U.S. lawmakers are negotiating to raise the debt ceiling before the Treasury is expected to run out of funds, leaving the country at risk of defaulting on its debt. Below are some key questions relating to the government bond market’s role in the markets, and how it would be affected by a potential default.

Why are Treasuries so important?

U.S. government debt is the largest bond market in the world and is considered one of the most risk-free assets. Treasuries are used widely to back loans used by financial institutions, including in the $5 trillion repurchase agreement market. Any delay in paying interest or principal on Treasuries could disrupt borrowing in these markets, and harm the credibility of the U.S. government as a borrower, sending up its interest costs. That, in turn, could increase costs for corporations, state and local governments, and foreign entities, many of which are priced in comparison to the U.S. Treasury rate.

Would all Treasuries be affected by a default?

Not technically. Analysts say that Treasuries do not have cross default provisions, meaning that only the individual issues that have delayed payments would be considered in default. Treasuries that mature or have coupon payments due in late October and early November are seen most at risk. As a result, yields on those maturities have risen steadily in the last few weeks.

Could there be contagion from a missed payment?

Yes. Concerns over exposure to affected Treasuries could spark broad aversion to the debt, and money market funds, which are large lenders to banks in repo that are backed by Treasuries, could risk investor redemptions. These funds and other lenders may also pare back loans and prefer to hold cash assets to protect themselves from losses.

What is the repo market?

The $5 trillion repurchasing, or ‘repo’ market, is a key source of ongoing funding for banks and other financial institutions. Various institutions agree to lend each other money for a short period of time – usually overnight – in exchange for collateral, which, more often than not, is Treasury securities. The firm receiving the cash pays interest, but concerns about missed payments have resulted in those receiving the Treasury collateral to demand more interest to make those loans. Similar strains in this market were seen in 2011, and during the financial crisis, concerns about counterparty risk caused this market to effectively grind to a halt.

Has the U.S. defaulted before?

Yes – but not in the manner envisioned now should Congress fail to reach an agreement to raise the debt limit.

The most oft-cited example is 1979, when back-office errors at the Treasury caused the government to inadvertedly be late in redeeming three series of Treasuries bills, according to an academic paper by Terry Zivney and Richard Marcus published in the Financial Review in 1989. The failure, which affected $120 million in securities, caused rates to rise, and the government faced lawsuits from investors hurt by the delays in repaying the bonds, they said. The bills were repaid quickly. Ratings agencies did not take action, however, and this occurrence is generally considered a fluke.

In 1779, during the U.S. Revolution, the Continental Congress was unable to pay certain debts as the 13 colonies did not have the power of taxation. In 1934, certain issues of Liberty Bonds – sold to pay for World War I – were unable to be repaid. President Franklin Roosevelt paid some of the debt and devalued the dollar when the gold standard was removed.

Would this time be worse?

Probably. Dramatic growth in repurchasing and derivatives markets since 1979 has increased the importance of Treasuries as collateral to back trades and loans. Any panic over missed payments could dry up lending, freeze markets and hurt riskier assets including stocks as investors evaluate how far any damage will spread.

Do money market funds have to sell defaulted Treasuries?

Analysts say that money funds are not legally required to sell defaulted Treasuries. That is seen as reducing the chances of a panicked selloff in the event of a default. Many funds, including those run by Fidelity Investments, PIMCO, JPMorgan Asset Management and BlackRock, however, have said that they are avoiding debt most at risk of delayed payments as a precaution.

What else is being done to prepare for a potential default?

Market participants are preparing for operational challenges in repo market in the event the U.S. is late in making Treasuries payments. The New York Fed’s Fedwire Securities Service, which is used to hold, transfer and settle Treasuries, would need some manual daily adjustments to ensure that debt that has matured by not repaid can continue to be transferred. Traders said that they will be able to extend the maturities of affected Treasuries if they receive enough notice from the Treasury that it will be late in paying debt principal or interest.

Can the Federal Reserve purchase defaulted Treasuries?

The Fed has not commented on this. Analysts at JPMorgan said in a report last week that the Federal Reserve Act allows the Fed to buy Treasuries without any restrictions relating to their payment status or credit ratings.

(Reporting By Karen Brettell; editing by Andrew Hay)