Growing calls for mandatory central clearing of US Treasury bonds is sparking a fierce debate about how key infrastructure supporting the world’s most important financial market should be organised, pitting principal trading firms against major investment banks.
The Group of 30, an independent body focused on financial issues, recommended clearing for interdealer Treasury trades in a landmark report released last month and called for further study of clearing dealer-to-client trades. The report, signed by former Treasury Secretary Timothy Geithner, added to a growing clamour for reform as policymakers have looked to increase the market’s resilience following wild gyrations as the coronavirus pandemic took hold last year.
Enforced clearing would have huge ramifications in particular for the non-bank dealer community, which now accounts for a large chunk of Treasury trading volumes – and whose trades mostly aren't cleared. These firms are calling for significant changes to current clearing practices to accompany any move to mandate clearing, putting them on a collision course with traditional bank dealers and the Depository Trust & Clearing Corp, the main clearinghouse for Treasuries.
That showdown will only complicate moves to reform the nearly US$21trn market for Treasury securities, something officials are already wary of doing given the pivotal role it plays in setting asset prices across the globe.
"There is definitely more momentum in recent months around calls for central clearing of Treasuries," said Nichola Hunter, head of rates at bond trading platform MarketAxess. "Whether it happens or not in the near to medium term really boils down to economics. This market is so systemically important that people are very nervous about tinkering with it."
Central clearinghouses act as middlemen in financial transactions to stop losses cascading through the wider system if one of the counterparties to transactions defaults before the trade is completed. In Treasury markets, transactions are usually settled the business day after a trade is agreed.
All Treasury bond trades in interdealer markets were cleared up until the turn of the millennium and all primary dealers for the Federal Reserve Bank of New York (which includes major banks and other broker-dealers) are still required to clear. But large parts of the interdealer Treasury market are no longer cleared due to the growing prominence of non-bank firms over the past two decades.
Principal trading firms now account for 21% of all Treasury bond trades and dominate electronic interdealer broker platforms with 61% of volumes, according to the Fed. Most trades involving PTFs are not cleared, but instead settle bilaterally. Similarly, for the G30 notes there is essentially no clearing of dealer-to-client trades. As a result, over three-quarters of Treasury bond trades aren't cleared, according to Fed data.
Market dysfunction
The Treasury bond market has not had a moment of reckoning to turbo-charge clearing reform efforts – unlike derivatives markets following the 2008 crisis or the market for foreign-exchange trading after the collapse of German lender Herstatt Bank in the 1970s. But there have been several episodes of extreme volatility to concern regulators, with March 2020 providing the most recent example.
Primary dealers reported around US$1.5trn in Treasury settlement failures in a three-week period starting in mid-March 2020, the G30 report said. Around that same time Treasury prices became very volatile, trading volumes collapsed and repo rates spiked.
"Treasuries did not serve their traditional safe-haven role. Instead, dysfunction in the Treasury market exacerbated the crisis,” the report said.
Clearing is not presented as a panacea. But several prominent voices, including Stanford professor Darrell Duffie and the Brookings Institute think tank, have subsequently urged policymakers to explore the implementation of such a mandate, as part of a broader package of measures to improve the overall market’s resilience.
But while such a move may sound appealing in theory, policymakers are wary of any efforts to enforce clearing that could prompt PTFs to pull back from trading Treasuries. Every cent counts for these high-volume, high-frequency trading firms given the razor-thin margins involved in buying and selling the world’s most liquid debt. And, as things stand, most simply don't have the scale or resources required to access clearing directly.
“One of the main reasons against mandated clearing is the impact it could have on the PTF community,” said the global head of rates at a major bank. “You may lose some of their participation or liquidity if you make it more expensive and they have to connect directly to clearing.”
Fit for purpose?
The FIA Principal Traders Group, a trade body representing PTFs, said in a July white paper it had consistently supported central clearing in financial markets and welcomed the discussions around moving more Treasury trading activity into clearing.
The group argued that the current set-up for Treasuries clearing is not fit for purpose and recommended several measures needed to address “limitations”, particularly around indirect access to clearing. Some of these proposals have the potential to alter the face of Treasury market infrastructure drastically and are sure to meet fierce resistance from other participants such as investment banks.
PTFs can become direct clearing members of the Fixed Income Clearing Corp, the clearinghouse for Treasuries run by the DTCC, but only a handful have done so given the substantial costs and commitments involved. Those include meeting capital requirements and possessing the operational capabilities to clear and settle trades.
Prominent PTFs such as Hudson River Trading, Jump Trading and Virtu Financial aren't direct clearing members of FICC. PTFs can clear indirectly through an FICC member, but many firms say they can’t find anyone willing to do so on their behalf.
"We'd love everything to clear. It's better for the market," said a PTF executive, adding: "we're more sensitive to capital inefficiencies than" major global banks.
Overall, the FIA PTG suggests in its paper that the deck is stacked against PTFs when it comes to accessing clearing indirectly. To remedy the situation, it recommends that clearing members should be required to operate independently from affiliated trading units when deciding whether to offer clearing services to a particular client (so banks can’t block competitors from clearing or make it prohibitively expensive). It also recommends banning any arrangements that allow clearing members to know the identity of a client’s trading partner or otherwise limit the counterparties that a client chooses to trade with.
Fair and open access
The DTCC rejects any notion that it doesn't already provide fair and open access to clearing through its membership and client clearing models, noting it has a regulatory obligation to do so. The clearinghouse said that its client clearing models support activity that is executed both between a client and its clearing member as well as between a client and an interdealer broker or other third-party member.
“As a post-trade market infrastructure with regulatory obligations to provide open access to its services, it is essential for FICC to support both of these styles of clearing given that many market participants looking to clear their activity may have regulatory and/or operational limitations that necessitate that they participate in one style of clearing versus the other," said Laura Klimpel, general manager of FICC.
The debate looks set to rage over the coming months as policymakers make more detailed studies over the potential impact of reforms and lobbyists get ready for action. But many industry veterans believe it is now only a matter of time until the world's most important market gets a major facelift.
"The Treasury market gets a lot of extra scrutiny and you want to be thorough when assessing any changes that will have an impact," said the global rates head. But "we think mandating central clearing for Treasuries in interdealer markets would be a sensible move and is likely to happen."