The Effect of Primary Dealer Constraints on Intermediation in the Treasury Market 
This paper studies the extent to which the Treasury securities market can be affected by regulatory constraints on primary dealers, a select group of market-making financial firms that are typically affiliated with large banking organizations. These dealers participate directly in the primary market for Treasuries, where the US government auctions new debt issuance, then resell the Treasuries to investors in the secondary markets. Identifying the effects of dealer constraints can be challenging due to a lack of available data and because constraints respond endogenously to broader market conditions. The authors address these issues by using confidential microdata on dealers’ risk limits, positions, turnover, and profits as well as two separate identification schemes. First, they employ a difference-in-differences strategy to study the impact of the supplementary leverage ratio (SLR), a regulatory constraint that targets the overall bank balance sheet. Second, they study the impact of internal risk-holding constraints at the trading-desk level by examining the aggregate impact of idiosyncratic shocks.
Key Findings
- Tighter constraints can impair liquidity in the Treasury market, as dealers reduce their Treasury positions, triggering a reduction in turnover and an increase in bid–ask spreads.
- Such constraints also affect Treasury yields by amplifying the effects resulting from demand shifts.
- In addition, tighter constraints can dampen dealers’ bidding behavior in Treasury auctions, which could lead to a decline in bid-to-cover ratios and a rise in the yield accepted by market participants, thereby increasing the federal government’s cost of issuing debt.
- The authors’ estimates indicate that bid–ask spreads and turnover are crucially affected by position constraints and depend on the shadow cost of the constraints. This shadow cost could be equal to about 26 percent to 33 percent of firms’ intermediation spread, or about $2.4 billion to $3 billion per year.
Implications
Regulatory constraints that target broad bank-level exposure can impair bank-affiliated dealers' intermediation capacity, which is crucial for Treasury market liquidity. Impaired liquidity due to dealer constraints could affect monetary policy transmission by amplifying yield movements. In addition, constraints on primary dealers might prevent them from absorbing additional federal government debt.
Abstract
Using confidential microdata, we show that shocks to primary dealers’ risk-bearing constraints have significant effects on the US Treasury securities market. In response to tighter constraints, dealers reduce their Treasury positions, triggering a reduction in aggregate turnover and an increase in bid–ask spreads. These effects are more pronounced in securities that contribute more to the utilization of risk constraints. The impaired intermediation also affects Treasury yields, amplifying the yield response to net demand shifts. Moreover, tighter dealer constraints weaken Treasury auction outcomes: Bid-to-cover ratios decline, driven by dealers’ less aggressive bidding, and the highest yield accepted by participants rises, thereby increasing the government’s cost of issuing debt. Using our estimates, we back out key elasticities to show that the shadow cost of dealer constraints is as high as one-third of dealers’ intermediation margin.