Khan Capital | March 2020
Key Takeaways
- The week of 9 to 20 March 2020 produced the worst liquidity crisis since 2008, as the COVID-19 selloff overwhelmed market structure, causing simultaneous failures in Treasury markets, corporate bonds, money market funds, and municipal securities in a “dash for cash” that spared no asset class.
- US Treasury markets, normally the world’s deepest and most liquid, experienced acute dysfunction, with bid-ask spreads widening to levels not seen since the 2008 crisis and off-the-run securities trading at unprecedented discounts to on-the-run benchmarks, as leveraged basis traders and risk parity funds dumped positions simultaneously.
- The “cash is king” dynamic forced the selling of assets across all correlations: stocks, bonds, gold, and credit all declined together, breaking the foundational diversification assumption that underpins modern portfolio construction and risk parity strategies.
- The Federal Reserve’s response was historic in both speed and scope, ultimately deploying over a dozen emergency facilities and purchasing Treasuries and MBS at a rate of $125 billion per day during the peak of the crisis, actions that stabilised markets but raised profound questions about central bank moral hazard.
The March 2020 Liquidity Crisis: When Everything Broke
In the second and third weeks of March 2020, the global financial system experienced a liquidity crisis of a severity not seen since the collapse of Lehman Brothers. Unlike 2008, where the crisis originated in the banking system and propagated outward, the March 2020 crisis was a universal dash for cash that hit every market simultaneously. Treasuries, corporate bonds, municipal securities, money market funds, gold, and equities all sold off in concert, producing the kind of cross-asset correlation spike that stress-test models warn about but real-world portfolios rarely encounter.
The catalyst was the COVID-19 pandemic’s exponential spread across Europe and the United States, compounded by the Russia-Saudi oil price war that erupted on 6 March. But the severity of the market dislocation was driven less by the fundamental shock and more by the structural vulnerabilities in market plumbing that the shock exposed: excessive leverage in the Treasury basis trade, the mechanical selling rules embedded in risk parity and volatility-targeting strategies, the fragility of money market funds, and the limited capacity of primary dealers to warehouse risk in a post-Dodd-Frank regulatory environment.
The Treasury Market Seizure
The most alarming aspect of the March liquidity crisis was the dysfunction in the US Treasury market, the $23 trillion cornerstone of the global financial system and the asset that serves as the risk-free benchmark for pricing virtually every other security on earth. During the worst days, bid-ask spreads on off-the-run Treasuries widened to 10 to 15 times their normal levels. Trading volumes collapsed as dealers withdrew from market-making. The spread between on-the-run and off-the-run 10-year notes, normally 1 to 2 basis points, blew out to over 30 basis points.
The proximate cause was the forced unwinding of the Treasury basis trade, a strategy employed by hedge funds with leverage of 50:1 or higher that exploits small price differences between cash Treasuries and Treasury futures. When the trade works, it generates steady, low-risk returns. When it unwinds, as it did violently in March, the selling is enormous and indiscriminate. Hedge funds rushed to liquidate cash Treasury holdings to meet margin calls, and the primary dealers who would normally absorb this selling lacked the balance sheet capacity to do so, constrained by post-2008 capital requirements.
| Market Metric | Normal | Peak Crisis (16-19 Mar) | Multiple |
|---|---|---|---|
| 10Y Treasury bid-ask spread | ~0.5bp | ~6-8bp | 12-16x |
| On/off-the-run spread (10Y) | 1-2bp | 30+bp | 15-30x |
| IG corporate spreads (OAS) | ~100bp | 400+bp | 4x |
| VIX | 12-15 | 82.7 (intraday) | 5-7x |
| Fed daily Treasury purchases | ~$0 | $75bn+/day | N/A |
| S&P 500 circuit breakers triggered | 0 | 4 in 10 days | N/A |
The Dash for Cash
The defining feature of the March liquidity crisis was the breakdown of diversification. In a normal risk-off event, investors sell equities and buy Treasuries, and bonds rise as stocks fall. In March 2020, investors sold everything. The simultaneous decline of stocks, bonds, gold, and credit was not irrational; it reflected a rational response to margin calls, redemption requests, and the fundamental uncertainty of a pandemic whose economic consequences were genuinely unknowable.
Risk parity funds, which allocate capital across asset classes based on their historical volatility and correlation properties, were forced to sell as realised volatility surged and cross-asset correlations approached 1.0. The strategies that had performed brilliantly in the low-volatility environment of 2017 to 2019, leveraging diversification to generate steady returns, became forced sellers in exactly the environment where their selling pressure was most destabilising. Bridgewater Associates’ flagship All Weather fund, the archetype of the risk parity approach, declined over 20% in March.
Money market funds experienced their own crisis. Prime money market funds, which invest in short-term corporate debt, saw redemptions of over $100 billion in a single week as investors questioned the liquidity and credit quality of underlying holdings. The echoes of the 2008 Reserve Primary Fund “breaking the buck” were unmistakable, and the Fed moved quickly to establish the Money Market Mutual Fund Liquidity Facility to prevent a repeat.
The Municipal Bond Meltdown
Among the most severe dislocations was in the municipal bond market, a $3.9 trillion market that funds state and local governments and is held primarily by retail investors and mutual funds. Muni yields, which normally trade below comparable Treasuries due to their tax-exempt status, surged above Treasury yields by margins not seen since the 2008 crisis. The iShares National Muni Bond ETF (MUB) traded at a discount to its net asset value of over 5%, reflecting the inability of authorised participants to create new shares in a market where the underlying bonds could not be bought or sold at reasonable prices.
The muni crisis had real-world consequences. States and municipalities attempting to issue bonds to fund pandemic-related expenses found the market effectively closed. New York, Illinois, and California either postponed or repriced planned issuances at dramatically higher yields. The Fed’s eventual establishment of the Municipal Liquidity Facility, authorised under the CARES Act, was a direct response to this dysfunction.
What the Market Was Misunderstanding
The most dangerous misunderstanding was the assumption that post-2008 regulatory reforms had made the financial system resilient to liquidity crises. In reality, the reforms had shifted risk from the banking system to the non-bank financial system: hedge funds, money market funds, ETFs, and algorithmic trading firms that are less regulated and less transparent. The Treasury basis trade that destabilised the government bond market was a post-2008 phenomenon, enabled by the same regulations that constrained bank balance sheets. The system was not more resilient; it was differently fragile.
The market also underestimated the speed at which the Fed would respond. By 15 March, the Fed had cut rates to zero and announced $700 billion in asset purchases. By 23 March, it had expanded to unlimited purchases and announced a suite of emergency facilities spanning corporate bonds, municipal securities, money markets, and asset-backed securities. The sheer velocity of the response, from first cut to unlimited QE in eight days, reflected the Fed’s recognition that the liquidity crisis, if left unchecked, would become a solvency crisis. Market participants who sold at the lows did so on the assumption that the damage would compound. The Fed ensured it would not.
Investor Implications
Portfolio construction: March 2020 exposed the limitations of traditional diversification in a liquidity crisis. When correlations approach 1.0, the only true hedge is cash or central bank intervention. Investors should maintain larger cash buffers than pre-2020 models suggested and stress-test portfolios for correlation breakdowns, not just individual asset drawdowns.
Fixed income: The Treasury market dysfunction revealed structural vulnerabilities that remain unresolved. The basis trade has rebuilt since March, and primary dealer balance sheet constraints are unchanged. A future liquidity shock could produce a similar Treasury market seizure. The Fed’s willingness to intervene reduces tail risk but does not eliminate it.
ETF structure: The NAV dislocations in bond ETFs during March raised legitimate questions about whether fixed-income ETFs can function as advertised during a crisis. The ETFs did ultimately provide price discovery when the underlying bond market was frozen, but the discounts experienced by holders who sold were painful. Investors in bond ETFs should understand that they may trade at significant discounts during periods of stress.
Central bank dependence: The March crisis and its resolution have deepened the market’s dependence on central bank intervention. The implicit expectation that the Fed will backstop any future liquidity crisis creates moral hazard that encourages leverage, reduces risk premia, and concentrates systemic risk in the one institution that can credibly backstop it. This dynamic is self-reinforcing and unlikely to reverse.
Conclusion
The March 2020 liquidity crisis was, in many ways, more structurally alarming than the 2008 financial crisis. In 2008, the system broke because specific institutions (Lehman Brothers, AIG, Bear Stearns) failed. In 2020, the system broke because the plumbing itself, the Treasury market, money market funds, ETF creation/redemption mechanisms, proved inadequate for the velocity and universality of the selling pressure. The Fed’s intervention was necessary, effective, and precedent-setting. But the vulnerabilities that the crisis exposed remain embedded in market structure, and the next test of system resilience is a matter of when, not if.
Sources: Federal Reserve emergency facility announcements and H.4.1 statistical releases; US Treasury auction results and secondary market data; BIS Working Papers on Treasury market dysfunction; FINRA TRACE corporate bond transaction data; Bloomberg terminal data for spreads, yields, and ETF NAV discounts; ICI money market fund flow data.
Related Reading: The liquidity crisis was the market microstructure dimension of the broader COVID-19 crash, compounded by the Russia-Saudi oil price war. The Fed’s response is detailed in Fed Goes Nuclear, and the fiscal complement in the CARES Act. For an earlier episode of similar market plumbing stress, see the UK mini-budget crisis. The repo market dysfunction that foreshadowed the March 2020 crisis is examined in the September 2019 repo crisis.
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