The lack of dealer liquidity provision during the March 2020 sell-off has triggered several proposals for market structure reform, not least in the US Treasury market. Authorities were clearly shocked that banks might not support trading in ‘risk free’ assets, which carry little balance sheet cost, and can be traded on a proprietary basis under the Dodd-Frank Regulation.
The importance of US Treasuries as the benchmark for other US bonds makes any challenges to price making and liquidity a serious concern.
In March 2021, Lael Brainard, Federal Reserve Governor, said, “Avenues to explore include the potential for wider access to platforms that promote forms of ‘all-to-all’ trading less dependent on dealers and, relatedly, greater use of central clearing in Treasury cash markets. These measures involve complex trade-offs and merit thoughtful analysis in advancing the important goal of ensuring Treasury market resilience.”
Now the Depository Trust & Clearing Corporation (DTCC), the US post-trade infrastructure provider has released a white paper advocating central clearing.
The paper, ‘More Clearing, Less Risk: Increasing Centrally Cleared Activity in the US Treasury Cash Market’, examines growing concerns around the increased adoption of bilateral clearing for Treasury activity and details the benefits of unifying the market under a central clearing model.
Treasury market activity is split between two disparate clearing processes: bilaterally cleared transactions, in which margin is exchanges by counterparties to offset their exposure to risk, and centrally cleared transactions in which the DTCC’s Fixed Income Clearing Corporation (FICC) acts as a central counterparty (CCP). A CCP takes the margin to offset risk and ensures that if one side goes bust, the other is not exposed to that firm directly.
According to the white paper, interdealer brokers (IDBs) are frequently executing transactions between FICC members and non-FICC members, in which one side of the trade is centrally cleared and the other is bilaterally cleared. The paper notes that this fragmentation is creating “contagion risk,” in part because if a non-FICC member defaults, there could be larger systemic impacts.
The white paper notes that the issue of fragmentation of clearing has taken on greater urgency due to ongoing market volatility, prompting discussion among industry participants and regulators on the need for an ideal market structure. Prior to 2000, all outright purchases and sales of Treasuries through IDBs were centrally cleared. Today, the Federal Reserve estimates that up to 60% of outright purchases and sales of Treasuries through IDBs involve Principal Trading Firms (PTFs), who generally do not participate in central clearing.
“The US Treasury market is the largest in the world, and its performance is critical to the strength and stability of the overall US economy,” said Murray Pozmanter, head of clearing agency services and global business operations at DTCC. “However, the bifurcation of treasury clearing activity, where part is bilaterally cleared and part is centrally cleared, is introducing greater risk into this growing market. DTCC continues to engage the industry to encourage further adoption of central clearing, to lower this risk and better protect the industry.”
According to the white paper, greater use of central clearing in the US Treasury Market would deliver industry-wide benefits, including:
• Reduced market risk through margin processing, which is collected twice a day. This promotes orderly control, wind-down and liquidation in the event of a member default, reducing the risk of liquidity drain and fire sales in a stress event.
• Added liquidity by allowing trades to be netted across all CCP members, lowering net settlement exposures and freeing up capital.
• Improved financial stability by increasing transparency in this important area of the treasuries market. FICC does not have visibility into its members’ Treasury market activity that clears bilaterally away from FICC.
Pozmanter added, “Central clearing would allow greater transparency into the bilateral treasury cash market while lowering counterparty and systemic risk and increasing resiliency. However, we believe many firms will not adopt this critical risk management capability unless there is a mandate from the official sector, such as a regulatory requirement for firms that make markets in US Treasury securities to centrally clear their cash activity.”
©Markets Media Europe, 2021
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