Expanded central clearing would increase Treasury market resilience

The smooth functioning of markets for Treasury securities is critically important to the U.S. economy. The federal government relies on the sale of Treasuries to finance essential services, and the Federal Reserve uses Treasury markets to implement monetary policy.

Treasury markets also underpin the broader U.S. financial system by providing safe and liquid assets and establishing a benchmark yield curve, which helps determine interest rates on other types of debt of various maturities. Disruptions in Treasury markets can interfere with credit availability for households and businesses.

In recent years, Treasury markets have suffered several episodes of significant deterioration in market functioning, in some cases requiring official sector intervention. Government and external reports have identified market vulnerabilities including data gaps, uneven risk management and insufficiently elastic capacity for intermediation (matching buyers and sellers) during periods of stress.

In response, government agencies have outlined an extensive array of potential reforms. We evaluate the potential benefits and costs of one such measure: a proposal by the Securities and Exchange Commission (SEC) to increase the scope of central clearing of Treasury securities.

Central clearing is an arrangement in which a financial institution—known as a clearinghouse or central counterparty—steps between the two parties to a financial transaction, becoming a counterparty to both sides and guaranteeing completion of the transaction.

The SEC proposal has two main components, each of which would strengthen Treasury market resilience. First, the proposed rule would expand the set of Treasury transactions that are required to be centrally cleared. Second, the proposed rule would require the segregation of collateral associated with customers’ centrally cleared Treasury transactions. We address each component and consider the public and private benefits and costs of the proposed rule.

Broadening central clearing

The Fixed Income Clearing Corp. (FICC) is currently the only central counterparty for outright purchases and sales and repo transactions in Treasury securities. (Repos are transactions in which a cash borrower sells securities to a cash investor with an agreement to repurchase the securities at a higher price on a future date, and can be thought of as collateralized loans. They are commonly used for overnight financing.)

To use FICC’s clearing services, a firm generally must become a clearinghouse member or have another firm that is a member agree to provide access to clearing services. FICC requires its members to centrally clear each of their transactions with another member, while transactions between a member and a nonmember need not be centrally cleared.

The proposed rule would require that FICC, or any other central counterparty clearing cash and repo transactions in Treasury securities, establish rules requiring members to submit for clearing their eligible secondary market transactions (as defined in the proposal) with nonmembers. Secondary market transactions are those that take place after a security is issued, as distinct from primary market transactions between the Treasury Department and the initial buyer of a security.

Outright, or cash, Treasury transactions have averaged more than $600 billion per day in 2022, according to the Securities Industry and Financial Markets Association. The Treasury Market Practices Group has estimated that 68 percent of cash transactions are not centrally cleared, and an additional 19 percent are subject to hybrid clearing, where part of a trade is cleared centrally and part is cleared bilaterally (without a central counterparty).

Repos by major broker-dealers with private-sector market participants total about $2.5 trillion on a typical day. Repos can be settled on the books of a clearing bank (triparty repo) or without the services of a clearing bank (bilateral repo). Most triparty repos are not currently centrally cleared and would be required to be centrally cleared under the proposed rule. Of bilateral repos, primary dealer activity reports suggest that roughly two-thirds are not centrally cleared; the proposed rule would generally require that this activity be centrally cleared as well.

Increasing the scope of transactions that are centrally cleared would enhance the resilience of the Treasury market in several ways.

• Uniform risk management standards would apply to more transactions. FICC holds cash and eligible securities from participants as collateral, also called margin, to guarantee completion of trades. FICC also imposes other risk management requirements. Today, only trades between two FICC members are required to comply with these requirements.
  
  For non-centrally-cleared transactions, margins (or equivalent haircuts on the value of securities used in repos) are negotiated bilaterally. In a recent pilot study, the Office of Financial Research found that 74 percent of non-centrally-cleared bilateral repos were subject to a zero haircut.
  
  The lack of consistent margin practices poses risks not only to the participants in trades with insufficient margins or haircuts but also to the broader market, especially the clearinghouse and the functioning of centrally cleared market segments. This is because the clearinghouse is exposed to firms such as interdealer brokers that also engage in non-centrally-cleared trades.
  
  A lack of uniform risk management also requires intermediaries to separately investigate the creditworthiness of each potential counterparty, possibly hindering efforts to rapidly scale up intermediation in response to demand.

• The balance sheet intensity of repo intermediation would be reduced. Intermediation that can scale rapidly is critical to the smooth functioning of the Treasury market, as noted in the 2021 Staff Progress Report of the Inter-Agency Working Group for Treasury Market Surveillance.
  
  Episodes of stress in the Treasury market have demonstrated that the supply of intermediation does not always respond elastically to changes in demand, in part because of balance sheet constraints at dealers serving as intermediaries. Expanded central clearing would allow increased netting of intermediaries’ repo positions. This netting would reduce the amount of balance sheet space they would need to dedicate to each additional repo transaction and could allow repo intermediation to scale more flexibly.

• Settlement risks would be mitigated. A central counterparty reduces participants’ gross exposures and settlement obligations by canceling out, or netting, offsetting positions. In addition, broadening the set of transactions settled through the central counterparty would replace a web of bilateral settlement obligations with a simpler hub-and-spoke model. This simplified network structure would reduce the likelihood of cascades of delivery failures such as those that occurred in March 2020, as described by researchers at the Federal Reserve Bank of New York. Central clearing also centralizes default management, simplifying the resolution process in the event of post-trade disruptions.
  
  Additionally, by netting down more settlement obligations, broader central clearing could reduce demands for funding liquidity under stress, helping make the market more resilient to funding-liquidity shortfalls such as those during the repo market stress event in September 2019.

• A foundation would be created for increased transparency of market transactions. Because all parties to a centrally cleared transaction are subject to risk-management and settlement obligations based on the terms communicated to the central counterparty, all parties have incentives to ensure data are correct. As a result, a central counterparty can provide accurate data on all centrally cleared transactions, which facilitates efficient and accurate production of reference interest rates and other data products.
  
  Data improvements can both benefit market participants and support more effective market oversight. FICC data are already used in the publication of the benchmark Secured Overnight Financing Rate (SOFR) and in the Office of Financial Research’s U.S. Repo Markets Data release, which provide pricing transparency to repo market participants.
  
  Broader central clearing of Treasury market transactions could also provide more granular information to support regulators’ and policymakers’ decision-making; the 2021 Inter-Agency Working Group staff progress report noted the value such information would have offered during market stresses in March 2020.

Customer margining changes

FICC typically nets a member’s position against the centrally cleared positions of the member’s customers before calculating and collecting margin and settlement obligations.

(An exception occurs when a customer becomes a “sponsored member” of FICC whose obligations to FICC are guaranteed by a full clearinghouse member. A sponsored member’s positions are segregated from those of the sponsoring member, and the sponsored member acquires standing as a member of the clearinghouse, albeit one with different obligations than a full member.)

As a result of how FICC normally handles customer positions, a dealer-to-customer transaction would not typically be centrally cleared in any meaningful sense because the dealer’s and customer’s positions vis-à-vis one another net to zero and do not generate any margin or settlement obligations. The proposed rule would require the central counterparty to calculate and collect margin separately for members and for their customers, allowing the central counterparty to guarantee trades between dealers and customers.

Importantly, the proposed rule would allow customer funds to be posted to the central counterparty as collateral for customers’ centrally cleared Treasury positions, provided that the customer funds were appropriately segregated.

The SEC’s existing customer protection regulations (known as Rule 15c3-3) do not allow dealers to post customers’ funds as collateral at FICC. Without a change, dealers would have to post their own assets as collateral for customers’ positions, which would require dealers to bear the costs of risk management for customers’ trading decisions. The proposal on customer protection would, thus, ensure that the appropriate party bears the cost of risk management for each trade.

Public and private benefits, costs under the proposed rule

The proposed rule would provide benefits such as standardized risk management, reduced settlement risk, centralized default management and increased transparency. At the same time, some have raised concern that clearing costs and minimum margins may make trading more costly, reducing Treasury market liquidity.

It is important to note that some private costs of the proposed rule to the firms participating in a transaction would be offset by benefits for the broader market and economy. For example, to the extent that the rule enhances the risk management of trades that are not currently centrally cleared, participants in those transactions may bear increased costs for risk management. However, enhanced risk management provides public benefits, including reductions in other market participants’ exposures to spillovers from inadequate risk controls and a decreased likelihood that the official sector would need to intervene to address market dysfunction.

Some trades may become uneconomical if participants must bear these trades’ full risk management costs under the proposed rule. However, if a trade makes sense only when third parties bear the risk management costs, the trade does not add value for the market as a whole. Requiring traders to internalize the costs of risk management makes the market healthier. Also, market participants would see some private benefits from the proposed rule, such as reduced balance sheet costs.

Moreover, some aspects of the proposed rule would support market liquidity in both normal and stressed circumstances. Broader adoption of standardized risk management practices would unlock the prospect of all-to-all trading—allowing any market participant to directly trade with any other participant—that could enhance liquidity. Additionally, decreased balance sheet and margin costs resulting from multilateral netting and segregated margin can boost intermediation capacity and the resilience of intermediation under stress.

Some market participants have expressed concern that the proposed rule would increase the cost of relative value trades. Relative value trades seek to arbitrage differences between the prices of economically similar securities. Such arbitrage can support market functioning because it helps to ensure that prices reflect fundamentals.

Relative value trades in cash Treasuries are often established using netted packages. Netted packages are matched pairs of repos and reverse repos collateralized by relatively similar Treasury securities, such as a pairing of an on-the-run security (the most recently issued Treasury of a specific maturity) with an older issue that has a similar remaining maturity.

As noted in the Office of Financial Research pilot study, the prevalence of these trades may account for a significant fraction of the 74 percent of uncleared bilateral Treasury repo trades conducted at zero haircuts. Netted packages may pose relatively less risk than many other repo trades because of the similarity of the securities used as collateral. However, netted packages pose some risk because spreads between the prices of economically similar securities can sometimes fluctuate significantly, especially during stress episodes. For example, significant deviations in the prices of economically similar Treasury securities occurred in March 2020.

The standardization of risk management under the proposed rule would help ensure that netted packages and other relatively lower-risk trades are subject to appropriate—not excessive—margin requirements. In particular, the SEC is proposing to require the central counterparty to ensure that its policies and procedures facilitate broader access to central clearing. The central counterparty could consider whether any features of the trades newly subject to central clearing would require different approaches to margining and fees in order to effectively, efficiently and prudently provide clearing services.

Enhancing Treasury market functions for broader benefits

The SEC’s proposal to broaden central clearing of Treasury transactions comes with potential benefits and costs. Although no one reform can address all vulnerabilities in the Treasury market, the SEC proposal has the potential to significantly enhance the market’s resilience. Further, some costs to private market participants would be offset by benefits to the broader market and to the public.