David Jones

Mr.Peter Breuer

Antoine Bouveret

Ms.Yingyuan Chen

Tsuyoshi Sasaki

Changes in the structure of the U.S. Treasury market over recent years may have increased risks to financial stability. Traditional market makers have changed their liquidity provision by increasingly switching from risk warehousing to risk distribution, and a new breed of market maker has emerged with the rise of electronic trading. The “flash rally” of October 15, 2014 provides a clear example of how those risks can materialize. Based on an in-depth analysis of the event—complementing the authorities’ work—we suggest i) providing incentives for liquidity provision, ii) improving market safeguards, and iii) enhancing the regulation of the Treasury market.

Lessons from the “Flash Rally” of October 15, 2014

Fragilities in the U.S. Treasury Market

The simultaneous unwinding of leveraged positions can trigger financial market turbulence. Although balance-sheet measures of leverage are available, it is useful to construct a measure of leverage that incorporates both on- and off-balance-sheet activities. This paper provides measures of leverage implicit in derivative contracts by decomposing the contracts into cash market equivalent components. A leverage ratio can then be calculated for this replicating portfolio, which consists of own funds (equity) and borrowed funds equivalents (debt). Methods for aggregating leverage by institution and by markets are presented. The interaction between leverage and risk is discussed, and a modified capital adequacy ratio is calculated, which captures off-balance-sheet exposure.

Mr.Peter Breuer

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