A hurdle too large to clear
22 November 2022
The SEC proposes to mandate central clearing in the US treasury and repo markets for all eligible secondary market transactions to improve risk management practices for CCPs. Carmella Haswell discusses its potential and impact on the markets
Image: stock.adobe.com/TheFotos
As firms evaluate the potential impact of central clearing reforms proposed by the SEC, market participants contemplate concerns for increased costs, disruption in liquidity flows and a reduction in trading activity for US treasury securities.
Formulated by the U.S. Securities and Exchange Commission (SEC), the proposal aims to improve transparency and lower systemic risk in the US$23.3 trillion market for US treasury securities. By increasing the number of transactions subject to central clearing, the Commission says that these amendments should strengthen the US treasury market and increase resiliency to unexpected shocks.
The SEC plays a critical role in how the treasury market functions, ensuring that the markets remain efficient, competitive and resilient. For SEC chair Gary Gensler, central clearing does not eliminate all risk, but it does lower it. He indicates that there is more work to be done in the treasury market, with only 13 per cent of treasury cash transactions centrally cleared in 2017. He says: “I think that these rules would reduce risk across a vital part of our capital markets in both normal and stress times.”
Part of the proposal would require clearing agencies in the US treasury market to mandate that their members submit for clearance and settlement all eligible secondary market transactions — including all repo and reverse repo trades collateralised by US treasuries.
The list of secondary market transactions refer to all buy and sell trades entered into by a clearing member that is an interdealer broker, and buy and sell trades between a clearing member and specified types of counterparty — specifically a government securities broker, a government securities dealer, a registered broker-dealer, a hedge fund or certain types of leveraged account.
Firms will have 60 days following the publication of this proposing release in the Federal Register to provide commentary on any concerns or advice for the SEC regarding the future of the US treasury and repo markets.
Falling short
The SEC’s objective to encourage greater adoption of central clearing in the US treasury market aims to reduce risk and improve resiliency, which is critical to the strength and stability of the US economy, according to the Depository Trust & Clearing Corporation (DTCC).
DTCC’s whitepaper “More Clearing, Less Risk: Increasing Centrally Cleared Activity in the U.S. Treasury Cash Market” notes that the US treasury market is the deepest, most liquid market that is dwarfing in size every other market in the world. The US-based post-trade financial services firm has long advocated for a greater use of central clearing, recommending that, as an industry, the causes, trends and risks in the shift to bilateral clearing for cash activity in the US treasury market must be explored further.
Central clearing plays a critical role in the financial system and became a key element of financial system reforms in the aftermath of the great financial crisis. This contributed to market resilience through the crisis by continuing to clear contracts despite the bilateral markets drying up. Since this time, central clearing has evolved significantly.
According to DTCC, there are various benefits to centrally clearing US treasury activity through the Fixed Income Clearing Corporation (FICC). For example, bilateral counterparty credit risk is mitigated through the novation of FICC and market risk is eased through standardised margin processing. In addition, central clearing repo transactions alleviates capital constraints by enabling members to reduce capital usage and, therefore, helps to maintain liquid markets.
Clear Street’s managing director and head of repo trading Joseph DiMartino says centrally clearing more US treasury transactions will improve liquidity. Balance sheet optimisation will be more efficient and fails will be dramatically reduced. However, DiMartino believes that the SEC’s proposal might fall short of some of its goals in regards to central clearing.
He explains: “During periods of economic volatility or market stress, participants will be more likely to face clients through a centrally cleared platform without taking on specific counterparty risk. However, the costs of such a significant increase in centrally cleared activity might be a hurdle too large for many participants.
“Additional transaction costs as well as increased capital requirements will make market making in US treasuries less favourable. The hurdle rate increase will lead larger banks and broker-dealers to re-allocate precious balance sheets.”
Among the listed proposals laid out by the SEC, the organisation dictates that CCPs would be required to calculate, collect and hold margin for a direct participant’s treasury securities transactions separately to that of an indirect participant. CCPs are also expected to take steps to ensure that there are appropriate means to facilitate access to clearance and settlement services of all eligible secondary market transactions.
Furthermore, the proposal suggests an amendment to SEC Rule 15c3-3a. The rule permits broker-dealers to include a debit in the reserve formulas for customer cash and treasury securities delivered to a treasury CCP to meet a margin requirement, with respect to such a customer’s treasury securities transactions.
Speaking to SFT, Colleen Stapleton, repo product manager at MarketAxess, says: “Like much of the coverage on this topic of late, improvements can and should be made to increase market stability, transparency and resiliency, but it should be a measured incremental response building off the success of the Sponsored Repo programme.
“A mandate of this nature will force the UST repo market to completely overhaul current technology and its operations approach. MarketAxess will work with the industry to support any regulatory change that will help make the market more efficient and resilient.”
A thoughtful approach
James Tabacchi, chairman of the Independent Dealer and Trader Association (IDTA), applauds the SEC’s desire to improve transparency, reduce systemic risk and level the competitive playing field for all participants in the US treasury market through a central clearing mandate.
The treasury market consists of a wide range of investor participants, including corporate treasuries, trading firms and dealers. Tabacchi notes that all of them are important participants in the liquidity flows of the treasury and treasury repo market — which is vast and currently trades with tight margins.
As the chairman of the IDTA, Tabacchi confirms that the organisation is preparing a comment letter on the SEC’s proposal on treasury market central clearing.
“We believe a disruption in any one of these participant liquidity flows could have negative systemic impact and should be planned and implemented in a thoughtful manner,” Tabacchi explains. He recognises that the impact that the SEC proposal will have on market competition is highly dependent on how central clearing will be implemented. He concludes: “Any central clearing mandate which would inhibit competition and narrow sources of liquidity, even in the short term, should be avoided at all costs.”
Despite the SEC’s confidence in its ability to improve transparency and lower systemic risk, several market participants are cautious about the new proposals and what they will mean for the treasury and repo markets.
The smaller, non-bank broker-dealer community has been a valuable source of liquidity for the buy-side for many years, says Clear Street’s DiMartino. He anticipates that additional transaction costs will be passed along to their clients, which will result in a reduction in trading activity in US treasury securities. DiMartino indicates that this will become a barrier for new entrants into US treasury trading and market making.
DiMartino adds: “The result could be less liquidity in times of stress as the totality of market makers and balance sheets have been reduced dramatically. Perhaps revisiting past regulatory exemptions would be a simpler way to improve transparency and lower systemic risk in the US treasury market.”
According to Tabacchi, it is not currently a realistic expectation to require all market participants to centrally clear — and certainly not all at once. He continues: “Central clearing requires mutualisation of risk and a likely increase in cost and capital requirements which, while potentially beneficial to the market in the long term, could cause a disruption in treasury liquidity flows in the short term.”
Tabacchi suggests that this could cause some disintermediated flows to be concentrated with the largest financial institutions. Since central clearing, by design, creates a single point of failure, he notes, any concentration risk is compounded by the potential disruption of just one large SIFI institution. “Concentration of risk is also, by definition, non-competitive, and inconsistent with the goals of Dodd Frank,” Tabacchi indicates.
Tabacchi concludes: “We believe a methodical, well developed, phased in plan, hopefully with the incorporation of DLT technology, makes sense and enables all participants to achieve the SEC’s stated objectives.”
The SEC will need to take onboard the thoughts and the expertise of industry participants as it attempts to pave the way for an improved and protected US treasury and repo market.
Formulated by the U.S. Securities and Exchange Commission (SEC), the proposal aims to improve transparency and lower systemic risk in the US$23.3 trillion market for US treasury securities. By increasing the number of transactions subject to central clearing, the Commission says that these amendments should strengthen the US treasury market and increase resiliency to unexpected shocks.
The SEC plays a critical role in how the treasury market functions, ensuring that the markets remain efficient, competitive and resilient. For SEC chair Gary Gensler, central clearing does not eliminate all risk, but it does lower it. He indicates that there is more work to be done in the treasury market, with only 13 per cent of treasury cash transactions centrally cleared in 2017. He says: “I think that these rules would reduce risk across a vital part of our capital markets in both normal and stress times.”
Part of the proposal would require clearing agencies in the US treasury market to mandate that their members submit for clearance and settlement all eligible secondary market transactions — including all repo and reverse repo trades collateralised by US treasuries.
The list of secondary market transactions refer to all buy and sell trades entered into by a clearing member that is an interdealer broker, and buy and sell trades between a clearing member and specified types of counterparty — specifically a government securities broker, a government securities dealer, a registered broker-dealer, a hedge fund or certain types of leveraged account.
Firms will have 60 days following the publication of this proposing release in the Federal Register to provide commentary on any concerns or advice for the SEC regarding the future of the US treasury and repo markets.
Falling short
The SEC’s objective to encourage greater adoption of central clearing in the US treasury market aims to reduce risk and improve resiliency, which is critical to the strength and stability of the US economy, according to the Depository Trust & Clearing Corporation (DTCC).
DTCC’s whitepaper “More Clearing, Less Risk: Increasing Centrally Cleared Activity in the U.S. Treasury Cash Market” notes that the US treasury market is the deepest, most liquid market that is dwarfing in size every other market in the world. The US-based post-trade financial services firm has long advocated for a greater use of central clearing, recommending that, as an industry, the causes, trends and risks in the shift to bilateral clearing for cash activity in the US treasury market must be explored further.
Central clearing plays a critical role in the financial system and became a key element of financial system reforms in the aftermath of the great financial crisis. This contributed to market resilience through the crisis by continuing to clear contracts despite the bilateral markets drying up. Since this time, central clearing has evolved significantly.
According to DTCC, there are various benefits to centrally clearing US treasury activity through the Fixed Income Clearing Corporation (FICC). For example, bilateral counterparty credit risk is mitigated through the novation of FICC and market risk is eased through standardised margin processing. In addition, central clearing repo transactions alleviates capital constraints by enabling members to reduce capital usage and, therefore, helps to maintain liquid markets.
Clear Street’s managing director and head of repo trading Joseph DiMartino says centrally clearing more US treasury transactions will improve liquidity. Balance sheet optimisation will be more efficient and fails will be dramatically reduced. However, DiMartino believes that the SEC’s proposal might fall short of some of its goals in regards to central clearing.
He explains: “During periods of economic volatility or market stress, participants will be more likely to face clients through a centrally cleared platform without taking on specific counterparty risk. However, the costs of such a significant increase in centrally cleared activity might be a hurdle too large for many participants.
“Additional transaction costs as well as increased capital requirements will make market making in US treasuries less favourable. The hurdle rate increase will lead larger banks and broker-dealers to re-allocate precious balance sheets.”
Among the listed proposals laid out by the SEC, the organisation dictates that CCPs would be required to calculate, collect and hold margin for a direct participant’s treasury securities transactions separately to that of an indirect participant. CCPs are also expected to take steps to ensure that there are appropriate means to facilitate access to clearance and settlement services of all eligible secondary market transactions.
Furthermore, the proposal suggests an amendment to SEC Rule 15c3-3a. The rule permits broker-dealers to include a debit in the reserve formulas for customer cash and treasury securities delivered to a treasury CCP to meet a margin requirement, with respect to such a customer’s treasury securities transactions.
Speaking to SFT, Colleen Stapleton, repo product manager at MarketAxess, says: “Like much of the coverage on this topic of late, improvements can and should be made to increase market stability, transparency and resiliency, but it should be a measured incremental response building off the success of the Sponsored Repo programme.
“A mandate of this nature will force the UST repo market to completely overhaul current technology and its operations approach. MarketAxess will work with the industry to support any regulatory change that will help make the market more efficient and resilient.”
A thoughtful approach
James Tabacchi, chairman of the Independent Dealer and Trader Association (IDTA), applauds the SEC’s desire to improve transparency, reduce systemic risk and level the competitive playing field for all participants in the US treasury market through a central clearing mandate.
The treasury market consists of a wide range of investor participants, including corporate treasuries, trading firms and dealers. Tabacchi notes that all of them are important participants in the liquidity flows of the treasury and treasury repo market — which is vast and currently trades with tight margins.
As the chairman of the IDTA, Tabacchi confirms that the organisation is preparing a comment letter on the SEC’s proposal on treasury market central clearing.
“We believe a disruption in any one of these participant liquidity flows could have negative systemic impact and should be planned and implemented in a thoughtful manner,” Tabacchi explains. He recognises that the impact that the SEC proposal will have on market competition is highly dependent on how central clearing will be implemented. He concludes: “Any central clearing mandate which would inhibit competition and narrow sources of liquidity, even in the short term, should be avoided at all costs.”
Despite the SEC’s confidence in its ability to improve transparency and lower systemic risk, several market participants are cautious about the new proposals and what they will mean for the treasury and repo markets.
The smaller, non-bank broker-dealer community has been a valuable source of liquidity for the buy-side for many years, says Clear Street’s DiMartino. He anticipates that additional transaction costs will be passed along to their clients, which will result in a reduction in trading activity in US treasury securities. DiMartino indicates that this will become a barrier for new entrants into US treasury trading and market making.
DiMartino adds: “The result could be less liquidity in times of stress as the totality of market makers and balance sheets have been reduced dramatically. Perhaps revisiting past regulatory exemptions would be a simpler way to improve transparency and lower systemic risk in the US treasury market.”
According to Tabacchi, it is not currently a realistic expectation to require all market participants to centrally clear — and certainly not all at once. He continues: “Central clearing requires mutualisation of risk and a likely increase in cost and capital requirements which, while potentially beneficial to the market in the long term, could cause a disruption in treasury liquidity flows in the short term.”
Tabacchi suggests that this could cause some disintermediated flows to be concentrated with the largest financial institutions. Since central clearing, by design, creates a single point of failure, he notes, any concentration risk is compounded by the potential disruption of just one large SIFI institution. “Concentration of risk is also, by definition, non-competitive, and inconsistent with the goals of Dodd Frank,” Tabacchi indicates.
Tabacchi concludes: “We believe a methodical, well developed, phased in plan, hopefully with the incorporation of DLT technology, makes sense and enables all participants to achieve the SEC’s stated objectives.”
The SEC will need to take onboard the thoughts and the expertise of industry participants as it attempts to pave the way for an improved and protected US treasury and repo market.
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