Christmas: Why markets go quiet — and fragile — at year-end

Markets slow to a crawl in the last days of the trading year, and casual observers take that for calm. Desks thin out, volumes in cash Treasuries and euro-dollar futures halve, and bid-ask spreads widen by small degrees. The pause hides real fragility. Under Basel III and the G-SIB capital rules, the final days of December are an obstacle course for global dealer banks, which shed risk-weighted assets to avoid heavy regulatory surcharges.

The rule behind this is simple. A bank's systemic importance score is based on a snapshot of its balance sheet at year-end. Expanding repo lines or holding off-the-run government bonds in late December brings punitive capital charges that last through the whole of the following year.

Why the snapshot matters

The surcharge rises in steps. A bank whose score crosses into a higher band must hold more capital against its entire business, and each step typically adds half a percentage point. For a large dealer that is billions of dollars of extra equity, a cost that dwarfs whatever it could earn from a few days of market-making. The sensible response is to shrink on the reporting date and expand again in January.

Foreign banks face a similar incentive at every quarter-end, because several regulators outside America measure leverage on those dates rather than as an average. The result is a regular pattern of window-dressing that the Bank for International Settlements has documented for years, and it is most intense in December, when the quarter-end and the G-SIB snapshot fall on the same day.

Treasuries weigh on balance sheets

A second rule makes government bonds costly to hold at any date. The supplementary leverage ratio requires big American banks to hold capital against all assets regardless of risk, so a Treasury bill counts as much as a corporate loan. During the pandemic regulators excluded Treasuries and central bank reserves from the calculation, but that relief expired at the end of March 2021 and has not been renewed.

Meanwhile the supply of Treasuries that dealers are expected to absorb keeps growing. Federal debt has risen sharply since 2020, and the Fed is now shrinking its own holdings rather than buying. More bonds and less balance sheet to carry them is a combination that shows up first on days when balance sheet is scarcest. Janet Yellen, the Treasury secretary, said publicly in October that she was concerned about liquidity in the market for government debt.

Dealers step back

To improve their scores, prime brokers and primary dealers pull back from market-making. Borrowers looking for overnight repo find it rationed or very expensive, and basis trades that depend on bank balance sheets are unwound in a hurry. Hedge funds that buy cash Treasuries and sell futures against them, funding the position in repo, are the most exposed. Money market funds sit on the other side, parking the cash that dealers will not take at the Fed instead.

In such thin markets even modest customer orders can cause big price gaps. A routine corporate rebalancing trade that would pass unnoticed on a Tuesday in October can set off an intraday liquidity scare in the last week of December.

Holiday trading has bitten before

Recent history has examples. In the thin trading of Christmas week in 2018, American shares slumped on Christmas Eve and the Dow Jones Industrial Average then rose by more than 1,000 points on 26 December, its biggest one-day points gain at the time. In September 2019 overnight repo rates spiked so far above the Fed's target that the central bank had to lend into the market for the first time in a decade. In neither case was the trigger proportionate to the price move, and both showed how little balance sheet was available when it was wanted.

The larger episodes happened outside the holidays but followed the same logic. In March 2020 even Treasuries became hard to sell as investors rushed for cash, and the Fed had to buy government bonds on an enormous scale to restore order. In late September this year Britain's gilt market came close to seizing up when pension funds using liability-driven investment strategies were forced to sell, and the Bank of England stepped in to buy long-dated bonds.

Calm without liquidity

With 10-year US Treasury yields drifting near 3.75 per cent into the holidays, prices look benign on the surface. The calm comes from an absence of trading, and there is little deep two-way liquidity behind it.

The strongest counterargument is that the Fed has built backstops since 2019. Its Standing Repo Facility, created in July 2021, lets primary dealers borrow cash against Treasuries at a set rate, which should cap any spike in funding costs. The facility helps, but dealers have used it very little, partly because borrowing from it also expands their balance sheets on the very date they are trying to shrink them. Its rate sits at the top of the Fed's target range, now 4.5 per cent, so it caps a spike without making the market cheap.

Who needs cash on 31 December

The borrowers most exposed are the ones with no alternative. Leveraged funds that rolled their repo into the new year early are safe; those still seeking funding in the final days pay whatever dealers ask. Foreign banks with dollar liabilities face the same squeeze in currency swaps, where the cost of borrowing dollars against yen or euros tends to jump over the turn.

The signals to watch are overnight funding rates on the last business day of the year, the jump in reverse repo usage that usually comes with it, and whether liquidity returns as usual in the first full week of January. A quiet turn would be the norm. A disorderly one would be a hint that the plumbing is tighter than it looks.

The Federal Reserve's Overnight Reverse Repo Facility (ON RRP) takes in more than two trillion dollars of surplus cash precisely because private intermediaries cannot afford to hold deposits on their balance sheets. The year-end lull is a creature of post-crisis regulation, and any unexpected shock in the last days of December will probably hit a market in which few dealers are willing to take the other side.