Treasury jitters and banking regulation

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Good morning. Microsoft announced that it would allow its cloud users to use artificial intelligence models from Elon Musk’s xAI on its platforms. It’s the latest sign that relations are cooling between the Seattle-based tech giant and xAI competitor OpenAI — which Microsoft owns a 49 per cent stake in. Rob is away, so email us instead: aiden.reiter@ft.com and hakyung.kim@ft.com.

The Treasury market and the SLR

When Moody’s downgraded the US’s credit rating going into the weekend, there was broad concern that the market would be in crisis on Monday. That appeared to be the case at the open: equities fell, and Treasury yields rose fast. But things settled down just an hour later. The S&P 500 finished the day flat, and yields on benchmark 10-year Treasuries were down by just three basis points. 

That puts 10 year yields just two basis points higher since Moody’s announcement. It appears the market did not much care — or it could be that investors are waiting to see the shape of the Republican budget proposals, which are expected later this week. But there was one concerning outcome: the dollar fell faster than Treasury yields yesterday, suggesting foreign buyers were selling off US assets:

This is just the latest in a series of troubling signals in the Treasury market. And we expect there are more to come. US debt is mounting; growth and productivity appear to be slowing, and all else equal, the current path of US trade policy will result in fewer dollars flowing abroad, probably leading to less foreign buying of US assets. As a result, it seems that policymakers are getting more serious about improving Treasury market function this year. Good. 

There are many proposals on the table, but the one that appears to be getting the most traction so far is to exempt Treasury holdings from the supplementary leverage ratio (SLR). Banks are required to meet a number of capital requirements to ensure that they have sufficient liquidity and capital to support safe lending. The SLR is the broadest capital requirement possible: it divides all of a bank’s liquid assets (cash and cash-like things) over all its liabilities, including safe risk-free assets such as Treasuries, reserves held at the Fed and off-the-book derivatives. The broadness of the measure is the point. It’s very hard to fiddle with. And, as opposed to the more complex risk-weighted ratios that did not properly gauge banking risks before the 2008 financial crisis, the simplicity of the SLR makes banks easier to regulate. 

The broadness of the measure, however, can lead to distortions and potential liquidity issues for the Treasury market. The banks themselves have argued that requiring banks to hold cash against risk-free assets such as Treasuries is counter-productive. It disincentives them from holding US debt, they say, and makes it more costly for their trading desks to be active in the Treasury market. 

We get the banks’ argument and are inclined to believe it. But it is unclear if exempting Treasuries or other risk-free assets will actually support Treasury market liquidity in moments of crisis, which is when it is needed most. The Fed exempted various risk-free assets from 2020-21. Some postmortems suggest there was more buying of Treasuries in that period. But other studies suggest the SLR is not a constraint, and exempting Treasuries would not be helpful in moments of Treasury market turmoil. Even if they needed less cash on hand to buy Treasuries, why would banks go charging into an imploding debt market?

It’s a tough call, but looking at the challenges we expect the Treasury market will face in the coming years, there is a good case for erring on the side of a Treasury exemption. In a market potentially losing buyers and facing higher and more volatile yields, extra liquidity is important. But this should not be a free pass for the banks. As Darrell Duffie, professor of finance at the Stanford Graduate School of Business, argued to Congress last week and noted to Unhedged, any change to the SLR should be offset by changes in risk-based capital requirements:

Without an offset, dealer capital levels would decline. Among other concerns, a decline [in] dealer capital would increase the interest rates that dealers pay to finance their inventories and reduce the incentives of dealers to offer liquidity to financial markets. Today, the best-capitalised dealers have lower debt funding costs and lower required returns on equity than less well capitalised dealers. Better capitalised dealers thus provide relatively more liquidity to their customers, especially during a crisis.

Reforms such as the proposed SLR exemptions will hopefully help prevent the next Treasury crisis. But it will only really help at the margins. It is far more important for the US to lower the deficit and pursue economic policies that lure foreign Treasury buyers back to auctions. Our attention will be on the budget this week.

(Reiter)

Coinbase in the S&P 500

Yesterday, the S&P 500 got a new member: Coinbase, the world’s largest cryptocurrency exchange and the second-largest stablecoin issuer. Crypto bugs have been calling it “a watershed moment” for the asset class — a stamp of legitimacy, but without all the messy regulation that the industry has long sought to avoid. And it’s clearly been a boon for the company: its shares jumped 24 per cent last week when its inclusion was announced.

Unhedged has been wary of crypto broadly, and stablecoins in particular. But it’s not worth litigating its inclusion. It’s in the index. Whether we like it or not, most 401ks are now exposed to Coinbase and the industry it represents.

But we do take issue with its inclusion in the financials grouping of the index. The company is a three-in-one hybrid of cryptocurrency exchange, broker and custodian. There’s no other financial company in the S&P 500 that has all those functions, and, crucially, the other members have regulatory oversight from the Securities and Exchange Commission. Compared to the highly regulated services companies in the financials sub-index, Coinbase’s revenue is also highly dependent on speculation. Fifty per cent of its revenue comes from fees drawn from coin-crazed retail investors. And 14 per cent of its revenue comes from the interest it reaps on its stablecoin reserves balance, which grows and shrinks in response to speculation, too. Tellingly, Coinbase’s stock price has closely mirrored bitcoin over the past few years:

All stocks respond to animal spirits and speculation. But we prefer stocks to respond to fundamentals, especially in the financial sector, which underpins the broader market. Thankfully, at its current market weighting, any violent swings in Coinbase’s — or bitcoin’s — price will not have a meaningful influence on the broader index. At its current market cap it is about 0.1 per cent of the total index and less than 1 per cent of the financials sector.

But would Coinbase not have made more sense as a consumer discretionary stock? Specifically, shouldn’t it have been within the gaming sub-index?

(Kim)

One good read

More on wage stagnation.

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