Bob Currie examines how the industry has reacted to SEC proposals, announced for consultation in September 2022, that could mandate central clearing for a wide array of US treasury-based transactions, potentially including repo, securities lending and UST cash securities trades
In September, the US Securities and Exchange Commission (SEC) put forward a proposed set of rules designed to enhance risk management practices for central counterparties in the US treasury (UST) market and to encourage central clearing of a wider range of UST-based transactions.
The SEC notes that the US$24 trillion US treasury market — "deepest, most liquid in the world" — is the foundation upon which so much of the US capital market is built. “Treasury markets are integral to how the Federal Reserve administers monetary policy. They are how we, as a government and as taxpayers, raise money,” says the SEC.
SEC chair Gary Gensler indicates that he is pleased to support these rules because, if adopted, “they would help to make a vital part of our capital markets more efficient, competitive, and resilient”. But these benefits are assumed in the SEC’s proposal, rather than demonstrated through clear argument based on empirical data. This is not to understate the benefits of central clearing, which have been widely articulated in Securities Finance Times. But if the SEC is to mandate central clearing for a wide range of UST-based transactions, it is important to be clear where existing risk and inefficiency resides — and how CCP clearing will solve this problem.
In making the case for the Proposed Rule, the SEC indicates that in 2017 only 13 per cent of US treasury cash transactions were centrally cleared. In the 1990s, by contrast, the Commission suggests that this ratio was significantly higher — prior to 2000, all users of interdealer broker (IDB) platforms were members of central clearing houses and their trades were centrally cleared. Since this time, the SEC maintains that there has been a significant increase in principal trading firms (PTFs) trading in this market and IDBs are taking on clearing house-like functions, even though they are not regulated as clearing houses. “This leaves our system potentially vulnerable to risks that may emanate in particular from those IDBs, PTFs, and hedge funds in the US treasury markets,” says Gensler.
Among other steps, the SEC plans to amend the standards applicable to clearing houses (or “covered clearing agencies”, CCAs) for US treasury securities, obliging each CCA to apply written policies which require direct participants to submit all “eligible secondary market transactions” (ESMTs) in treasury securities for clearing and settlement. It also proposes selective amendments to CCA risk management standards designed, according to the SEC, to protect investors, reduce risk and increase operational efficiency.
Access to clearing
In responding to the SEC consultation proposal, Jennifer Han, chief counsel and head of global regulatory affairs at the Managed Funds Association (MFA), states that although the MFA supports the Commission’s intentions to strengthen the US treasury market, the first priority should be to expand the availability of central clearing.
Without this, the MFA believes that the SEC’s proposal is likely to be counterproductive, potentially reducing market efficiency and resilience by making it more difficult and expensive for investors to transact and, ultimately, increasing market concentration and risk.
With this in mind, this buy-side trade association advises that the SEC’s proposals should focus initially on market segments where the benefits of central clearing are most obvious and existing market infrastructure is best able to support more central clearing — which, in the first instance, should be for bilateral repo and reverse repo transactions.
In contrast, the MFA does not believe that mandatory central clearing is appropriate at the current time for UST cash securities transactions, or that mandatory clearing should be applied for triparty repo transactions.
“Rather, the potential benefits of central clearing are less significant with respect to these types of transactions relative to bilateral repo transactions, while the costs are likely to be significant and outweigh those potential benefits,” says Han. Specifically, the MFA advises that expanding the clearing mandate beyond bilateral repo transactions would “interact unfavourably” with existing practices in the areas of cash and collateral management and securities custody, for example by inhibiting same-day access to treasury securities for investment or margining purposes.
The International Swaps and Derivatives Association (ISDA) conducted a survey of market participants during 2022 to gauge the industry’s appetite for additional clearing requirements for UST cash securities and repo transactions. The survey reveals a diversity of views on whether extension of clearing would improve the resilience and efficiency of the UST marketplace. Many, it noted, were generally supportive of clearing, but few supported broad clearing mandates, believing this could prompt some participants to reduce their activity or to withdraw from the market entirely, thereby reducing market liquidity.
However, many did support reforms that they believed would improve efficiencies in the UST marketplace, including provision of relief under the supplementary leverage ratio (SLR), steps to improve access to indirect clearing, and the ability to post client collateral to the clearing agency. Respondents also highlighted potential for facilitating additional cross-margining opportunities between cleared cash and futures markets.
ISDA notes that the SLR, risk-weighted asset (RWA) and global systematically important bank (GSIB) surcharges are binding constraints on some banks and these regulatory overheads have prompted some firms, over time, to exit certain business lines. ISDA is therefore supportive of adjustments to the SLR and GSIB surcharges, for example, which would bring greater cost efficiency and balance sheet efficiency to banks’ trading activities in the UST marketplace. “We recognise that the SEC does not itself have the ability to modify the SLR, but we strongly encourage the SEC to work with prudential regulators to implement modifications prior to finalising the proposal,” says Ann Battle, senior counsel for market transitions at ISDA.
Securities lending
Commenting on the SEC’s proposals, the Risk Management Association’s (RMA’s) director for securities lending and market risk, Fran Garritt, and chair of the RMA committee on securities lending, Mark Whipple, raise concerns that if the SEC Proposed Rule is adopted, US treasury repo transactions conducted by lending agents when reinvesting cash collateral — collateral received on behalf of beneficial owner lenders through securities lending trades — would need to be cleared through a CCA.
The RMA Council questions whether it was the SEC’s intention to capture reinvestment of cash collateral through UST repo transactions under the Proposed Rule. As such, it asks the Commission to conduct further research on the impact of these proposals on agency securities lending before taking further action towards mandatory clearing.
More generally, the RMA indicates that it opposes the inclusion of securities lending trades in the list of eligible secondary market transactions that should be subject to mandatory clearing. “Owing to the razor thin spreads on US treasury securities lending transactions,” proffers the RMA, “any additional capital or liquidity costs to lending agents, or requirements for additional margin or clearing fund contributions, could result in these transactions not making economic sense for any party.”
For Q2 2022, the RMA’s data indicates that slightly less than US$2 trillion of US treasuries were available in securities lending programmes as lendable assets, with just under US$660 billon on loan globally. For these on-loan securities, more than US$265 billion of US treasury securities were on loan against cash collateral.
“As treasury securities lending transactions are low-risk, low-spread transactions, requiring them to be cleared through the Fixed Income Clearing Corporation (FICC) would impose additional costs and margin, which could cause some treasury securities lending transactions to become economically unviable for beneficial owners or lending agents,” says the RMA in its response to the SEC. “Fewer treasury securities lending transactions could lead to reduced liquidity in the overall treasury market.”
Clearing models and incentives
The Securities Industry and Financial Markets Association (SIFMA) advises that the SEC should consider sequencing its approach to reforms in the US treasury clearing market in a different order. Specifically, the Commission should start with providing better incentives for firms to enter UST trades for central clearing without prematurely making it a requirement.
At root, this should begin with CCAs offering more efficient and straightforward clearing models that offer better protection for investors. With these improved models in place, SIFMA believes this will encourage more market participants to clear UST-based transactions voluntarily and will encourage greater liquidity.
According to managing director and assistant general counsel of SIFMA’s asset management group William Thum, the SEC should only introduce a broad requirement to clear when it has already tested other mechanisms designed to incentivise central clearing and after these have demonstrated improvements to the operation of the UST marketplace.
Before central clearing is made mandatory in the UST markets, SIFMA says, the industry must also have a more robust clearing ecosystem that has been designed with input from all relevant stakeholders. Specifically, the SEC should “only impose a clearing mandate when FICC and at least a second covered clearing agency (emphasis added) are able to offer access to clearing solutions that will fulfil enhanced rule requirements and meet the needs of market participants.”
Addressing a similar point, the RMA contends that the SEC Proposed Rule is likely, in its current form, to bring higher concentration risk through raising clearing volumes through DTCC-owned FICC as a single clearing entity. “The Proposed Rule, to include UST securities lending transactions in addition to UST repurchase transactions, would concentrate all of the counterparty risk associated with these transactions with a single CCA,” says the RMA. “In determining whether to adopt the Proposed Rule, the RMA Council urges the Commission to carefully consider that any disruption or failure of this single CCA, whether financial, operational, or technological, would almost certainly harm beneficial owners, lending agents, borrowers, the capital markets, and ultimately, the global financial system as a whole.”
Additionally, for SIFMA, the clearing model ultimately delivered through these SEC proposals must offer protection that more closely mirrors the risk management framework applicable for FCM-cleared OTC derivatives. “Although the market for US treasury transactions is very different from the OTC derivatives markets, prior to any clearing mandate being imposed, there must be an available clearing solution which provides market participants with a level of resilience and protection more like that currently provided for cleared OTC derivatives cleared through a futures commission merchant (FCM),” says Thum. “Among other things, this model should ensure that collateral posted by customers is appropriately segregated and not subject to the risk of a direct clearing member default.”
Elaborating on this principle, Futures Industry Association president and CEO Walt Lukken explains that, among other requirements, FCMs must hold these funds and securities in customer segregated accounts established in accordance with the provisions of Commodity Futures Trading Commission (CFTC) Rule 1.20 (with regard to futures traded on US futures exchanges) and Rule 22.2 (with regard to cleared swaps). Specifically, an FCM must deposit futures customer funds with a bank, or other permitted depository, under an account name that clearly identifies them as futures customer funds. In doing so, it must obtain a letter from the depository which acknowledges that the FCM has deposited money or securities held on behalf of a customer.
“The depository acknowledges that such customer assets ‘will be separately accounted for and segregated’ on the depository’s books from the FCM’s own funds ‘in accordance with the provisions of’ the CEA and the CFTC’s rules, and ‘must otherwise be treated in accordance with the provisions of section 4d of the [CEA]’ and the CFTC’s rules,” the FIA explains.
SIFMA indicates that it is also important that market participants have access to standardised documentation to govern their clearing relationships, along with industry legal opinions that address the enforceability of netting and collateral arrangements for cleared treasury transactions under applicable bankruptcy laws. “To our knowledge, no such standardised documentation or legal opinions currently exist for the clearing models currently accessible to indirect participants clearing through FICC,” says Thum.
With these considerations in mind, there is a case for requiring separation of initial margin from default fund requirements at FICC that can be subject to loss mutualisation. This may improve capital efficiency for banks and bank-affiliated dealers, but may also widen participation from firms that are currently prevented from participating in loss mutualisation arrangements.
More broadly, industry commentators advise that the SEC may need to make rule changes to enable a debit under the SEC Rule 15c3-3a customer reserve formula, enabling broker-dealer direct participants at the clearing house to pass customer margin through to the CCP, thereby simplifying the mechanisms through which margin can be transferred to the CCP on behalf of indirect participants.
Costs and benefits
In concluding, the MFA observes that the costs of requiring central clearing of triparty repo transactions and cash market transactions are likely to outweigh any potential benefits. “Relative to bilateral repos, triparty repo transactions already provide for additional risk mitigants and protections due to the role of the triparty agent and related regulatory oversight of the market,” says the MFA’s Han.
More broadly, the MFA proposes that cash UST transactions do not present the same level of credit risk as repo transactions, which implies that a principal benefit of central clearing, namely risk mitigation, will be less obvious in these markets. This may particularly be the case for indirect clearing participants, where the MFA indicates that “certain more frequently used clearing models for cash transactions do not provide meaningful opportunities for clearing-related netting and risk mitigation benefits for indirect participants.”
SIFMA believes that the SEC, and other financial regulators, need to engage in additional analysis of the US treasury market, considering all available market data, before imposing central clearing on broad portions of this market.
“Given the state of the existing clearing infrastructure, the immediate benefits of a central clearing mandate are not obvious, and more evidence is required to demonstrate how clearing will mitigate contagion and systemic risk and improve capacity and resiliency in this market,” concludes SIFMA’s Thum.
Specifically, SIFMA indicates that it has seen no convincing data demonstrating how a requirement to centrally clear, along the lines advanced in the Proposed Rule, would have fixed some of the recent liquidity problems highlighted by the SEC — for example, the "flash rally" of 2014, the stress in the US treasury repo market during September 2019 and the COVID-19 market shock of March 2020.
Like the MFA, SIFMA does not currently support a clearing requirement for UST cash transactions. In SIFMA’s view, any requirement to clear cash transactions will “increase costs, generate operational complexities and reduce liquidity”, without producing meaningful benefits to address perceived shortcomings in the UST cash transaction market.
Pittsburgh-based investment manager Federated Hermes questions the need for an extension of central clearing for UST-based repo trades, indicating that the SEC “does not cite any circumstances where parties have encountered difficulties in clearing and settling repurchase agreements”.
Specifically, Federal Hermes believes that the SEC’s Proposed Rule fails to take into account significant changes regarding clearing of triparty repo trades that have been implemented since the 2008 financial crisis. “The clearing bank handles the settlement of triparty repurchase agreements through its collateral allocation systems and [this] has resulted in a well-functioning process that already operates under severe time constraints,” says Federated Hermes.
The asset manager indicates that it has also not experienced significant difficulties in clearing and settling US treasury repo trades on a bilateral basis. “These repurchase agreements are settled on a same-day, DvP basis,” it notes. “[We] give instructions for the settlement of these repurchase agreements as soon as they are confirmed, so settlement generally is completed as rapidly as possible.”
