The Broken Treasury Market

If you want to worry about naked shorting, don't worry about the stock market, where it's vanishingly rare. Worry instead about the Treasury market, where it's a major problem.

Helen Avery has a huge and important story up about failures-to-deliver in the Treasury market. It's crucial that there be trust in the Treasury market, but right now, with fails reaching the trillions of dollars, the market is looking increasingly broken.

Following the collapse of Lehman Brothers in September, fails to deliver among the 17 primary dealers in the US treasury market have rocketed to more than $2 trillion over a period of weeks and still lie above $1.3 trillion. Broker/dealers have stopped delivering bonds. Holders of US treasuries are now scared to lend into the repo market in case their bonds are not returned, and potential buyers sit on the sidelines fearful of handing over their money to a counterparty that at best might not deliver a bond on time, and at worst might go under.

The problem is that there's little incentive for brokers to deliver bonds they've sold but don't own, since the only penalty for failing to deliver is to pay the Fed's overnight interest rate, which is less than 1%. If that broker goes bust before it can deliver the bonds, then the person who thought they were buying Treasury bonds ends up with nothing but a few days' worth of nugatory interest.

The Bond Market Association seems to be the villain of this story, consistently pushing back against attempts to impose steeper penalties on brokers who fail to deliver Treasury bonds they've sold. And of course there's the general deregulatory trend of recent years, which has mitigated against new regulations. But this should be a top priority for Treasury and the Fed, now. This is not something to wait until January.

(HT: Matt Tubin)