## SAFEGUARDING THE TREASURY MARKET

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**Canonical URL:** [SAFEGUARDING THE TREASURY MARKET](https://www.imf.org/-/media/files/publications/fandd/article/2026/03/kashyap.pdf)

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### Modern market structure and sources of fragility
- The ratio of publicly held federal debt to GDP is now about 100 percent.
- Growth in Treasury supply has outpaced the expansion of traditional intermediaries’ balance sheets; post–2008 regulations (for example, the supplementary leverage ratio) and tighter risk management make it costly for dealers to hold large inventories.
- Institutional asset managers (pension funds, insurance companies, mutual funds, exchange-traded funds) increasingly hold long-term interest rate exposure but often obtain duration via derivatives (Treasury futures, interest rate swaps) rather than holding equivalent cash Treasuries.
- Hedge funds and dealers arbitrage cash-versus-derivative price differences; profitability relies on high leverage and ready funding in the repo market.
- Hedge funds may finance cash Treasury positions by borrowing as much as 99 percent of the overall position in the repurchase (repo) market.
- Dealers’ constrained balance sheets limit their ability to absorb large flows during stress, crowding out market-making and repo intermediation functions.

### Mechanics of stress episodes
- Stress often reflects the interactions among asset managers (holders of unhedged duration risk), hedge funds (leveraged providers of arbitrage), and broker-dealers (limited-balance-sheet intermediaries), rather than macroeconomic shocks alone.
- A typical stress dynamic: margin calls or funding shocks force hedge funds to unwind basis trades → fire sales of cash Treasuries and rushes to cover short derivative positions → divergence between cash and derivative prices → dealers’ balance sheets are strained → bid-ask spreads widen and liquidity evaporates → repo funding conditions deteriorate.
- March 2020 example: rising volatility and COVID-19 driven liquidation pressures led hedge funds to pull back from the basis trade; dealers’ balance sheets were blown up, reducing market making and repo intermediation.

### Historical Fed response and limitations
- The Federal Reserve purchased roughly $1.6 trillion in Treasury securities in a few weeks during March 2020 to restore market functioning.
- Large-scale, unhedged bond purchases restored functioning but blurred the distinction between market-function support and monetary policy; purchases continued after market functioning stabilized.
- March 2020 reforms proposed in response include: adjustments to leverage regulations, expansion of standing repo facilities, minimum margin requirements for futures, and broader central clearing of Treasury trading — all helpful but not panaceas.

### Central bank intervention: proposed narrower tools
- Core proposal: when intervening to restore market functioning, the Fed should buy cash Treasuries while simultaneously selling Treasury futures or entering into equivalent derivative positions (i.e., hedge the interest rate exposure of purchases).
- Economic equivalence: this hedged purchase is akin to a repurchase transaction in economic terms, differing mainly in the identity of counterparties on the two sides.
- Advantages of hedged (duration-neutral) intervention:
  - Relieves pressure on dealer balance sheets more effectively because dealers are not left with large unhedged interest rate exposures.
  - Separates market-function support from monetary policy, avoiding unintended signaling of monetary easing—important if dysfunction occurs during higher inflation.
  - Obviates the need for ex post commitments to quickly unwind purchases; duration-neutrality is built in up front.
  - Limits the Fed’s interest rate exposure and reduces the risk of large ex post losses.

### Moral hazard and mitigation
- Backstops create moral hazard: expectations of intervention could induce greater leverage by arbitrageurs.
- Hedged interventions are arguably less prone to moral hazard than unhedged purchases because unhedged purchases more clearly establish an absolute floor (“Fed put”) for bond prices.
- A “penalty-rate” approach can mitigate moral hazard: allow basis spreads to widen beyond normal levels and intervene only to cap extreme dislocations, permitting some private-sector losses while preventing worst-case outcomes.

### Key policy lesson and outlook
- Treasury market dysfunctions are endogenous to a market structure that relies on leveraged balance sheet intermediation to absorb a rapidly growing supply of government debt; stresses are amplified when this structure is tested.
- The lesson is not to avoid intervention but to prepare more surgical, duration-neutral tools in advance so future interventions stabilize markets effectively with fewer undesirable side effects.
- Federal government debt could exceed 170 percent of GDP by the mid-2050s, according to the Congressional Budget Office—implying the central bank will likely need appropriately designed tools again as the market continues to grow.

*Source: Anil K. Kashyap and Jeremy C. Stein, “Safeguarding the Treasury Market,” F&D, March 2026.*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2026/03/kashyap.pdf_