Academic journal article Federal Reserve Bank of New York Economic Policy Review

Commentary

Academic journal article Federal Reserve Bank of New York Economic Policy Review

Commentary

Article excerpt

This thought-provoking paper by Michael Fleming raises several interesting issues in light of my experience, and makes an effort to establish some empirical regularities relating to different benchmark securities. After a brief review of the paper's major conclusions, I will address a set of public policy issues that the paper raises.

MAJOR CONCLUSIONS OF THE PAPER

First, the premise of the Fleming paper is that the value of the Treasury market as a benchmark will be called into question by improved fiscal performance. This conclusion is itself predicated on a trend shift in productivity growth and greater fiscal restraint that will lead to extensive efforts to pay down debt over a protracted period.

Second, the paper contends that recent worldwide shocks and events including the Long-Term Capital Management (LTCM) crisis "heightened concerns about the Treasury market's benchmark role."

Third, the paper argues that increasingly there will be alternative benchmarks emerging for the pricing and hedging of securities, including the agency debt, corporate debt, and swaps markets. Much of this argument is based on the idea that these forms of debt are characterized by credit risks that will be more correlated with spread products and that these forms of debt will be a better hedge than Treasuries-despite disadvantages in such areas as market size and liquidity.

PUBLIC POLICY ISSUES RAISED

BY THE PAPER

Although the Fleming paper presents some interesting empirical correlations, relationships, and trends, it leaves the reader asking several questions-all of which have a public policy implication and none of which are actually discussed that explicitly.

These questions include:

What characteristics should a benchmark security actually have and, more basically, what do we mean by a "benchmark"?

Is the premise of the paper, which suggests the need for new benchmarks versus a Treasury benchmark, actually relevant?

Might it be that the Treasury market (on-the-run and off-the-run issues) actually functioned quite well during the fall 1998 crisis and during the run-up to Y2K in recent months?

Are the recent changes relating to the repo market and the eligibility of agency debt as collateral in Federal Reserve System open market operations worth maintaining in light of the discussion of alternative benchmarks, or are there reasons why this would be dangerous public policy?

What are some of the specific advantages and disadvantages of each form of alternative "market benchmark" noted in the paper?

Can we expect systemic and other forms of risk to increase with the introduction or proliferation of many different benchmarks and with the advent of many types of trading formats-such as ECNs and the new E-bond market?

WHAT DO WE WANT IN A BENCHMARK

SECURITY?

A benchmark is a concept that can have a variety of meanings. One definition used in portfolio management refers to a benchmark portfolio of securities against which performance can be measured. Another meaning refers to a benchmark security whereby the market determines what specific issue or form of security can serve in such a capacity. Several characteristics seem critical: the credit quality of the issuer must be very strong, the issue must be very liquid (transactions should not materially impact the price of the security), and the overall structure of the market for the contract or security in question must have what we might call "integrity." Therefore, the market for a benchmark security should have minimal prospects of being squeezed or cornered by participants.

Benchmark securities are also important for properly measuring and calculating the value of other securities in the same class or other financial contracts more broadly. Often, Treasury securities are useful because they reflect a riskless rate of return. As such, these securities can be compared with other nongovernment-backed securities subject to greater credit risks. …

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