It’s a bit odd that something as fundamental as clearing was hardly addressed at the New York Fed’s annual Treasury market-structure conference last week. It was especially strange because Treasury market plumbing has become — dare we say — exciting!
When the world’s biggest bank was hacked this month, it had to manually confirm Treasury trades, slowing the process significantly. As our colleagues at mainFT wrote in a nice analysis, ICBC has a sizeable Treasury-clearing business because it provided trading firms a route to clear trades outside of primary dealers’ bond desks.
Central clearing — where a (hopefully) supersafe clearing house sits between buyers and sellers and settles trades, rather than everyone facing each other — was on the regulatory agenda long before the ICBC mishap.
The SEC proposed a rule in October 2022 to expand central clearing in Treasuries. More recently, Fed Vice Chair Michael Barr and former New York Fed president Bill Dudley both called for more central clearing to improve the market’s resilience. As even the Bank of England noted in a recent report on the subject:
Trading demand has overwhelmed dealer intermediation capacity in recent episodes such as the September 2019 strains in the US Treasury repo market, the March 2020 global ‘dash for cash’ and the September-October 2022 stress in the UK gilt market . . . Moreover, with government bond markets growing faster than dealer balance sheets, there is a risk that such episodes could recur or even become more frequent in the future.
But what does all of this mean for the Treasury market, and why do so many people care? Clearing is a market-plumbing issue that nobody besides message-board conspiracists pays much mind. At least until something really blows up, and it becomes everyone’s problem.
And it really does matter for Treasuries, where the roster of market players has changed significantly since the global financial crisis. The SEC’s clearing rules will help determine how easily and cheaply newer entrants can access the market — and who will bear the costs if something goes wrong.
Over the past 15 years, the size of the Treasury market has ballooned, and banks’ balance-sheet capacity has been limited by regulations. This left an opening for a cohort of prop-trading firms and hedge funds to step in and act as intermediaries instead. This is largely how the rules were meant to work; with rare exceptions, hedge funds and other end investors can take big losses in markets without also risking a collapse of the global financial system.
The catch is that these newer intermediaries still need financing and/or leverage, and that comes from banks. So in a global dash for liquidity and bank funding (like in March 2020), the cost of trading Treasuries skyrockets and things start to get really weird for everyone, whether they’re a bank or not.
So the goal of expanding central clearing in the Treasury market — and repo markets, where lots of Treasury trades are financed — is to loosen pressure on that bank-funding bottleneck. As the BoE said:
When a contract is centrally cleared, a central counterparty (CCP) becomes both the seller to the buyer and the buyer to the seller. As a result, the original buyer and seller no longer face each other as counterparties, but rather face a CCP, which is by design an extremely robust counterparty. Moreover, comprehensive central clearing would mean that instead of having exposures to multiple trading counterparties, dealers would only have exposure to a single counterparty: the CCP. Hence, buy and sell trades pending settlement or lending and borrowing via repo could be netted, reducing balance sheet exposures and capital requirements.
This is kinda what it looks like:
That said, the expansion of central clearing will not be a simple process, because a large share of Treasury and repo trading is done bilaterally (ie not cleared). The DTCC’s Fixed Income Clearing Corporation, or FICC, is responsible for Treasury clearing, and Barclays estimates that FICC’s volumes would double as a result of the SEC’s proposed rule.
Regulators are still ironing out the clearing rules, and have already delayed the final rule until next year, according to Risk.net. And market participants have of course been getting their two cents in.
To get a sense of how this might work, Barclays’s analysts have laid out four ways that non-bank traders and investors could centrally clear their Treasury and repo trades:
(1) Becoming members of FICC: This is the priciest and possibly most work-intensive route. Members have minimum capital requirements and only “regulated entities” can join, as Barclays points out. So joining FICC might require money managers to set up broker-dealer subsidiaries if they don’t have them already.
(2) Sponsored access to FICC through current members: In sponsored repo clearing, first introduced in 2019, non-bank traders are sponsored by FICC clearing members. The FICC-member banks don’t need to use up valuable balance-sheet capacity the way they would normally. But the sponsoring banks do need to guarantee their sponsees’ trades, put up any extra capital required and pay gross margin fees on their own accounts and their sponsees’ accounts, rather than netting the two. (Put simply, banks get to put their extra balance-sheet capacity towards more profitable use, but they pay higher fees for the privilege.)
(3) Clearing through a bank’s prime-brokerage business: This option is less popular, and is “currently limited to cash transactions and used primarily by small [bank] clients” who don’t want exposure to their prime broker’s counterparty risk. Principal trading firms have “expressed interest” in this type of clearing arrangement, Barclays says. But fees “may be charged on a transaction basis”, which seems like it could become rather pricey for a fast-trading firm. FICC allows members to net their margin across different prime-brokerage clients, but the SEC’s rules call for separating house and client margin accounts, so it isn’t clear if that practice will continue.
(4) Centrally cleared institutional tri-party repo: This is a limited membership for only cash lenders, so their requirements are lower. But these cash lenders they do have a liquidity commitment if their counterparty defaults. Also, FICC apparently hasn’t been able to expand access to money-market funds, who are the cash-lending elephants in the room (especially this year).
To risk sounding repetitive, these clearing arrangements solve the core problem of limited bank balance-sheet capacity. The impact can me humongous.
The New York Fed found in a 2021 study that dealers’ daily gross settlement obligations would have been 60 per cent lower if central clearing of trades had been used in the lead-up to the March 2020 dash for cash, and 70 per cent lower when trading was at its busiest.
Central clearing does introduce a new universe of potential costs for non-bank trading firms, however, through FICC’s fees and capital requirements. And at risk of sounding conspiratorial, the DTCC is mostly owned by banks. No one in finance appreciates paying extra fees to their competitors and/or counterparties.
Luckily for us, Barclays has a nice breakdown of margin costs charged by FICC:
While the “conditional charges” — a bit more vague by definition — have ratcheted up a bit in recent years, they’re still pretty tame compared to VaR margin (value-at-risk).
FICC also requires its members to put up money so it can mutualise losses if one of its members fails. While one of these emergency funds (the Capped Contingency Liquidity Facility) isn’t “pre-funded”, meaning members don’t need to produce the cash until it’s needed, joining FICC does require a firm commitment, and those costs are included in bank stress tests and capital plans, Barclays notes.
For firms who don’t want to join FICC, sponsored clearing access is the most popular option (see the chart below).
The Barclays analysts tie the popularity of sponsored repo to the resurgence of the much-spotlighted basis trade, a popular arbitrage that maintains tight price relationships between futures and cash markets.
Speaking of the basis trade, they add that FICC and the CME, the futures exchange and clearinghouse, are rolling out a cross-margining product for members that could be expanded more broadly, the bank says:
While sponsored repo is the favoured choice of non-bank Treasury traders, Barclays says “a few hedge funds” have set up direct access to FICC, “mainly as a back-up”.
This makes sense. Sponsored repo and bank financing is easily accessible and not prohibitively expensive when markets are working normally. But when March 2020 or another crisis rolls around and every global investor and corporation is scrambling to hoard cash and draw on their credit lines, banks will not be a cheap or reliable source of funding for Treasury trades. That’s when it’ll be important to have other options for clearing.
That’s not to say FICC is cheap to access in bad times. Margin requirements are cyclical in Treasuries, just like all other markets. (See the Robinhood Gamestop saga.) As a market gets more volatile, clearinghouses require traders to put up more margin as collateral. This reduces leverage, and in effect demand, for markets when they are already under stress. This also contributed to the March 2020 mess in markets, according to a survey from the Futures Industry Association.
Another more specific concern: When it comes to Treasuries and repo, clearinghouses generally don’t recycle all of their cash collateral back into money markets or even bank accounts. They park a good deal of it at the Fed instead.
This has the effect of draining liquidity that might be available in a bilateral repo transaction. (Depending on the circumstances and agreement, repo counterparties can rehypothecate securities and cash, which is not always a good thing but frees it up nonetheless.) Anyway, here’s the breakdown of clearinghouse cash use from Barclays:
All in, FICC estimates that clearing costs could rise by $27bn with the SEC’s new rules. But Barclays — modelling a large matched-repo book meant to “simulate market activity” — estimates that clearing costs could rise by as much as $60bn under the SEC’s proposed rules.
Even with the various risks and costs, it’s probably good for Treasury traders to have an emergency option for market access, right? Seems better than trying to force trades through a narrow bank-capital door packed with companies and investors trying to grab whatever liquidity they can find.
And lest we forget, banks aren’t supposed to have the ability to take unlimited risks with their balance sheets. That’s the whole point of the post-GFC regulations!
— What is a primary dealer?