‘Very little support’ for a US Treasury clearing mandate – Isda

The idea that dealers and investors should be forced to clear all trades in US Treasury bonds has “very little support” from the industry, according to a survey conducted by the International Swaps and Derivatives Association.

“Our survey shows there’s currently very little consensus on the impact of increased clearing in the US Treasury market, suggesting further research on the costs and benefits is necessary,” noted Isda chief executive Scott O’Malia. “We support the aims of US policy-makers to strengthen the resilience of this critical market, and we hope our survey serves as a useful data point as they weigh up their options.”

Many respondents to the survey, published on August 10, prefer the carrot of clearing incentives such as relief under supplementary leverage ratio rules, over the stick of mandatory clearing.

Primary dealers, who are obliged to buy new debt issued by the US government, made up 13 of the 25 responses to the Isda survey, with asset managers the second-largest group, at four. Other respondents included inter-dealer brokers, market infrastructure providers including clearing houses, and a single principal trading firm.

One asset manager noted that the legal and operational implications of compulsory clearing would be “enormous”, and consequently the firm would “strongly oppose a clearing mandate for dealer-to-client trades”.

“Many UST cash market participants… are not accustomed to putting in place the legal documentation and operational infrastructure associated with clearing,” the asset manager warned in its response.

One market infrastructure firm argued that liquidity could decrease if there was a requirement for margin to be posted in advance of a UST trade being settled.

The survey is the latest intervention in an ongoing debate over changes to Treasury market structure, and comes a year after a study led by former Treasury Secretary Tim Geithner came down in favour of central clearing for all Treasury cash and repo trades between banks via inter-dealer brokers. A subsequent report by the US government inter-agency working group on Treasury market reform was more circumspect, laying out both the benefits and drawbacks of such an approach.

Isda notes that while most respondents are generally supportive of clearing Treasury bonds (UST), there is little appetite for a sweeping mandate to force participants to do so, amid warnings that such measures could result in at least some liquidity providers withdrawing from the market entirely.

Treasury market reform has been in focus for US regulators since liquidity dried up in March 2020 at the start of the Covid-19 pandemic, forcing direct intervention from the US Federal Reserve. The pandemic resulted in a large rise in government borrowing, triggering further concerns after a number of jittery Treasury auctions in early 2021.

Ann Battle, senior counsel at Isda, says there was a consensus among survey participants that central clearing would not have prevented the liquidity crisis that occurred at the start of the pandemic. By contrast, “there is not really a consensus on whether clearing has benefits that outweigh its costs, particularly under existing models,” says Battle.

Pros and cons

Respondents point to a number of potential benefits from clearing more UST trades. Advantages include increased liquidity due to “reduced strain” on dealer balance sheets, improved market transparency, stability and reductions in settlement risk.

One dealer says they feel clearing would ensure proprietary trading firms are operating under the same framework as other participants in the UST market.

Other respondents feel the benefits would accrue more to the repo market than the cash Treasury market, as settlement risk is negligible in cash Treasury trades.

Concerns about the clearing proposals from dealers and investors in US sovereign debt include fears that it could increase margin requirements, push up fees, and result in technological, legal and operational costs.

Margin payments, fees and capital contributions to central counterparties (CCPs) would start “eroding returns for investors without material benefit to investors or markets”, noted the asset manager.

One primary dealer told Isda that it “does not believe that additional clearing of UST cash client transactions is a policy imperative, given that the potential benefits are unclear”.

Alternative approaches

A second asset manager suggested regulators should change bank capital rules to allow dealers to take more risk, rather than mandating clearing.

“We believe the markets would significantly benefit from changes in the banking regulations to allow banks to be more elastic and dynamic during periods of higher market volatility and stress,” they stated.

There was also wide support across respondent types for measures to facilitate cross-margining for all market participants, not just the existing clearing members. This would lower the costs of clearing and thereby help a wider group of market participants to clear their Treasuries trades.

At present, cash and repo Treasury trades are cleared by the Fixed Income Clearing Corporation, while Treasury futures and options are cleared by CME. Although the two CCPs allow some cross-margining, members’ positions and collateral are still held in two separate pots, which has limited the benefits of the arrangement.

“Clearing brokers would need to be able and/or willing to clear UST cash transactions on behalf of a large segment of the client market, and the various CCPs should be able to offer cross-margining arrangements to reduce any potential unnecessary margin requirements on participants,” one primary dealer urged.

Editing by Philip Alexander