Introduction
The past several weeks have seen heightened volatility in the UK government bond, or gilt, market that has been met with a significant policy response by the Bank of England (BoE). At first, the BoE responded to falling prices and rising yields simply by buying gilts to reduce volatility and raise prices. The second-round policy response was for the BoE to launch a Temporary Expanded Collateral Repo Facility to lend cash in exchange for gilts to banks on behalf of banks’ pension fund clients. This repo facility is potentially important as much of the heightened volatility stems from forced selling by pension funds who bought gilts with borrowed funds and don’t have the liquidity needed to make the required “margin call” when prices fall. The ability to pledge gilt collateral in exchange for cash would allow pension funds to make the required margin calls and maintain their gilt position rather than selling it and creating further downward price pressure.
These recent and seemingly unusual events should make all of us ask one simple question … Why? More specifically, why is the government now engaging in an activity that is typically carried out by the private sector?
The Mystery of Missing Intermediaries
Government bond markets are intermediated primarily by large bank “market makers” that routinely buy and sell government bonds from client end users such as pensions and asset managers. The events of the past few weeks in the U.K. government bond market are unusual and should come as a surprise. Normally, when selling pressures push prices down, market makers deploy their balance sheet to purchase assets, build inventory, and provide liquidity to the market. They provide liquidity to support their clients because market making is a longstanding business activity that mutually benefits market makers and their clients. Clients benefit by having market makers “take the other side” of the trade they wish to make and market makers earn a fee for providing liquidity to their clients. In addition, large bank market makers are also typically significant suppliers of credit to their clients – often in terms of repo financing like the kind now being offered by the BoE.
Both the outright government purchases of gilts and the creation of a special facility with the expressed purpose of facilitating bank-client repo financing by the BoE indicates that private market intermediaries are not stepping in to provide liquidity as market forces would generally predict.
A Theory of the Case
Some insight into the present lack of private liquidity provision in the UK government bond market can be gleaned from recent analysis on the effects of the Supplementary Leverage Ratio (SLR). The G30 recently issued a report on the liquidity of the U.S. Treasury market. In that report, the authors find that “[i]n large measure because of the massive expansion in recent years of the Federal Reserve’s balance sheet (and the accompanying expansion of central bank balances on bank balance sheets), risk insensitive leverage ratios (notably the Supplementary Leverage Ratio [SLR]) have become the binding regulatory constraint on the allocation of capital for most of the banks whose dealer subsidiaries are the largest providers of liquidity to the Treasury markets.” The G30 report is focused on the U.S. and the U.S. Treasury market, but the same economic forces have been operating across the globe as the SLR is applied internationally and central banks across the globe, including the BoE, have massively increased the size of their balance sheets in the wake of COVID. Indeed, a recent analysis showed that the BoE’s balance sheet, as a proportion of GDP, is now larger than it has ever been since 1701! As central bank balance sheets have ballooned, leverage requirements have become more binding, putting pressure on the ability of bank dealers to provide liquidity.
The fundamental problem being pointed out by the G30 report is that intermediating government bonds is a relatively low-risk and low-return activity for market making banks. At the same time, the SLR effectively applies the same capital requirement to both low-risk and low-return activities as it does to high-risk and high-return activities. As a result, market makers are disincentivized from investing in and intermediating low-risk and low-return assets such as government bonds because their return on invested capital is higher for higher-risk and higher-return activities.
The squeeze put on the intermediation of low-risk and correspondingly low-return assets such as government bonds has been widely understood and studied for some time. Economists such as Darrell Duffie of Stanford University have warned for years of the oncoming liquidity strains due to the ascendant and increasingly binding leverage ratio. Indeed, even regulators themselves have acknowledged that tighter capital markets regulation may indeed necessitate more official sector intervention to maintain market liquidity. As far back as 2014, the Committee on the Global Financial System (CGFS), a group of central bankers, issued a report considering how central banks could ease liquidity strains in a world where private market liquidity provision is more constrained. Indeed, the report highlighted the potential dangers of continued official sector intervention when it wrote that “backstopping market liquidity directly risks structurally distorting economic incentives for market participants and, as a result, could aggravate liquidity illusion,” referring to market participants’ overestimation of market liquidity.
The Next Shoe to Drop?
Predicting the future is a notoriously fraught exercise. As one looks at recent ructions across the pond, however, it is important to ask whether the UK’s government bond market volatility could soon arrive on our own shores. As the Federal Reserve normalizes its balance sheet, it will increasingly rely on the large bank dealer community to intermediate heightened flows in the Treasury market. Large banks operating near capacity coupled with large flows into and out of the Treasury market do provide the necessary preconditions for a liquidity event. More specifically, with less intermediation capacity or “balance sheet” being devoted to government bonds, the impact of any particular shock to the government bond market is likely to be felt more widely and for a longer period of time. Consider the analogy to the effects of a single fender bender on a congested highway. If the highway is uncrowded, a single fender bender goes largely unnoticed. If the highway is packed bumper to bumper, a single fender bender reverberates through the entire traffic jam causing considerably more damage.
Treasury Secretary Janet Yellen recently recognized the potential for heightened illiquidity in the U.S. Treasury market and connected that possibility to the strains caused by the SLR. Whether such an event occurs is impossible to forecast, but if such an event occurs it is highly likely that the reverberations will be stronger and last longer given current regulatory constraints. It also remains to be seen whether the U.S. would actively step in and replace private sector market makers to restore liquidity while at the same time distorting incentives as presaged by the CGFS. Finally, it should also be noted that the U.S. Treasury has also recently inquired about the prospect of purchasing certain “off-the-run” and less liquid Treasury securities for the expressed purpose of improving Treasury market liquidity. Again, under normal circumstances private markets, not government intervention, would regulate liquidity levels.
Conclusion
The recent bout of volatility in the UK gilt market and associated official sector response raises real questions about the incentives to engage in private market making in the government bond market. The potential for a liquidity pullback in this low-risk, low-return market has been recognized for years. Indeed, the Federal Reserve committed to reviewing the SLR in recognition of exactly this basic concern. And now this important issue is receiving new and justified attention from academic economists, central bankers and other government officials. The increasingly binding nature of risk-insensitive leverage ratios makes private market intermediation less economic and puts more of the onus on governments to maintain market liquidity – especially in low-risk asset markets like government bonds. Regulators should reflect upon recent events in the UK and ask whether current regulations appropriately incentivize the private sector to provide liquidity and whether permanently increasing the government’s role in provision of market liquidity is desirable or justified. Finally, the appropriate role of governments in intermediating our private capital markets is an important public policy question that deserves more attention and consideration from policymakers.