion in short positions that dealers could not easily absorb, precisely the mechanism that triggered the liquidity crisis.
Policy solution: hedged purchases
Rather than the Fed’s March 2020 approach of buying $1.6 trillion in unhedged Treasuries (which later morphed into $4 trillion of traditional quantitative easing), the authors propose a hedged-purchase facility:
- The Fed simultaneously buys cash Treasuries and shorts an equivalent amount of Treasury futures.
- This replicates the hedge funds’ trade, so it absorbs their deleveraging pressure without placing duration risk onto the Fed’s balance sheet.
- Because the purchase and short hedge each other, the Fed doesn’t expand duration exposure, avoiding any confusion with monetary policy easing.
- No preset unwinding date is needed; the natural reversal of the futures hedge provides the exit mechanism.
- Bagehot-style guardrails (e.g., price limits on purchases, haircuts) can limit moral hazard while still preventing systemic spillovers.
The authors argue that other reforms—tweaking regulatory capital rules, standing repo facilities, or margin requirements—are helpful but insufficient when the binding constraint is dealer balance-sheet capacity, not just funding. Hedged purchases directly address that constraint.
Treasury Market Dysfunction and the Role of the Central Bank
Authors: Anil K. Kashyap, Jeremy C. Stein, Jonathan L. Wallen, Joshua Younger
From: University of Chicago, Harvard University, Columbia University
Building a war chest: Treasury portfolio tilting for market-functioning readiness
Rochelle M. Edge and Dan Li, in this paper, model how shifting the Fed’s System Open Market Account (SOMA) Treasury portfolio toward shorter-maturity bills creates a recurring “war chest” for market‑functioning asset purchases. Using a baseline $6.1 trillion SOMA portfolio, the authors:
- Benchmark the proportionate portfolio (20% bills, matching outstanding Treasury debt maturity structure), yielding around $385 billion in monthly maturing bills available for reinvestment.
- Calculate incremental war‑chest capacity: each additional percentage‑point tilt toward bills adds about $19.2 billion per month.
- Model tail‑risk scenarios with a generalized Pareto distribution, calibrating March 2020’s $850 billion Fed purchases to the 99th–99.9th percentile of potential private‑sector Treasury sales.
- Simulate restoration timelines: after full war‑chest depletion, passive rebuilding by reinvesting maturing coupon proceeds into bills takes 2.5 years (20% bills), 4 years (30%), or 5.5 years (40%).
- Assess financial stability risks (e.g., runnable liabilities, money‑market stress) and compare alternatives such as selling near‑maturity bills or active coupon sales.
Findings
- War‑chest sizing: A 30% bill share provides about $577 billion monthly; a 40% share yields around $769 billion—sufficient to cover sizable (but sub‑Covid) disruptions under reasonable tail‑risk assumptions.
- Restoration speed: Passive rebuilding is too slow for frequent market‑depth episodes; active sales of stress‑purchased coupons would accelerate war‑chest replenishment and better align intervention duration with shock magnitude.
- Neutrality: The proportionate portfolio is not demonstrably most neutral; historical SOMA overweighting of long‑term bonds caused no market strains, suggesting room for bill tilts without distortion.
- Financial stability: Post‑GFC money‑market fund reforms have reduced prime‑fund run risk, mitigating concerns that fewer available bills would push investors into unstable private money‑like assets.
- Operational feasibility: March 2020 demonstrated that accelerating bill reinvestments ($37 billion in one day) can provide temporary relief; however, outright sales of non‑maturing bills face low secondary‑market depth.
Policy implications
The FOMC should consider bill tilts up to 40% as a preparedness tool, enabling market‑functioning purchases without expanding the balance sheet or reserves, thereby clearly separating such operations from monetary‑policy easing. This approach complements surgical interventions (e.g., Kashyap et al.’s hedged purchases) by addressing the operational constraint of balance‑sheet size, while preserving Fed independence relative to Treasury‑led buyback programs.
Central bank preparedness for market-functioning asset purchases as a consideration for long-run balance sheet composition
Authors: Rochelle M. Edge, Dan Li
From: Federal Reserve Board
