Bond yields could drop under an idea that would make Treasury trading more like the stock market

• Treasury markets have a liquidity problem that was fueled by regulatory changes after 2008.
• All-to-all trading, similar to how equities operate, is a possible fix that regulators are studying.

Treasury markets have a liquidity problem fueled by regulatory changes after 2008, and one idea for fixing it could send trading volume higher — and bond yields lower.

Known as "all-to-all" trading, the idea would allow any market participant to interact directly with another, without intermediaries. That's more like how the stock market works. But in the Treasury market, banks have traditionally acted as dealers for buyers and sellers.

Federal regulators are studying the idea. The Inter-Agency Working Group — which includes officials from the Federal Reserve, Treasury, SEC, and CFTC — said in November it's looking at the pros and cons of all-to-all trading in the Treasury market.

Whether it happens or not, some changes to the Treasury market appear likely as it has become less liquid.

Before 2008, banks were able to take on large trade flows from Treasury investors without having to increase their capital. But after the financial crisis, new regulations required more capital, and banks found themselves unable to add to their balance sheets when big trades arrived.

At the same time, the Treasury market skyrocketed after 2008, as the government injected large quantities of stimulus into the economy that sent debt soaring. Deficit spending increased with the COVID-19 crisis, and marketable US debt shot up to nearly $23 trillion, compared to $5 trillion in 2008.

Although the debt was meant to fuel economic recovery, it also weakened the market's liquidity, especially when Treasury traders tried to move large volumes in moments of stress, such as during the pandemic's onset.

"Investors around the world sold their Treasurys en masse, and the dealers were unable to handle the flow of volume," Stanford professor Darrell Duffie told Insider, referring to March 2020. "They basically said, 'I hardly have any space on my balance sheet. If you want to sell me something, it's going to be at a really low price.' And so, basically, the depth of the market disappeared."

That's why all-to-all trading has become a relevant idea, he said: it offers a reprieve from relying on dealers, making the market more resilient.

Duffie, who has previously consulted the Chicago Federal Reserve, also said it would lead to astronomical growth for the Treasury market.

He referenced the equity options market, which underwent a similar change in 1973. Once a dealer-intermediated operation, trades exploded after the Chicago Board Options Exchange was set up to match buyers with sellers.

"You'll just see this kind of huge ramp that goes from the low millions per year to the many, many billions per year," Duffie said.

In addition, all-to-all trading tends to be facilitated on electronic platforms, encouraging trades of any size while opening the doors to algorithmic and high-frequency trading, he added. And as more traders start to participate, costs go down, encouraging even more participation.

With the increase in liquidity, Duffie expects transaction costs to drop, helping asset prices go up — "Meaning the yield of a Treasury security will go down, and the government will be able to fund the US deficits more cheaply."

Left unsaid was the implication for stock prices, which tend to rise when bond yields go down. The S&P 500 tumbled last year as yields shot up amid Fed rate hikes, and stocks rallied early this year when yields retreated.

But all-to-all trading may also introduce less rational investors into Treasury markets, applying a gambling mentality to some trades.

"You might have a little bit more day-to-day choppiness," Duffie said, but added that, "as markets get deeper, they tend to be less volatile."