Safe assets—typically government securities like U.S. Treasuries—are considered the bedrock of global finance. They are designed to provide security and liquidity, especially during periods of stress. Yet, recent events have revealed a paradox: these very assets, prized for their stability, can become the center of market turmoil. A recent theoretical study sheds light on how this happens, offering insight into the mechanisms that transform calm into chaos in markets built on safety.
What Makes an Asset “Safe”?
Safe assets serve two fundamental roles. First, they are expected to hold their value and pay back in full at maturity, making them a core component in portfolios for risk-averse investors. Second, they function as liquid instruments—easy to sell when cash is needed. Investors hold these assets either as a hedge against risk or as a reserve for meeting sudden obligations.
During market stress, these roles come into conflict. Some investors rush to purchase safe assets, seeking refuge from risk (a “flight to safety”). Others, facing urgent liquidity needs, sell those same assets in a “dash for cash.” Ideally, these forces balance out. But under certain conditions, they don’t—and that’s when trouble begins.
Why Safe Asset Markets Are Not Always Stable
Safe asset markets depend heavily on dealers—financial institutions that stand ready to buy and sell these assets. These dealers operate under balance sheet constraints, which limit how much they can absorb during times of stress. When investors fear future losses due to illiquidity or dealer limitations, they may choose to sell preemptively—even if they don’t need the cash immediately.
This preemptive selling can trigger a chain reaction. As more investors sell, prices drop. Lower prices increase the pressure on dealers, who may be unable to step in effectively due to regulatory or capital restrictions. As the market weakens, the incentive to sell early grows stronger, creating a self-reinforcing downward spiral.
Such fragility means that even small imbalances between buyers and sellers can cause severe price dislocations. What begins as a routine need for liquidity can quickly evolve into a full-scale run on safe assets.
Strategic Selling and Market Runs
Investors managing liquidity risk make strategic decisions about when to sell. If they anticipate worsening conditions, it can be rational to sell early to avoid being forced to liquidate at lower prices later. This creates a scenario where expectations alone can drive market behavior.
In markets with low perceived liquidity risk, most investors will hold onto their safe assets. But when liquidity concerns rise, even those without urgent needs may join the sell-off, fearing future losses. In extreme cases, nearly all liquidity-sensitive investors may rush to exit at once. This phenomenon—a market run—results in a flood of selling, distorting prices and undermining the market’s function.
The Covid Treasury Market Shock
The U.S. Treasury market crash in March 2020 offered a real-world example of these dynamics. As the pandemic hit, three destabilizing forces converged: increased regulatory constraints on dealers, surging demand for safety amid global economic fears, and an abrupt spike in liquidity needs due to lockdowns and uncertainty.
Foreign central banks and mutual funds dumped Treasury holdings at a historic pace. Yet, data showed that much of the selling wasn’t tied to immediate liquidity demands—suggesting that strategic preemptive selling played a major role. Dealers, constrained by post-2008 regulations like the Supplemental Leverage Ratio, couldn’t absorb the supply effectively. Bid-ask spreads widened dramatically, signaling a breakdown in market function.
Relief only came after the Federal Reserve stepped in with large-scale Treasury purchases, easing pressure on dealer balance sheets and helping restore order.
A Stark Contrast with the Global Financial Crisis
The behavior of safe asset markets during the COVID crash stood in sharp contrast to the 2007–2009 financial crisis. Back then, despite massive financial stress, the Treasury market remained functional. Why? Because dealers were not facing the same regulatory constraints and liquidity demands were less acute.
This comparison highlights how critical market infrastructure—and particularly dealer capacity—can determine whether safe assets perform their stabilizing role or become sources of systemic risk.
Final Thoughts
The paradox of safe asset markets is that their very stability can sow the seeds of instability. In times of stress, when investors need safety most, these markets can falter if structural conditions—such as dealer capacity and liquidity dynamics—are unfavorable. Understanding these risks is essential for policymakers, asset managers, and anyone relying on government securities as a financial safe haven.
Future reforms must account not only for credit risk but also for market mechanics that can transform security into fragility.
