I am pleased to have the opportunity to discuss this important topic with these accomplished panelists.1 I would like to share some lessons learned from the New York Fed’s Open Market Trading Desk (Trading Desk) implementation of market function purchases in the U.S. Treasury and agency MBS markets in the spring of 2020. Before proceeding further, I would like to note that these remarks reflect my views and do not necessarily represent the views of the Federal Reserve Bank of New York or the Federal Reserve System.
Let me begin with a brief background on the conditions that led the Fed to initiate market function purchases. the emergence of the epidemic in early 2020 created an extreme demand for liquidity – a “cash sprint” – and -the uncertainty of the economic outlook. Many investors held U.S. Treasuries for their currency-like nature, and as these investors attempted to convert their holdings to cash, the U.S. Treasury market became the recipient of a massive selling wave. Sales quickly outpaced end-user demand for purchases and the ability of intermediaries to respond to the imbalance, leading to a two-way market collapse, with the pressure spreading to other related markets, including agency MBS. In response, the Federal Open Market Committee (FOMC) took unconventional actions to address the market dysfunction, first by directing the department to increase the daily issuance of overnight repurchase agreement transactions (repos), and to offer new term repos. and to provide new term repos. The temporary financing provided by these operations, while helpful, could not meet the permanent liquidity needs of all investors, and soon after, the department was directed to purchase U.S. Treasury and agency MBS securities at an unprecedented rate to support market operations.2
Today, I will share three key lessons I learned from my experience implementing market-operated purchases in March 2020: first, the importance of being able to adapt p
urchases to changing conditions; second, the importance of using the purchases themselves to assess market pricing; and third, the importance of continuing to pursue regulatory and market structure initiatives that support the resilience of government debt markets.
Real-Time Radar: Adjusting Purchases to Changing Market Operating Indicators
In times of severe market failure, policymakers inevitably find themselves making quick decisions with imperfect information. The first lesson I learned from our experience is that adjusting market function purchases based on real-time indicators of market functions (both market intelligence from participants and signals from operational results themselves) is critical to their effectiveness.
At the start of the pandemic, various market indicators suggested that markets were becoming increasingly illiquid. By analyzing Treasury trading data (TRACE), other flow data, and reports from market participants, we observed a sharp increase in selling pressure. Primary dealers’ positions are already at high levels, have limited ability to intermediate large flows, and are at greater risk as volatility increases. Bid-ask spreads have widened sharply, particularly for large amounts of out-of-period notes and bonds.3 However, our understanding of some of these important trends is limited, in part due to the lack of real-time and comprehensive cash market data on positions and leverage in areas such as the uncleared bilateral repo market.4
Given these factors, the department initially targeted purchases of a broad range of U.S. Treasuries and announced plans to spread our previously planned $80 billion in monthly purchases across the curve. Although the purchases were planned for the mid-March to mid-April period, it quickly became apparent that the need for immediate “cash liquidity” required a more rapid response, and we subsequently loaded $37 billion of these purchases up to one day earlier (Friday, the 13th). These operations received more than $100 billion in offers from primary dealers, indicating a large and immediate need for liquidity. On March 15, the FOMC announced large-scale purchases of U.S. Treasuries and agency MBS, followed by an announcement on March 23 that purchases would be expanded to “5 At the end of the first four weeks of purchases, the department had purchased more than $1 trillion in U.S. Treasuries and nearly $500 billion in agency MBS. 6
In addition to adjusting the timing and volume of purchases, the department frequently adjusts the specific parameters of its purchasing operations. At the end of each purchase date, the department evaluates the results of the purchase operations, the status of market indicators of liquidity and relative value, positioning and flow data, and market intelligence we have collected, and uses these variables to adjust our plans for upcoming purchases. For example, we typically do not purchase securities with the lowest delivery costs for active Treasury futures contracts to avoid exacerbating the scarcity of these issues. However, given the significant unwinding of cash-futures basis trades at the time, we chose to include these securities in our business to help absorb these sales. in the MBS market.
Certainly, access to better data will help make these judgments, and many important efforts are underway to improve data availability.7 But even with the best data, designing such purchases in a crisis requires judgment and adaptability, and the use of real-time metrics, operational results and market intelligence remains critical to help make these decisions.
Ensuring the right price: Using operations to assess market prices
Dysfunctional markets pose a particular problem for central banks as they assess the appropriate price for the securities they purchase: in the absence of a liquid two-way market, market pricing sources can be unreliable. A second lesson from the sector’s pandemic purchases is that the purchasing operation itself provides important information in order to obtain the correct price.
Historically, the department has chosen to purchase securities by conducting mass auctions, selecting quotes for specific securities based on their price relative to the prevailing market price or, in the case of Treasury purchases, based on our proprietary model of theoretical value measurement. For Treasury purchases, this approach typically works well during a pandemic, with market price measures that are fairly close to the prices received in our business. From March through June 2020, at the peak of the market dysfunction, nearly all U.S. Treasury purchases were executed at below-market prices.
In contrast, agency MBS market price sources were more volatile. In the Treasury market, high-speed electronic trading is widely used to trade recently issued securities, while most trading in agency MBS is done through the Request for Quote (RFQ) system, which is slower for dealers and customers. The major institutional MBS trading platforms provide the approximate price levels at which trades are likely to occur. Under normal circumstances, these “indicative” prices are very close to the actual bid and ask prices at which market transactions are conducted. However, at the height of dysfunction, the quotes we receive in our operations vary significantly from these indicative prices – sometimes by more than a quarter of a percentage point, above or below expectations.
As a result, we have developed a variety of methods to use the prices provided to us in operations to establish effective market prices for each security, which helps us select which securities are valued by the market as cheap and should be targeted for purchase. For example, one pricing measure used is the second best price we receive for a security from a dealer other than the dealer offering the best price (a measure commonly referred to in the market as “coverage”).8 As two-way market activity picks up, we continue to adapt these methods and integrate market price feedback into our security pricing evaluation.
Don’t forget the dog just because he doesn’t bark
Finally, we should learn the lesson of the “dog that didn’t bark” during the epidemic. Despite the unprecedented flow of government securities in the market, we were fortunate not to see cracks in the market infrastructure – the financing, clearing and settlement systems that underpin the U.S. Treasury and agency MBS markets. Some have cited this as evidence that these processes need not be a priority in efforts to increase the resilience of the Treasury market. Let me be clear: this is not a lesson we should learn.
We know that the processes for financing, clearing, and settling government securities markets could be more resilient.9 In recent years, the U.S. Treasury Market Practice Group (TMPG) has highlighted the risks of clearing and settling in the U.S. Treasury market, finding that market participants may not be using the same risk management for financing, clearing, and settling U.S. Treasuries that they do for securities in other markets.10 For example, the TMPG found that central clearing s market share of Treasury cash has shrunk to less than 25 percent over the past 20 years, reducing market share and liquidity resource requirements subject to standard risk management processes such as margin and default processes.11 Similarly, TMPG found that inconsistent risk management practices, including zero discounting, exist in the large, uncleared bilateral repo market. Many counterparty risk management professionals consider such practices to be problematic at best.12 More should be done to ensure that these transactions effectively manage counterparty credit risk, and I am pleased that both public and private sector groups have plans to work in this area.13
Importantly, we do not know how the financing, clearing, and settlement of Treasury and agency MBS would have proceeded if the Federal Reserve had not offered an unprecedented number of Treasury repurchase agreements and purchased large amounts of these securities. If a large market participant defaults, especially in the uncleared segment, it could reverberate through the system’s pipeline. It is important to guard against bilateral and systemic risks in the financing, clearing, and settlement process that could lead to transactions
