On-the-run Premia, Settlement Fails, and Central Bank Access

The premium on “on-the-run” Treasuries (i.e., the most recently issued ones) is an anomaly. I explain it using a model in which primary dealers hold inventories of Treasuries. There is less variation across primary dealers’ inventories of on-the-run Treasuries compared with off-the-run Treasuries. Because there is less inventory uncertainty, on-the-run Treasuries fail to settle less frequently and trade at a premium. My theory is consistent with the USD 33 billion of Treasury contracts that fail to settle each day, with the median failure rate of off-the-run Treasuries being almost twice that of on-the-run Treasuries. I use the model to analyze the effects of granting access to central bank facilities to non-banks active in the Treasury market. Broad access stimulates trading and reduces the on-the-run premium, but settlement fails increase and, counterintuitively, only primary dealers benefit.