Treasury bills ; Government securities ; Liquidity (Economics) ; Debts, Public

Vaughn O'Regan

English

Research Papers in Economics

FRBNY Economic Policy Review / April 2000 121
ver the years, I have been involved with issues related to 
the Canadian government’s debt management activities 
and the functioning of capital markets in Canada. Recently, as 
in the United States, a key issue has been the repercussions of 
much smaller government borrowing requirements. The 
Canadian government moved into a fiscal surplus situation 
three years ago. As we like to point out, this was a year before 
the United States did.
  The focus of this conference is on the implications of a 
rather substantial pay-down of U.S. Treasury debt over the 
coming years. In Canada at this time, further pay-down of 
government debt is part of discussions on how to make use of 
the improved fiscal situation, but so are tax cuts and reinstated 
spending in such areas as health and education.
  However, regardless of what happens going forward, there 
already has been a significant change in Canadian debt markets 
as a result of shifts in government borrowings. The most 
dramatic impact has been on the treasury bill market, where 
the outstanding supply has been cut sharply. This has reflected 
not only the swing from a sizable federal government deficit to 
a surplus, but also a move to reduce the government’s exposure 
to interest rate changes by substituting bond borrowings for 
bills. This substitution has limited the reduction in the supply 
of Government of Canada bonds to a modest amount, at least 
so far.
  Of interest, the decline in trading volumes in both the bill 
and bond markets is greater than the decline in outstandings. 
In other words, the rate at which the supply is turning over is 
down. Turnover ratios had increased through the mid-1990s, 
but now have returned to the levels of earlier in the decade. 
Presumably, this reflects the more stable role of “buy-and-
hold” investors, compared with trading accounts, and the 
proportionately lower trading volumes by distributors of new 
issues when handling smaller offerings. 
  I will return to the Canadian situation later, as I expect this 
is where I can most add value to these discussions. In the 
meantime, I will make some comments on the paper by Paul 
Bennett, Kenneth Garbade, and John Kambhu. Given my 
background, I will defer to the experts on the technical 
workings of the New York debt market and limit my comments 
to a general nature.
  In the preamble to the specific proposals in the paper, I 
found the discussion of liquidity and Treasury debt 
management objectives to be quite useful. Several of the issues 
covered in this section are very familiar to me from discussions 
of the Canadian situation. While the authors cite three goals 
and a number of principles used by the U.S. Treasury 
Department for its debt management, it seems to me that this 
list could be boiled down to: 1) minimizing borrowing costs 
and 2) enhancing the workings of the capital market. And since 
liquid markets help to achieve both of these objectives, steps to 
improve liquidity are certainly worth serious consideration.
  The proposal to reduce the fragmentation of the market for 
STRIPS is similar to one that we are now considering in 
 Vaughn ORegan
The views expressed are those of the author and do not necessarily reflect 
the position of the Federal Reserve Bank of New York or the Federal 
Reserve System.
Commentary 
Vaughn O’Regan is an adviser to the governor of the Bank of Canada.
O122 Commentary
Canada. We have assured ourselves, after reviewing the 
authority under which our federal government borrows, that 
there is no legal impediment to the creation of an issue in 
excess of the original principal amount; I assume that this is 
also the case for U.S. Treasury issues. 
  I would agree with the authors that there is considerable 
merit to their STRIPS proposal. However, they should note 
that there are trade-offs involved: some issues will lose liquidity 
while others (and the overall market) will gain as a result of 
stepped up stripping and reconstitution activity. That is, 
irregularities will be dispersed over the market but not 
eliminated. Also, the placing of a cap on the amount that can 
be reconstituted can be a source of uncertainty for market 
participants, in that the gathering of relevant pieces for 
reconstitution could prove fruitless if it was later discovered 
that the limit had been reached. To ease these concerns and to 
provide as transparent a marketplace as possible, a means 
should be provided for making available on a regular basis 
information on the amounts of debt pieces outstanding.
As for the proposal to alter the two-year note issues, I see the 
more natural choice as integrating these issues with the rest of 
the note and bond programs. A shift to a 104-week bill would 
introduce a zero-coupon instrument providing no cash flow 
for two years—an instrument that may not be accepted by a 
segment of the conventional bill and note markets. For this 
reason, I would think that this proposition has some risk 
attached. Also, there is the risk that transferring supply from 
the note market to the bill market would further widen the 
liquidity gap that now exists between the two markets.
  It is at this gap that the “more adventurous” proposal in the 
paper is aimed. As an outsider, I clearly am in no position to 
pass comments on the particular workings of the U.S. market. 
The proposal assumes that the Treasury is able and prepared to 
issue and cancel debt expeditiously and that it will accept a 
shuffling, from one month to another, of refunding 
requirements. It assumes as well that investors will accept 
cancelations of pieces of issues that they hold (which has a 
somewhat different meaning than investors accepting that 
stripping and reconstitution can affect their holdings).
  As a summary comment, I see value in seeking ways to 
enhance liquidity in a market that is no longer receiving as 
much new supply. However—and I sense that this may be the 
case with the paper by Bennett, Garbade, and Kambhu—there 
can be excessive expectations as to what can be accomplished 
with technical adjustments. Enhanced stripping and 
reconstitution possibilities will provide more overall liquidity 
and will help ease “squeeze” situations, but this can also leave 
the market with more “loose ends.” The exchange proposal 
would establish more uniform pricing with the market and 
would help dealers to accommodate transactions, but trading 
volumes and bid-ask spreads would still not be uniform.
  There are, and presumably will continue to be, underlying 
reasons why anomalies exist even in very sophisticated markets 
with large numbers of arbitrage players. In the case of the 
Treasury market, I assume that a major influence can be the 
number of buy-and-hold investors, who have requirements for 
a specific issue to match flows or offset liabilities, or who are 
governed by legislation or guidelines to hold Treasuries, or who 
simply are risk-averse and are comfortable only with top 
creditworthiness. These are not investors who will move for a 
few basis points, and their role vis-à-vis that of opportunistic 
players will affect market liquidity. The authors do not discuss 
this underlying situation, perhaps because it is addressed in 
references and taken as understood.
I will finish with a return to the Canadian situation, making 
three comments:
1. For some time, the Canadian government has favored the 
reopening of existing bond issues whenever possible. As a 
result, the market does not have the same number of dif-
ferent “pieces” as the U.S. Treasury market does, and the 
reconstitution potential is not as large. Therefore, while a 
proposal is being examined to allow for full fungibility of 
interest and principal STRIPS, the potential benefits seem 
more marginal for the Canadian market.
2. The Canadian government, through the Bank of Canada, 
has been running a bond buyback program for a year. Off-
the-run bonds have been purchased around the time of 
new issues on six occasions so far. Payment for these bonds 
has been covered by a larger amount of new issue offerings 
than would otherwise be the case. The primary goal has 
been to maintain benchmark issuance size. Of note, with 
this substitution of benchmarks for off-the-run issues, the 
spread between the two has not changed much, presumably 
reflecting the overall spread environment of the past year.
3. While the turnover in Government of Canada debt has 
fallen recently, in Canada there has been a pick-up in 
activity in asset-backed securities, futures markets, and, to 
a degree, in the corporate market. This pick-up in activity 
does suggest that other markets will fill at least some of 
the void created by diminished government borrowings.
The views expressed in this paper are those of the author and do not necessarily reflect the position of the Federal Reserve Bank 
of New York or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty, express or 
implied, as to the accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of any 
information contained in documents produced and provided by the Federal Reserve Bank of New York in any form or 
manner whatsoever.

Enhancing the liquidity of U.S. Treasury securities in an era of surpluses - commentary

http://www.newyorkfed.org/research/epr/00v06n1/0004oreg.pdf

Enhancing the liquidity of U.S. Treasury securities in an era of surpluses - commentary

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