A new theoretical paper illustrates the logic behind runs and crashes in modern safe asset markets. Safe assets are characterized by stable value and high liquidity. In times of distress “flight for safety” increases demand for these assets, while “dash for cash” increases supply. However, these two are not generally in balance. If the need for liquidity is expected to dominate and dealer balance sheets are constrained by inventory and regulation, investors have an incentive to liquidate safe assets pre-emptively to avoid outsized mark-to-market drawdowns. Put simply, concerns over liquidity and dealer balance sheets are self-fulfilling. Without government intervention they can escalate into runs and render a safe asset market dysfunctional. This dynamic was illustrated by the U.S. Treasury market sell-off in the first quarter of 2020.

The below post is fully based on quotes from the following paper:
Eisenbach, Thomas and Gregory Phelan (2022), “Fragility of Safe Asset Markets”, New York Fed Staff Reports, 1026

This post ties in with this site’s summary on financial system risk, particularly the section on the side effects of regulatory tightening.

Characteristics of safe assets

“First, safe assets are safe in the sense that they will pay par at maturity with very high probability so investors hold them as a store of value, useful for diversification and intertemporal smoothing…Second, safe assets are liquid, meaning that they are ‘money-like’ and trade at a convenience yield. Some investors hold safe assets to sell them when in need of liquidity for consumption or to meet obligations.”

“[Many] investors…are risk averse and value the asset for its safety, holding it in a portfolio together with a risky asset. In times of stress, when fundamentals worsen for the risky asset (e.g., lower expected dividends), these safety investors rebalance their portfolio to buy more of the safe asset. This behavior captures the classic flight to safety and has been the focus of most existing analyses of safe assets in times of stress. [Also, many] investors…are subject to liquidity shocks and therefore hold the safe asset for its liquidity. When faced with an immediate consumption need, these liquidity investors sell the safe asset to raise cash in order to consume… Examples [are] foreign official agencies that may face sudden liquidity needs due to foreign exchange interventions or mutual funds that may face sudden liquidity needs due to investor withdrawals.”

A safe asset market is stable and well-functioning as long as the market is sufficiently deep. In this case, flight to safety and dash for cash are complementary phenomena, with investors who buy the assets for safety absorbing sales from investors who sell the assets for liquidity.”

Why safe asset markets are fragile

Markets where trading occurs in a decentralized, sequential way and where dealers play a large role intermediating flow imbalances over time are inherently fragile. These elements generate a strategic trade-off where an investor can hope to receive the average in-run price when selling pre-emptively but has to worry about bearing the full impact of dealer inventory when being forced to sell in the future.”

“Safe asset markets suffer from fragility because of…characteristics of the assets—safety and liquidity that interact with each other and with frictions in how the markets operate…During times of stress, investors’ liquidity needs can increase, leading to a ‘dash for cash’ that competes with the usual ‘flight to safety’ and exerts downward pressure on the price of safe assets…Safety and liquidity roles of safe assets can interact in such a way that flight to safety can worsen fragility, making dash for cash more likely… If the strategic concerns of liquidity investors are sufficiently strong, then additional demand from safety investors today can induce liquidity investors to sell today, precisely because the market today has relatively higher capacity to absorb sales.”

“There are dealers who buy and sell the safe asset and whose main role is to intermediate over time. Dealers are subject to balance sheet constraints and therefore provide an elastic residual demand for the safe asset. Because dealers’ demand in the present is affected by inventory they took on in the past, they provide an important intertemporal link between prices in different periods…Markets for safe assets such as U.S. Treasuries tend to rely heavily on dealers to intermediate trades. When dealers face costs for intermediating on their balance sheets [for example] due to the Supplemental Leverage Ratio rule (an unweighted capital requirement for banks that was introduced as part of the Basel III reforms in 2014.), they can become a bottleneck during times of stress, increasing price volatility in safe asset markets and contributing to market dysfunction.”

The market can break down with prices falling precipitously if trade involves dealers that are subject to balance sheet constraints. The risk of market break-down can be self-fulfilling, as it leads investors without genuine liquidity needs to sell pre-emptively in order to avoid potentially having to sell at lower prices in the future. Surprisingly…flight-to-safety purchases of safe assets can exacerbate the dash for cash when markets are fragile.”

“The liquidity role of safe assets together with dealer balance sheet constraints implies that a safe asset market can be fragile. Whether the market is fragile or stable depends on the degree of liquidity risk, which governs both the baseline level of non-strategic sales today as well as the likelihood that a strategic investor is forced to sell tomorrow.”

The dynamics of a run

“Market runs can arise in equilibrium because investors face an intertemporal decision regarding when (or if) to sell assets, and some investors may strategically choose to sell early to avoid the possibility of being forced to liquidate at depressed prices in the future…The market breaks down with dash-for-cash dynamics leading to a collapse in prices.”

“Investors…have to decide whether to sell their assets in the current environment, or whether to hold on and face the risk of a liquidity shock in the near future. An individual investor may prefer selling pre-emptively today if they expect conditions to deteriorate sufficiently tomorrow. As a group, liquidity investors interact strategically and introduce the potential for fragility. Sales today have a direct effect on the price today and, through dealer balance sheets, an indirect effect on the price tomorrow. An individual liquidity investor’s payoff from selling pre-emptively or holding on to the safe asset therefore is a function of other liquidity investors’ decision. Depending on the relative strength of the effect of sales today on the prices today and tomorrow, the interaction between liquidity investors can feature strategic complementarities: The individual investor’s incentive to sell pre-emptively can be higher if more of the other investors also sell pre-emptively.”

An individual investor’s incentive to sell pre-emptively is increasing in the degree of liquidity risk, as is the slope of the incentive with respect to other investors’ sales. For very low liquidity risk, an investor never finds it optimal to sell pre-emptively, irrespective of what other investors are doing; the only equilibrium in this case is for all strategic investors to hold on to the safe asset such that the only investors selling are those with a genuine liquidity need. For very high liquidity risk, the opposite is true, and an individual investor finds it dominant to sell pre-emptively such that the only equilibrium is for all liquidity investors to sell. In this case, the safe asset market is flooded with sales, including by investors who do not actually have liquidity needs — a ‘market run.’”

Covid crash versus the great financial crisis

Events in the U.S. Treasury market at the onset of the Covid-19 pandemic in March 2020 [reflected] a ‘perfect storm’ of the three features: First, financial regulation in the wake of the financial crisis of 2007–2009 had significantly tightened dealer balance sheet constraints, increasing the inherent fragility of the market. Second, the pandemic threatened a global economic slowdown leading to a powerful flight-to-safety demand, further destabilizing the market. Third, lockdowns created unprecedented liquidity needs among consumers and official agencies.”

“[In 2020Q1] foreign investors and mutual funds sold Treasuries on an unprecedented scale, an order of magnitude larger than in any previous quarter. In addition, there is suggestive evidence that a considerable fraction of these sales were not due to genuine liquidity needs: Among foreign investors, foreign official agencies sold $196 billion of Treasury bonds but ‘consumed’ only 24% of the proceeds in the form of a $48 billion reduction in their total U.S. Dollar assets. Among mutual funds, those in the CRSP dataset sold $157 billion of Treasuries but ‘consumed’ only 66% of the proceeds to satisfy outflows as $54 billion of their sales were in excess of outflows.”

“Panel B of [the figure below] shows that dealer balance sheet space allocated to Treasuries (via direct holdings and reverse repos) increased through both the run-up in Treasury prices and their crash. Treasury markets also became unusually illiquid during this period, with bid-ask spreads increasing by a factor of 10…The recovery in Treasury prices after March 18 coincided with dealer balance sheet pressure receding as the Federal Reserve’s Treasury purchases ramped up (Panel B).”

The behavior of the markets for Treasuries in March 2020 is particularly striking in contrast to the great financial crisis in 2007–2009 (GFC), during which Treasury markets rallied and did not feature dysfunction and illiquidity…During the GFC, dealers’ activities in Treasury markets were relatively unconstrained and thus investors did not need to worry about dealers running out of balance sheet space and Treasury prices collapsing…Because the GFC did not feature dealers constrained by balance sheet costs, and because the shock to liquidity needs was arguably smaller, the Treasury market remained in the stable region in which flight to safety prevents a dash for cash.”