Good morning Mr. Phelps; your assignment, should you decide to accept it, is to read the IMF Working Paper on Lessons from the "Flash Rally"

http://www.imf.org/external/pubs/ft/wp/2015/wp15222.pdf 

The volatility in financial markets over the last few years has provided researchers with numerous opportunities to assess possible causes and to hopefully help us understand how we might prepare for, or more importantly, help survive, the next crisis.  In this #IMF working paper released yesterday, the three authors analyze the events, examine the market structures and, as the IMF disclaimer clearly points out, give their opinion for "Ways to strengthen the U.S. Treasury Market". 

In their paper, they suggest:  "The resilience of the Treasury market could be strengthened to prevent the occurrence of similar events in the future.   To achieve this, measures could be considered in three broad areas:  (i) providing incentives for liquidity provision, (ii) improving market safeguards, and (iii) enhancing the regulatory framework of the Treasury market."

Let's begin with "providing incentives for liquidity provision".  Having spent more than 30 years in the Interdealer Broker business I understand the inherent value of market makers to the liquidity of the Treasury market.  This paper concurs and suggests that steps can be taken to incentivize Primary Dealers to meet liquidity provision obligations.  Models such as maker-taker, for example, used for decades in the IDB markets are noted as a suggested remedy.

The paper calls for greater regulation in the Treasury market and a proposal to require a consolidated tape.  I found this part of the paper to be odd to the extent that the only use of the word "transparent" in the paper is a quote from a politically-appointed Commissioner.  Prices in US Treasuries are among the most transparent of all fixed income securities and Primary Dealer trades are reported to the Fed.  These Primary Dealers are a key component in the author's suggested targets for liquidity provision and some level of protection for them so that they aren't "catching a falling knife".  It would be interesting to hear from the firms that provide liquidity of what provision they would suggest.  Something tells me that trade reporting wouldn't be high on that list.  In fact, the debate continues regarding the impact of trade reporting to liquidity in the Corporate Bond market after the implementation of TRACE reporting requirements.  That debate, by the way, has very strong proponents on both sides of the argument between those who believe that liquidity hasn't been impacted and those that believe it has.  It seems that the Liquidity Providers are on the side of the argument that trade reporting has hurt liquidity. 

I see a paradox in this paper.  On the one hand, the authors do a superb job of analyzing the data to provide the context of the argument.  On the other, the suggestion for creating incentives for market maker obligations, and their call that "market making requirements should also ensure that market makers are not exposed to significant risks during stress periods" seem at odds.  Don't we need market makers to step up specifically at times of stress?  Would the call to protect them together with the call for trade reporting create a conflict of motivations?

This is a working paper and again, the opinion of the authors, but I applaud them for their superb work and for furthering the debate around dealing with the liquidity events in the U.S. Treasury market.  More work is needed in this area in order to preserve the liquidity of, to use their words, "the bedrock of the financial system".

In my  view, innovative trading solutions are needed to preserve the ability for Primary Dealers and other Market Makers to survive the transition from full-time liquidity providers to a balance of agency broking and principal trading.  Providing dealers with models that enable them to serve their clients, and turn a fair profit, is the best incentive for any business, including our own.

I can go on with many other recommendations from this working paper but that would take time away from you to read it.