Darrell Duffie, The Adams Distinguished Professor of Management and Professor of Finance, Stanford University
Oct 27, 2023
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Renowned finance professor Darrell Duffie discusses his vast research contributions and recent focus on the US Treasury market. They explore the bond market meltdown in 2020, yield volatility, liquidity breakdown, and policy implications. They also delve into topics like cross currency basis swaps, transitioning from LIBOR to risk-free overnight rate, and the importance of the base asset in pricing.
Improving the resilience of the US Treasury market is crucial to maintain liquidity and reduce reliance on central bank interventions.
Balance sheet usage by dealers significantly impacts liquidity in the Treasury market, with heavy loading leading to wider spreads and reduced depth.
Central bank interventions are less effective in mitigating volatility-driven by fundamental factors, highlighting the importance of enhancing market structure and implementing central clearing in the Treasury market.
Deep dives
Resilience of the US Treasury market and the need for central clearing
March 2020 highlighted the need to improve the resilience of the US Treasury market, which functions as the world's safe haven and allows the US government to fund itself. Liquidity in the Treasury market broke down as dealers struggled to manage their balance sheets, causing wide bid-offer spreads and reduced market depth. Research shows that yield volatility explains a significant portion of liquidity, but when balance sheets become overloaded, the relationship between volatility and liquidity breaks down. One important policy recommendation is the implementation of central clearing in the Treasury market, which would enhance market stability, allow for netting of trades, and reduce dealer commitments. Other measures, such as improving intermediation capacity under stress, are also needed to ensure the proper functioning of the Treasury market and reduce the reliance on central bank interventions.
The impact of balance sheet usage on Treasury market liquidity
Research shows that balance sheet usage by dealers plays a crucial role in determining liquidity in the Treasury market. When balance sheets become heavily loaded, liquidity is negatively impacted, leading to wider bid-offer spreads and reduced market depth. This effect becomes more pronounced once balance sheet usage exceeds a certain threshold, typically around 40%. To measure balance sheet usage, various metrics were used, including gross and net positions, value at risk, and incoming flows from customers. Understanding and addressing the challenges associated with balance sheet usage is essential for enhancing the liquidity and resilience of the Treasury market.
Effectiveness of large-scale asset purchases in volatile markets
During periods of high volatility, such as in 2022, it may be less effective for central banks to intervene through large-scale asset purchases in the Treasury market. Volatility driven by fundamental factors, like monetary policy uncertainty or geopolitical risks, cannot be easily mitigated by central bank interventions. However, central clearing and other market structure improvements are crucial for addressing liquidity issues in the Treasury market and reducing the need for central bank support. While central bank interventions can help stabilize markets, enhancing market structure is the key to preventing and quickly resolving liquidity challenges in the Treasury market.
The fiscal challenge and risks in Treasury markets
The high level of deficit spending without an end in sight poses a fiscal challenge for the US government. With projections of increasing Treasury debt, investor demand for higher interest rates may rise. While the Federal Reserve can step in to stabilize the market, it cannot address the underlying fiscal problem. To ensure the stability of Treasury markets, regulatory efforts should focus on improving market structure, such as central clearing, to handle increased flows and volatile conditions. Financial market resilience is critical in preventing market dysfunction and reducing reliance on central bank interventions.
Future research on Treasury buybacks
Exciting new research is underway on Treasury buybacks, exploring the cost-benefit analysis and potential implementation strategies. This project aims to understand the implications of Treasury buybacks and their impact on the market. Details and findings of the research will be shared at a later stage. The importance of examining Treasury buybacks lies in their potential effects on market dynamics and the overall functioning of the Treasury market.
Over a distinguished 40-year career as an academician in finance, Darrell Duffie has made important contributions to our collective understanding of how markets work. Earning a PhD from Stanford in 1984, Darrell has taught finance there ever since and now serves as the Adams Distinguished Professor of Management and Professor of Finance at the Graduate School of Business. Along the way he has written several books, authored countless papers and provided guidance to policymakers who have sought his counsel in addressing complex regulatory questions.
We review some of Darrell’s research over the past 4 decades, starting with equilibrium models of asset pricing in the 80’s, termstructure models in the 90’s and work on default correlation post the GFC. We spend most of our time on his recent research on the US Treasury market, that risk-free asset class that recently appears anything but. Darrell shares some conclusions from analysis of the melt-down of the bond market in March of 2020 and the policy implications that result. First, he states that yield volatility explains a large proportion of the breakdown of liquidity in what should be the world’s most liquid asset class. Higher vol and compromised liquidity generally go hand in hand. Darrell and colleagues show that the bond market freeze could further be traced to dealers reaching their capacity to warehouse risk, a factor that impacts liquidity in a highly non-linear manner.
We shift to the policy recommendations that arise in light of his research. First, Darrell notes that a campaign of large-scale asset purchases is considerably more effective in combatting a volatility episode when dealer balance sheets are stretched as they were in March of 2020 than the market turbulence of 2022, when dealers had space to absorb more risk. He also points to a greater need for centralized clearing in the Treasury market, a mechanism that would provide much needed netting of risk exposures. Lastly, Darrell shares some new research he is engaged in, specifically, exploring the 2024 Treasury program to buy-back securities.
I hope you enjoy this episode of the Alpha Exchange, my conversation with Darrell Duffie.
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