When Alexander Hamilton, the first Secretary of the United States Treasury and founder of the Bank of New York, created a plan for the nation’s debt, it was rooted in two core attributes: safety and liquidity. Government bonds would be safe because they would be backed in full by the U.S. government on their original terms, and liquid because they could be easily converted to cash at a fair market price.1
Even so, several liquidity events over the past nine years have raised public and private sector concerns about the market’s resilience. As part of an interagency response, the U.S. Securities and Exchange Commission (SEC) is expected to release a final rule that will expand central clearing of Treasury securities. In its proposal, the SEC highlighted that, with only about 13% of the Treasury cash market fully centrally cleared, the market is more susceptible to counterparty credit and systemic risks in the event of a default.
Central counterparties (CCPs) clear market transactions by effectively becoming the buyer to every seller and the seller to every buyer, reducing counterparty credit risks. They net down transaction flows across the market and then require counterparties to put up margin, such as cash or securities, and commit other resources to guarantee that the trade's obligations are met, even if either counterparty defaults.
The SEC believes that the expansion of central clearing will reduce risk by increasing the share of activity that is subject to the centralized netting and risk management systems of a central counterparty, of which there is currently only one in the Treasury market, the Fixed Income Clearing Corporation (FICC). The SEC’s aim is to bolster the market’s resilience through improved default management processes, smaller settlement flows and reduced settlement fails.
Central clearing will strengthen the market’s core attributes of safety and liquidity in times of stress. But implementation will be difficult and will reassemble the way the Treasury market functions at a time of heightened volatility. The rule is likely to be finalized soon, and the implementation timeline may be shorter than expected. Market participants would do well to prepare.
The SEC rule comes amidst an extended period of turbulence.
The market has grown dramatically since the pandemic and the Congressional Budget Office forecasts it will almost double in size over the next 10 years, with government deficits and the rising cost of interest payments pushing the market from today’s $27 trillion to around $46 trillion. This will pressure dealer intermediation capacity and boost the amount of collateral to be financed.
At the same time, the Federal Reserve continues to battle inflation and reduce its balance sheet, which will increase the demand for liquidity by banks as their reserves fall. Technological and regulatory changes are also making liquidity management more urgent, by speeding up payments and increasing liquidity requirements at banks. These factors will further increase the demand for cash and other forms of short-term liquidity. Geopolitical tensions have added to the uncertainty, amplifying high levels of volatility that seem unlikely to abate soon.
A well-functioning Treasury market is particularly important given the environment.
The SEC’s proposal to expand central clearing was announced in September 2022, and is arguably the most significant of five workstreams being explored by the official sector to strengthen the Treasury market’s resilience.
The SEC proposed the rule to protect the FICC, or any other Treasury market CCP, from contagion risk that could arise from a counterparty default in the non-centrally cleared portion of the market, which has grown rapidly in the last two decades. Three of the main sources of contagion risk noted in the SEC’s proposal include:
In simple terms, under the SEC’s proposal, members of any Treasury market covered clearing agency, like the FICC, would be required to centrally clear:
The proposal includes exemptions for transactions with certain types of entities, including central banks.
Estimating the additional volume of activity that will be centrally cleared is difficult and will depend on the final rule and its implementation. However, as proposed, the rule is likely to expand central clearing to encompass the interdealer cash market segment, and the non-centrally cleared bilateral and tri-party financing market segments, comprising over $3 trillion dollars in daily activity. FICC member trades with hedge funds and levered accounts in the dealer-to-customer cash market segment could increase that amount, while exemptions could reduce it.
Given the broad impact of the rule as proposed, market participants need to start preparing now for the changes ahead. There are four key areas:
The requirements and costs of central clearing will likely alter the economics of many transactions in the cash and repo markets, with far-reaching consequences.
An analysis by the New York Fed found that central clearing could reduce the gross settlement obligations of primary dealers by as much as 70%. This may offer some additional balance sheet capacity for intermediaries and reduce settlement fails.
Transaction costs will increase as clearing costs go up for many market participants that do not centrally clear their transactions today. In a recent survey, FICC estimated that the amount of additional margin as a result of centrally clearing more indirect participants could be as much as $27 billion. However, that number could be higher because it is based on a subset of market participants. FICC also maintains sizeable liquidity resources – in the form of member funding commitments – that could be used to fund a defaulting member’s transactions. The survey was inconclusive on whether expanded central clearing would increase the size of these liquidity commitments.
The improvements in risk management expected to come from greater central clearing should increase the market’s resilience by lowering systemic risks in the event of market stress or a counterparty default. Consistent and transparent risk management should make market participants less likely to pull back from counterparties in times of stress, allowing the market to remain more liquid under such conditions. In the event of a default, the default management process, and margin and liquidity resources, should help avoid contagion and fire sales, and perhaps may forestall the need for official sector intervention. And from the official sector’s perspective, these benefits should come at the price of a modest increase in trading costs and somewhat lower liquidity in normal times.
But for market participants, these changes are likely to feel more profound.
Participation and pricing in interdealer cash markets, which today rely on a large volume of high-frequency trading by non-FICC members, will change as the requirements of clearing are passed along to non-FICC liquidity providers. Prices in interdealer markets are widely used as benchmarks for pricing transactions in other market segments.
Highly levered or low-margin trading strategies, like many basis and relative value trades, may become uneconomical at current levels, contributing to basis-widening, for example, between futures and cash markets, or between on- and off-the-run securities. This could reduce the demand for Treasury securities for market participants engaged in these strategies, contributing to upward pressure on bid-ask spreads or outright yields.
In repo markets, netting should reduce some balance sheet costs, but additional margin and the costs of sponsorship are likely to push bid-ask spreads wider, increasing the cost of repo funding and leverage. On net, in both Treasury cash and financing markets, liquidity in normal times is likely to be less continuous than many have come to expect.