Why markets became dysfunctional in March, 2020

It is being said that the biggest market-making failure during this Covid-19 crash has been in the fixed income space. The bid-ask in US treasures reached unprecedented levels (see image below) which came as surprise to most traders, given that it is supposed to be one of the most liquid markets in the world.

What happened

As selling began in Feb, dealers that make markets saw that people/funds were selling to them. They bought to point of the their balance sheet, but there came a point when they couldn't any more. Everyone still wanted to sell to these dealers, but they were stuck -- they were having difficult time making markets. That was primarily showing up in credit markets.

Usually when you sell a Treasury bond, there is a dealer who takes the other side of the trade, and usually that dealer finds it easy to fund the purchase by using the bond itself as collateral for borrowing, say from his clearing bank.  But when everyone else is also selling, and when the dealer’s bank is using its balance sheet to meet contractual credit lines, then there may be no one to take the other side, or only at a fire sale price.  Market liquidity disappears. - Perry Mehrling

Fed interventions

The FED obviously saw what was happening. It saw that dealer B/S were full and they cannot buy anymore. So the FED said that we will offer you repo at a trillion dollars a day (real number is infinity).

The first problem was that dealers were not taking it. The reasons probably are these post 2008 rules that prevent banks from leveraging up.

So, the FED then says OK your balance sheets are full and you cannot take any of my repo, so I will drain your balance sheets (also known as QE). The point was that the Fed will buy there treasuries (some MBS also) and the dealers could then fill them up again.

Freeze

The second problem was that the market makers were still hesitant to buy. Contextually, you have see that big bond ETFs (EGG, BND, Vanguard Total Bond Fund, TLT 20yr treasury, iSHares LQD Corporate Bond Fund, HYG) were trading much lower than their NAVs (upto a massive 4-6% discount). The reason for these discounts could be anything but the fear was that the market was telling us that the real fair value in the post virus world is far lower prices.

The Dealers Dilemma was that although they are being drained/given reserves and being told to make markets, they are stuffed with these securities and they don't wanna mark them down and take gigantic losses.