Safeguarding the Treasury Market

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For decades the US Treasury market was assumed to be highly liquid and resilient, tradable in large quantities rapidly and with little friction.
Recent episodes—most notably March 2020 and April 2025—show that the Treasury market can seize up abruptly, with systemic consequences.
The ratio of publicly held federal debt to GDP is now about 100 percent, and given the current US fiscal stance, this ratio will keep rising.
Central argument: do not increase frequency of Fed intervention; instead, design better-targeted interventions to be used when market functioning breaks down.

Treasury supply has expanded rapidly while bank-affiliated broker-dealers have not expanded balance sheets to the same degree.
Post–2008 regulations (e.g., supplementary leverage ratio) and elevated risk-management standards increase costs for dealers to hold large inventories.
Institutional asset managers (pension funds, insurance companies, mutual funds, ETFs) increasingly dominate Treasury holdings but often avoid holding full exposure in cash bonds.
To achieve duration exposure while conserving balance-sheet capacity, asset managers use long positions in derivatives (Treasury futures, interest rate swaps), driving derivative prices up relative to cash bonds and creating arbitrage opportunities.
Hedge funds and dealers arbitrage by taking the opposite side and hedging with cash Treasuries; much of this arbitrage is highly leveraged.
Hedge funds may finance long cash-Treasury positions by borrowing as much as 99 percent of the overall position in the repurchase (repo) market.

Asset managers are the ultimate holders of unhedged duration risk; their preferences and constraints determine the “term premium.”
Hedge funds and broker-dealers generally remain roughly duration-neutral and connect cash and derivative markets via hedged arbitrage (e.g., cash-futures “basis trade”).
The cash-futures basis trade: buy cash Treasuries, sell Treasury futures, finance cash purchase in repo; profitability depends on aggressive borrowing due to small price differentials.
Implications:
- High leverage makes hedge funds vulnerable to shocks (capital, funding, margin requirements, risk tolerance).
- Dealers’ limited balance-sheet capacity constrains absorption of large flows during stress and crowds out market-making and repo intermediation.

As COVID-19 shock intensified, investors raised cash by selling Treasuries and riskier assets; volatility rose and hedge funds faced margin calls on short futures positions, prompting rapid withdrawal from basis trades.
Result: selling pressure blew up dealers’ balance sheets, forcing cutbacks in market making and repo intermediation.
The Fed purchased roughly $1.6 trillion in Treasury securities in a few weeks, restoring market functioning.
Concern: large unhedged purchases blurred the line between market-function support and monetary policy; purchases continued well after functioning stabilized, raising questions about narrower alternatives.
Reform proposals following March 2020 included adjustments to leverage regulations, expansion of standing repo facilities, minimum margin requirements for futures, and broader central clearing—each helpful but none a panacea.

Core proposal: when forced to purchase Treasury bonds during extreme market stress, the Fed should hedge purchases against interest rate risk—buy cash Treasuries while simultaneously selling Treasury futures or entering equivalent derivative positions.
Rationale:
- Addresses root problem: need for a counterparty to take the other side as leveraged intermediaries unwind hedged positions.
- Economically similar to a standard central bank repurchase operation, differing only in counterparties across the two sides.
Advantages:
- Relieves pressure on dealer balance sheets more effectively than unhedged purchases because dealers avoid significant unhedged interest-rate exposure.
- Keeps the intervention duration-neutral, separating market-function support from monetary policy and avoiding unintended signaling of monetary easing (especially important if dysfunction occurs during higher inflation).
- Removes need for post-intervention commitments to unwind purchases since duration-neutrality is built in.
- Limits Fed interest-rate exposure and reduces risk of large ex post losses.

Central bank backstops raise moral hazard concerns: arbitrageurs might take more leverage if they expect intervention whenever basis trades move against them.
Hedged purchases are less likely to create an absolute “Fed put” than unhedged purchases, reducing moral hazard relative to large unhedged purchases.
Mitigation measure: a “penalty-rate” approach—allow basis spreads to widen beyond normal and cap only extreme dislocations, intervening at clearly dysfunctional thresholds and permitting some private-sector losses.

Treasury-market dysfunction arises from a market structure that relies on leveraged balance-sheet intermediation to absorb a rapidly growing supply of government debt; when stress hits, this structure amplifies shocks and overwhelms traditional broker-dealers.
March 2020 showed the necessity of a central bank backstop and the cost of using blunt tools that are hard to disentangle from monetary policy.
Preparing surgical, duration-neutral tools in advance will enable future interventions to stabilize markets more effectively and with fewer undesirable side effects.
As the Treasury market grows, the question is whether the central bank will be ready with the right tools when called to act.

Safeguarding the Treasury Market, ANIL K KASHYAP and JEREMY C. STEIN, F&D Magazine, March 2026.

Safeguarding the Treasury Market
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