US treasury market – The mechanics: fear of counterparty failure has frozen the Treasury repo market
Although the catalyst that led to this record amount of fails in treasuries, spiking at $2 trillion, was the collapse of Lehman Brothers, it is the settlement system and lack of regulatory oversight that has led to this risk of market failure.
The treasury market has always been highly liquid. Dealers are able to sell treasuries without owning them, borrowing them in overnight through the repo markets in order to meet the T+1 delivery. The supply of treasuries into the repo market has, in calmer markets, been so bountiful that selling treasuries without owning them was not considered by most traders to be a concern. After Lehman collapsed, however, several things happened to dry up supply to the repo market, explains Rob Toomey, formerly with the BMA which is now part of Sifma (The Securities Industry and Financial Markets Association). “There was a tremendous flight to quality so a lot more investors were buying treasuries,” he says. “At the same time, holders of treasuries that would ordinarily lend the securities overnight in the repo markets stopped lending as they became fearful of counterparty risk.”
Investors in treasuries are largely risk-averse by nature. Central banks, for example, and pension funds are large holders of treasuries. ‘They’re not going to risk lending out treasuries in this environment,” says Stan Jonas, director of Axiom Capital Management, a New York investment and banking firm. “If you lend stock in a bear market you get collateral in exchange and then if your counterparty goes belly-up you’ll keep that and the stock will have dropped so you can buy it back cheaper than when you loaned it.