Wall Street's elite bond club is cracking at the worst possible time

On the eve of the biggest boom in U.S. bond sales since World War II, cracks are appearing in the exclusive Wall Street club responsible for ensuring the market functions smoothly.

For decades, the firms, known as primary dealers, have sat at the nexus of the Treasuries market, buying newly issued bonds to disseminate throughout financial markets and trading directly with the Federal Reserve. This relationship has helped the Fed implement its policy goals, yet the implosions of recent months suggest that the group is under duress.

Dominated by big banks like J.P. Morgan Chase and Goldman Sachs Group, the 24 primary dealers struggled to keep money moving within the core of global finance during the coronavirus panic in March. The Fed deployed a series of unprecedented interventions in response, including trillions of dollars worth of emergency funds — and inadvertently fueled debate on the need for reform.

One proposed solution: end Wall Street's near-monopoly on club membership. Bond giant Pacific Investment Management Co. argues that asset managers should be included in the group. That could benefit the Newport Beach, Calif.-based firm and would add trillions of dollars to the collective firepower of primary dealers, further boosting the influence of these investing behemoths.

"Certainly increasing the number of primary dealers would be useful. Instead of increasing it to smaller dealer financial institutions, widening it out to larger asset managers seems a better bang for your buck," PIMCO economist Tiffany Wilding said in an interview. "The Fed's programs and policies will be more efficiently transmitted throughout the financial system if it opens up its operations to a broader set of counterparties."

Because primary dealers are obliged to buy new Treasuries when they're auctioned, they'll be critical to helping absorb the record supply of debt the U.S is selling to rescue the economy from the ruin of the pandemic. On Monday, the federal government said its debt load will rise by a record $3 trillion from the end of March to June.

It doesn't look like money is getting where it's needed in times of stress — or not without massive intervention by the central bank. In March, Treasuries market makers — traditionally banks, which can no longer trade as freely given post-financial crisis regulations — were overwhelmed as volatility spiked to levels last seen in 2009, siphoning liquidity from the longest-dated bonds. That seizure came barely six months after convulsions in the repo market, where much of the trading in Treasuries is financed.

The solution for the Treasury market could lie in loosening roles that the New York Fed has cultivated over the decade of recovery from the last recession. That's how the central bank in 2013 tackled the excess funds sloshing around the system after three rounds of quantitative easing, bringing money managers into the fold as counterparties for reverse-repo operations to help drain some of that cash.

Looking ahead, it might allow asset managers to qualify for operations in which it adds credit to the banking system by borrowing Treasuries and mortgages from primary dealers. Ms. Wilding is among those who say asset managers would be particularly well-situated to participate, given they have the capacity both to offer securities in bulk to the New York Fed and to distribute the funds.

But for the Fed to expand its trading counterparties, it'd have to be confident in the safety and soundness of that institution. Any asset manager would need sufficient scale, and safeguards against any conflicts across their businesses.

Allowing money managers to jump into its repo operations would be a useful contingency for the central bank in times of stress, said Wrightson ICAP economist Lou Crandall. "Whether the Fed wants to do that in the ordinary course of business is another question."

Even though Treasuries became exceptionally difficult to trade in March, that isn't to say that primary dealers shirked their market-making duties. The surge in trading revenue last quarter across the large banks — including a record for J.P. Morgan — suggests a big engagement, and daily average volume catapulted to an all-time high exceeding $1 trillion in early March.

But primary dealers have to manage their own risks in a crisis, said Kevin McPartland, director of market structure at research firm Greenwich Associates.

"The fact that the Fed had to intervene at the level that it did tells you there were obviously liquidity issues. We heard anecdotally from the asset managers there were definitely some challenging moments," he said. "For market makers and even primary dealers, while their job is to help the markets continue to function, their job is not to catch the falling knife."

Wall Street has long lobbied against post-2008-crisis regulations that banks say have constrained their market-making function. J.P. Morgan CEO Jamie Dimon said as much in an October earnings call to explain why the bank didn't lend into the prior month's repo turmoil.

Indeed, one solution the Fed landed on in March to unclog the market was to relax the supplementary leverage ratio, effectively freeing up space on dealer balance sheets. The Fed might consider extending that forbearance.

"I'm not going to be surprised if things don't improve at the end of March 2021, to see that rule extended or made permanent," said Alex Li, U.S. rates strategist at Credit Agricole.

That seems quite possible as the Fed reviews how the guardrails put in place over the past decade have served the system in its first crisis since then. For policymakers, there's a balance to be struck between loosening the leash in a crisis and ensuring dealers are maintaining appropriate buffers in more peaceful times.

But for some, adding more primary dealers is a better solution. The New York Fed hasn't signaled an intention to revise its trading relationships or further expand its primary dealers circle, and it declined to comment for this story. But it has long experimented with the terms of its closest dealer relationships.

In the 1940s, the Fed tightened its inner circle to an 11-strong band of "qualified dealers" that it kept on a short leash in a restricted market, where U.S. interest rates were capped at low levels to finance the war effort. A subcommittee tasked with reframing that role in 1954 noted that "privilege as such is repugnant to the spirit of American institutions." The qualified-dealer status was scrapped, and for several years the club had no specific membership criteria.

The group's size peaked at 46 firms in 1988 and shrank to just 17 in 2008 after Bear Stearns, Countrywide Financial and Lehman Brothers dropped out. The downfall of independent broker-dealer MF Global, which became a primary dealer in 2011 and was bankrupt by the end of that year, didn't exactly embolden policymakers to relax criteria for entry.

Though the central bank lowered a capital threshold in 2016 to encourage smaller firms, it has admitted only one since: Amherst Pierpont, a smaller broker with expertise in mortgages, joined last year. A giant may be waiting in the wings, as Ken Griffin's Citadel Securities, one of the largest trading firms in the world, has made no secret of its interest.

Another push to add capacity at this point might have appeal as the Treasury's supply projections explode and the Fed wades deeper into unconventional policy — including the possible return of WWII-era yield-curve control.

Those who weathered the recent volatility are putting their faith in the Fed's next steps.

"It was challenging, a little more challenging than I remember the financial crisis," said Gemma Wright-Casparius, a fixed-income portfolio manager at Vanguard and member of the Treasury Market Practices Group, which advises the U.S. government on bonds. "You could find liquidity — and we did — but you had to navigate around the market to do that," she said. "The Fed has been aware of those issues."