Remarks before the Market Risk Advisory Committee of the U.S. Commodity Futures Trading Commission

Thank you, Chair [Alicia] Crighton. And thank you to Commissioner Johnson for the invitation to speak with you today.

My name is Sam Schulhofer-Wohl. I am senior vice president and senior advisor to the president at the Federal Reserve Bank of Dallas. In this and previous roles, I have been closely involved in work to support the resilience of Treasury markets and other parts of the U.S. financial system. I have also had the privilege of collaborating since 2021 with the Inter-Agency Working Group for Treasury Market Surveillance (IAWG) on its program of analysis and policymaking in support of Treasury market resilience.

Today I will review the state of play, as I see it, in efforts to enhance the resilience of Treasury markets. I will then take a deeper dive into one dimension of those efforts: the examination of possibilities for expanded central clearing, and how it relates to the cash-futures basis trade.

My remarks will represent my views and not necessarily those of the Federal Reserve Bank of Dallas, the Federal Reserve System or any other organization. Also, because today falls in a communications blackout period ahead of this week’s Federal Open Market Committee meeting, I will not comment on current or prospective economic and financial conditions or uses of the Fed’s policies and tools. No inference should be drawn from my silence on these matters.

The history of the Treasury markets, including those for cash securities, repurchase agreements (repos), and Treasury futures, has been one of ongoing evolution. I see that ongoing evolution as critical to ensuring these markets can continue to reliably serve their vital purposes, such as financing the government, establishing risk-free benchmark interest rates and providing safe and liquid assets.

I would date the current chapter of the Treasury markets’ evolution to the stresses experienced in 2019 and 2020. In September 2019, repo rates spiked by hundreds of basis points in a single day as tax payments and a Treasury auction settlement drained bank reserves.[1] Then, in March 2020, the dash for cash overwhelmed Treasury markets’ intermediation capacity at the onset of the COVID-19 pandemic.[2] Following these episodes, experts across industry, academia and the official sector began examining how to mitigate the vulnerabilities they revealed.

The IAWG, which consists of staff from the Treasury Department, Federal Reserve Board, New York Fed, Securities and Exchange Commission (SEC) and CFTC, launched workstreams to evaluate policy issues and options in five areas: improving resilience of market intermediation, improving data quality and availability, enhancing trading venue transparency and oversight, examining effects of leverage and fund liquidity risk management and evaluating expanded central clearing.[3] Significant progress has been made across all of these areas.[4] A few accomplishments I’d highlight are:

• Enhancements to the quality and scope of data collection for the Trade Reporting and Compliance Engine (TRACE) of the Financial Industry Regulatory Authority.[5]
• Publication of more detailed TRACE data.[6]
• A pilot study by the Office of Financial Research (OFR) of data collection for noncentrally cleared bilateral repo (NCCBR) and subsequent proposal for permanent data collection.[7]
• The Treasury Department announcement of a buyback program that aims in part to support market liquidity.[8]
• The approval of a new cross-margining agreement between the Chicago Mercantile Exchange (CME) and the Fixed Income Clearing Corporation (FICC) for Treasury futures and cash transactions.[9]
• The SEC’s proposal to broaden the scope of central clearing in the cash and repo markets, whose potential adoption the Commission will consider this Wednesday.[10]

The framework the IAWG has established for evaluating policy issues may be as important in the long run as any of these specific steps. In 2021, the IAWG staffs proposed six principles to guide public policy in the Treasury markets:[11]

• Resilient and elastic liquidity.
• Transparency that fosters public confidence, fair trading and a liquid market.
• Prices that reflect prevailing and expected economic and financial conditions.
• Economic integration across cash, funding and derivatives markets.
• Financing that does not pose a significant threat to financial stability.
• Infrastructure that operates effectively and efficiently.

The benefits of a principles-based approach to public policy are familiar to the CFTC and participants in the markets it regulates—in particular, the way principles-based regulation can provide flexibility to adjust to changing conditions alongside clarity about desired outcomes.[12] While the IAWG principles do not have the force of law or regulation, I hope they will offer some of the same benefits in Treasury markets.

I will now discuss in more depth the potential for expanded central clearing—and, related, how I think about the basis trade—in light of the IAWG’s principles.

A substantial share of transactions in the Treasury markets is already centrally cleared. However, a significant set of transactions is not centrally cleared, especially typical dealer-to-customer transactions. Additionally, cash transactions on electronic interdealer broker (IDB) platforms are often subject to hybrid clearing: Trade legs between IDBs and members of FICC are centrally cleared, while trade legs between IDBs and typical principal trading firms are not.[13] The SEC has proposed to require clearing of a broad range of repos and cash transactions, including all transactions at IDBs.

Several of the IAWG’s principles provide useful frameworks for assessing the implications of such a change.[14]

First, resilient and elastic liquidity. During stress episodes, market liquidity in the Treasury markets has sometimes come under strain because balance sheet costs or constraints discouraged intermediaries from expanding the supply of intermediation sufficiently to meet rising demand.[15] Central clearing allows for multilateral netting, which reduces the balance sheet intensity of intermediation and may permit dealers to more significantly increase their intermediation when demand rises.[16]

Second, transparency. Because centrally cleared transactions are, of necessity, reported to the central counterparty (CCP), collecting data on them is straightforward. By contrast, collecting data on bilaterally cleared transactions has proven challenging. The $2 trillion NCCBR market still lacks routine data collection, though the OFR is proposing to close this gap. Broader central clearing would support more efficient data collection that could enhance transparency for the official sector and market participants.

Third, infrastructure that operates efficiently and effectively. I’ve already mentioned netting efficiencies. There is also the matter of effectiveness. The current hybrid clearing model for transactions on IDB platforms poses a contagion risk to the CCP, which lacks visibility into non-centrally-cleared trade legs but is exposed to their risks via the IDB. Moving all IDB transactions into central clearing should enable more effective risk management at the CCP.

Finally—I’ll take these together—economic integration across markets and financing that does not pose a significant threat to financial stability. In the Treasury markets, the economic integration trade par excellence is the cash-futures basis trade. Market participants’ ability to buy a cash security, finance that security in the repo market and short the corresponding future helps ensure two tight links: between the prices of cash securities and futures, and between the implied financing rates in repo and futures markets.

A trader who puts on a cash-futures basis position faces a couple of main risks that could lead to de-levering in the face of a shock. First, if the repo funding is overnight, it will have to be rolled until the expiry date of the future and may become expensive or scarce. Second, although the trade has a defined return if financed with term funding and held until expiry, it can generate margin calls in the interim.

Broader central clearing can mitigate both of these risks. One challenge to arranging term financing is the need to monitor and risk manage the borrower over the life of the loan. Broader central clearing of repos could support a more robust term repo market by efficiently centralizing this risk management task at the CCP. Additionally, if combined with an efficient and broadly available cross-margining arrangement between the cash and futures CCPs, broader central clearing could reduce margin calls on basis positions as margins would be based on the net risk of these positions, which is much smaller than the gross risk of each leg.

Thus, broader central clearing could support the economic integration that basis trades foster, while reducing potential risks to financial stability.

More work beyond adoption of the SEC’s clearing proposal would be needed to fully achieve these benefits. Most notably, the new FICC-CME cross-margining agreement still covers only clearing member portfolios, not customer portfolios. But one shouldn’t take this or other current challenges to customer clearing as given. Importantly, the SEC’s clearing proposal would modify Rule 15c3-3 on segregation of customer funds. If adopted, this change would open a path to significantly lower costs of customer clearing. Under current rules, a clearing member at a securities CCP must post its own funds, not the customer’s, as collateral for customer trades. This increases the costs of customer clearing, as I’ve documented in my research.[17]

For those of you who come from a derivatives background and aren’t deep into Treasury market plumbing, it may be surprising that customer funds can’t currently be posted as collateral for cleared customer trades in the Treasury market. After all, separate margining of customer positions is standard practice in the CFTC’s markets. I’m encouraged that the SEC has proposed to allow clearing members at a Treasury securities clearing agency to post customer funds as collateral for customer trades.

Another way broader central clearing can support financing that does not threaten financial stability is by providing for uniformly strong risk management of repos. The OFR’s pilot collection of NCCBR data found that 74 percent of NCCBR transactions against Treasury collateral are done with a zero haircut.[18] While in some cases, such as prime brokerage, the cash investor may be protected by portfolio-level margining, the data also show transactions that are simply unmargined. For example, with netted packages—repos and reverse repos collateralized by different securities as part of a relative value trade—it is common to set a zero haircut on the theory that the collateral perfectly offsets. But that approach doesn’t account for the risk that the relative value of the two securities may change, which is the reason for the trade in the first place. Broader central clearing would apply the CCP’s strong risk management standards to the market more uniformly.

Lest you think I am a total Pollyanna, I want to acknowledge that broader central clearing has potential costs. These include costs for market participants to meet the CCP’s risk management requirements, knock-on effects on market liquidity from participants’ higher costs, and concentration of risk at the CCP. But as the IAWG has noted, it is important to distinguish between private and social costs.[19] At present, when a market participant chooses not to centrally clear a Treasury trade, that market participant may reap the savings from lighter-weight risk management, but the market and society as a whole bear the cost of stresses when inadequately managed risks emerge. So while broader central clearing could have some costs for individual market participants and for market liquidity at normal times, those costs must be weighed against the market-wide benefits, especially at times of stress.

Thank you. I look forward to today’s discussion and to ongoing engagement with all of you.

Notes

1. “Understanding recent fluctuations in short-term interest rates,” by Sam Schulhofer-Wohl, Chicago Fed Letter, No. 423, 2019.
2. For a detailed review, see “Recent Disruptions and Potential Reforms in the U.S. Treasury Market: A Staff Progress Report,” U.S. Department of the Treasury, Board of Governors of the Federal Reserve System, Federal Reserve Bank of New York, U.S. Securities and Exchange Commission and U.S. Commodity Futures Trading Commission, 2021.
3. “Remarks at the Federal Reserve Bank of New York’s Annual Primary Dealer Meeting,” by Brian Smith, U.S. Department of the Treasury, April 8, 2021.
4. For a full review, see U.S. Department of the Treasury et al., 2021; “Enhancing the Resilience of the U.S. Treasury Market: 2022 Staff Progress Report,” U.S. Department of the Treasury, Board of Governors of the Federal Reserve System, Federal Reserve Bank of New York, U.S. Securities and Exchange Commission and U.S. Commodity Futures Trading Commission, 2022; and “Enhancing the Resilience of the U.S. Treasury Market: 2023 Staff Progress Report.” U.S. Department of the Treasury, Board of Governors of the Federal Reserve System, Federal Reserve Bank of New York, U.S. Securities and Exchange Commission and U.S. Commodity Futures Trading Commission, 2023.
5. “Order Approving a Proposed Rule Change to Amend FINRA Rule 6730 (Transaction Reporting) to Enhance TRACE Reporting Obligations for U.S. Treasury Securities,” Securities and Exchange Commission, Release No. 34-95635, File No. SR-FINRA-2022-013, 2022a; “Announcement of Board Approval Under Delegated Authority and Submission to OMB,” Board of Governors of the Federal Reserve System, 2021, (FR 2956; OMB No. 7100-NEW), Federal Register 86, No. 206 (October 28): 59716–59718; “TRACE Reporting of U.S. Treasury Securities,” Financial Industry Regulatory Authority, Regulatory Notice 22-27, December 1, 2022.
6. “Notice: Enhancements to Aggregated Reports and Statistics for U.S. Treasury Securities – Updated Date,” Financial Industry Regulatory Authority, technical notice, December 28, 2022.
7. “OFR’s Pilot Provides Unique Window Into the Non-centrally Cleared Bilateral Repo Market,” by Samuel J. Hempel, R. Jay Kahn, Robert Mann and Mark Paddrik, Office of Financial Research, U.S. Department of the Treasury OFR Blog, December 5, 2022; “Collection of Non-Centrally Cleared Bilateral Transactions in the U.S. Repurchase Agreement Market,” Office of Financial Research, U.S. Department of the Treasury, Federal Register 88, No. 5 (January 9): 1154–1170, 2023.
8. See “Remarks by Assistant Secretary for Financial Markets Josh Frost at the International Swaps and Derivatives Association Derivatives Trading Forum,” by Josh Frost, U.S. Department of the Treasury, September 21, 2023.
9. “Self-Regulatory Organizations; The Fixed Income Clearing Corporation; Order Granting Approval of Proposed Rule Change to Amend and Restate the Cross-Margining Agreement between FICC and CME,” Securities and Exchange Commission, Release No. 34-98327, 2023. “Standards for Covered Clearing Agencies for U.S. Treasury Securities and Application of the Broker-Dealer Customer Protection Rule With Respect to U.S. Treasury Securities,” Securities and Exchange Commission, Federal Register 87, No. 205 (October 25): 64610–64682, 2022b; “Open Meeting Agenda, Wednesday, December 13, 2023.” Securities and Exchange Commission, 2023.
10. “Standards for Covered Clearing Agencies for U.S. Treasury Securities and Application of the Broker-Dealer Customer Protection Rule With Respect to U.S. Treasury Securities,” Securities and Exchange Commission, Federal Register 87, No. 205 (October 25): 64610–64682, 2022b; “Open Meeting Agenda, Wednesday, December 13, 2023.” Securities and Exchange Commission, 2023.
11. U.S. Department of the Treasury et al., 2021.
12. See, for example, “It’s a Matter of Principles,” by Walter Lukken,  remarks at the University of Houston’s Global Energy Management Institute, January 25, 2007; and  “Rules for Principles and Principles for Rules: Tools for Crafting Sound Financial Regulation,” by Heath P. Tarbert, Harvard Business Law Review, Vol. 10, 2020.
13. For additional details on how different types of transactions are cleared, see U.S. Department of the Treasury et al., 2021.
14. For additional discussion of benefits and costs of broader central clearing, see Securities and Exchange Commission, 2022b; U.S. Department of the Treasury et al., 2021; and “Expanded central clearing would increase Treasury market resilience,” by Matthew McCormick and Sam Schulhofer-Wohl, Dallas Fed Economics, December 23, 2022.
15. “Resilience redux in the U.S. Treasury market,” by Darrell Duffie, paper presented at the Jackson Hole Economic Symposium, 2023.
16. “The Netting Efficiencies of Marketwide Central Clearing,” by Michael Fleming and Frank Keane, Federal Reserve Bank of New York Staff Report No. 964, 2021.
17. “The customer settlement risk externality at U.S. securities central counterparties,” by Sam Schulhofer-Wohl, Journal of Financial Market Infrastructures 10(1), 57–74, 2022.
18. Hempel et al., 2022.
19. U.S. Department of the Treasury et al., 2021.