Revisiting US Treasury Market Capacity and Resiliency: Part II

Evaluating the Likely Impact of the Basel III Endgame and Other Recent Regulatory Proposals on the Treasury Markets

In Part I of this two-part blog, we examined how growing U.S. government debt issuance and constrained dealer balance sheet capacity arising from bank capital requirements have raised questions about the resiliency of the U.S. Treasury market in recent years. In Part II below, we evaluate the potential impact of recent regulatory proposals and actions on the Treasury markets.
The banking agencies’ Basel III Endgame proposal, particularly the proposed trading book capital increases resulting from the Fundamental Review of the Trading Book (“FRTB”), would likely result in a further contraction of dealer balance sheet capacity. In addition to these additional capacity constraints, the proposed minimum haircut framework for securities financing transactions (“SFTs”) could severely disrupt the functioning of the Treasury repo market.
Other aspects of the Basel III Endgame proposal, together with a separate proposal to amend the Global Systemically Important Bank (“GSIB”) Surcharge, could cause bank dealers to pull back their market making activity in the Treasury futures and options markets, creating further significant disruptions, and raising costs for a wide variety of market participants.
The negative effects of these prudential reforms could be compounded by new market structure rules that may well result in increased costs and impact market liquidity, notably the SEC’s recently finalized rule designed to significantly expand central clearing, as well as possible measures designed to increase public transparency in less liquid market segments and require registration for certain classes of market participants.
Regulators should evaluate the costs and benefits of these measures to ensure that they do not exacerbate existing capacity problems in the Treasury markets. Moreover, the banking agencies should take proactive steps to reform existing rules to reduce balance sheet capacity constraints on bank dealers operating in the Treasury markets.

Overview

In Part I of this blog, we discussed how the significant increases in Treasury issuance over the past 15 years, combined with constrained dealer balance sheet capacity resulting from bank capital requirements, have contributed to market disruption events and heightened volatility in the U.S. Treasury markets in recent years, calling into question the resiliency of this bedrock component of the global financial system. Over the longer term, these concerns about the Treasury market liquidity and resiliency could increase the cost of financing U.S. government debt, placing burdens on taxpayers and raising costs for borrowers across the economy.

Thought leaders have responded by proposing a variety of measures aimed at reforming the Treasury markets to increase resiliency. As discussed in a prior SIFMA blog, these reform efforts have largely revolved around four main ideas: the creation of a standing repo facility by the Federal Reserve, which would serve as a backstop ensuring market liquidity; the expansion of central clearing and “all-to-all” platforms; improved data collection and disclosure in the secondary markets; and reforms to bank capital requirements to improve dealer capacity. Policymakers have begun to act on a number of these issues, with the Federal Reserve creating a standing repo facility in July 2021.^[1]

Other recent proposals, however, would further constrain dealer balance sheets, disrupt key parts of the market, and increase costs for a wide range of market participants. Among these, the U.S. banking agencies’ Basel III Endgame proposal would have a particularly deleterious impact, in large part owing to the large trading book capital increases envisioned as part of the Fundamental Review of the Trading Book (“FRTB”). Other elements of the proposal, such as the minimum haircut framework for securities financing transactions (“SFTs”), could severely disrupt the functioning of the Treasury repo market. Other Basel reforms, taken together with the Federal Reserve’s GSIB Surcharge proposal, would significantly constrain bank dealer capacity in the Treasury futures and options markets. Finally, the negative impacts of these prudential rule changes could be compounded by market structure reforms – such as the SEC’s recently finalized proposal on central clearing.

The FRTB Component of the U.S. Basel III Endgame Proposal Would Further Constrain Dealer Capacity

The Basel III Endgame proposal^[2], which was issued by the Federal Reserve, the Office of the Comptroller of the Currency (“OCC”) and the Federal Deposit Insurance Corporation (“FDIC”) in July 2023, would have far-reaching impacts on the ability of bank dealers to engage in a wide variety of trading activities, including acting as market makers in all parts of the Treasury markets. Initial estimates suggest that the FRTB portion of the proposal will increase the risk-weighted assets (“RWA”) for largest banks’ trading activities by 75%; when all trading book capital increases are factored in (including the Credit Valuation Adjustment or “CVA” as well as trading-related operational risk increases), the RWA increase could be closer to 150% for the largest banks. This is the main driver of the estimated 24% increase in aggregate RWA for the U.S. GSIBs.

These impacts could be even greater owing to structural “gold-plating” resulting from the interaction of the proposal with the existing U.S. capital framework.^[3] This is primarily because there would be an effective “double counting” of risks between the FRTB reforms and the Global Market Shock (“GMS”) component of the supervisory stress tests. These tests in turn help set a firm’s minimum risk-based capital requirements (as a result of the Stress Capital Buffer or “SCB” requirement), in contrast with other major jurisdictions, where stress test exercises are not used to set minimum regulatory capital requirements.

Taken together, the large, proposed trading book capital increases and the double count between the FRTB component of the Basel III Endgame and the GMS component of the U.S. stress tests would force large banks to rationalize their balance sheet capacity to focus on high-return capital markets activities. Given that market-making in U.S. Treasuries is a low-return business relative to other asset classes, banks would be incentivized to allocate only a very limited portion of their balance sheet to those activities. Since the majority of Treasury market primary dealers are banks covered by the proposal, this would inevitably further constrain dealer capacity – and by extension market resiliency during periods of stress. Constrained capacity and higher capital costs for banks would also likely result in increased transaction costs for Treasury market participants.^[4]

The Basel III Endgame’s Proposed SFT Haircut Framework Could Disrupt Treasury Repo Markets if Certain Provisions Were Implemented

While the Basel Endgame – and the FRTB component in particular – will constrain Treasury dealer capacity, another component of the package could have a disruptive impact on the Treasury repo markets. In the U.S. proposal, the banking agencies decided to adopt a portion of the Basel III standards known as the Securities Financing Transactions (“SFT”) minimum haircut floor. In brief, the SFT haircut floor works by eliminating the benefit of collateral taken for securities lending transactions, reverse repos, and eligible margin loans where for transactions that fall below a specified floor, a measure intended to limit the build-up of leverage in the hedge fund sector. The U.S. is moving forward with adoption despite decisions by the EU, UK, Japan, and Canada not to implement this portion of the standards because of its overly broad scope, with pension funds, mutual funds, and insurance company SFTs treated similarly to hedge fund transactions, as well as concerns about the potentially disruptive effects on the SFT markets more generally. ^[5]

Although the U.S. proposal currently excludes non-defaulted sovereigns, the agencies make clear that they are contemplating including those exposures as collateral under the SFT haircut framework.^[6] This would bring U.S. Treasury repo-style transactions would be brought into the scope of the framework. Because of the draconian consequences of breaching the minimum haircut floor (i.e., all the non-exempted SFTs would be treated as unsecured loans), bank dealers would be likely to pull back from engaging in SFTs secured by U.S. Treasury securities with a wide range of non-bank institutions, including pension funds and asset managers. This would create significant disruptions to the functioning of the Treasury repo markets, raising costs for securities lenders and significantly reducing liquidity in those markets and the underlying cash markets. Moreover, it would impede the effective transmission of U.S. monetary policy via the repo markets. In short, this is an outcome that the banking agencies should avoid at all costs.

Extension of the SLR, CVA, and SA-CCR Requirements to All Large Banks Will Further Constrain Capacity and Impact the Treasury Futures and Options Markets

The Basel III Endgame proposal would also extend the SLR to all banking organizations with more than $100bn in assets; previously Category IV banking organizations were exempt from this provision. This extension of the SLR could act as an additional capacity constraint in the Treasury markets.

The proposal would also make changes to the calculation of derivatives exposures, which will negatively impact costs in the Treasury futures and options markets. First, the new Credit Valuation Adjustment (“CVA”) capital charge, designed to capture credit deterioration of a derivative counterparty, will make a wide range of derivatives transactions more expensive, including client-cleared transactions such as Treasury futures. As in the case of the FRTB, CVA risk is already captured in the U.S. stress tests through its GMS component, leading to an effective double counting of these risks and thus acerbating these negative impacts.

The Basel III Endgame proposal will also require all large banks to calculate the credit risk associated with their derivatives exposures using the Standardized Approach to Counterparty Credit Risk (“SA-CCR”) instead of the Current Exposure Method (“CEM”); previously Category III and IV banking organizations had the option of using either SA-CCR or CEM. The mandatory adoption of the SA-CCR framework will materially increase the counterparty credit risk capital requirements that smaller bank dealers need to maintain against Treasury futures and options transactions, potentially limiting their ability to intermediate in those markets, inhibiting competition, and raising costs for market participants. The fact that there is an overlap in risk capture between the CVA and SA-CCR frameworks will only further compound these effects.

Reforms to the U.S. GSIB Surcharge Would Inhibit Liquidity in the Treasury Futures Markets and Further Constrain Dealer Capacity

As discussed in Part I of this blog, the GSIB Surcharge capital charge, based on the Federal Reserve’s Method 2 approach, may act as an additional constraint on the ability of U.S. GSIB bank dealers to intermediate in the Treasury markets. The Federal Reserve’s recent proposal^[7] to amend the calculation of the GSIB Surcharge would not address concerns that have been raised about the GSIB Surcharge’s impact on these markets i.e., it would not amend the way in which government securities are calculated to reduce their impact on the overall score, nor would it adjust the coefficients to account for economic growth. In fact, the changes could serve to attenuate bank dealers’ ability to clear Treasury futures and options. Given the linkages between prices, trading, and market-making activities that connect the cash, repo, and futures markets, this could have significant effects on overall Treasury market liquidity and raise costs for market participants.^[8]

First and most significantly, the proposal would change the treatment of client-facing derivatives transactions – including U.S. Treasury futures and options that are cleared via a central counterparty (“CCP”). Central clearing of over the counter (“OTC”) derivatives is part of internationally agreed post-GFC reforms designed to reduce systemic risk, complexity, and interconnectedness.

Despite this, the GSIB Surcharge proposal would add client-facing leg of client-cleared derivatives transactions to the Surcharge’s “complexity” and “interconnectedness” systemic risk indicators. As such, it would have significant impacts on U.S. GSIBs that provide client clearing services: when this change was last proposed (but subsequently not adopted) by the Federal Reserve in 2017^[9], there were expectations that it would move all client clearing GSIBs into a higher GSIB Surcharge “bucket” and be equivalent to having to maintain additional capital of 0.5% of risk-weighted assets beyond the surcharges already in place.^[10] Indeed a Risk.net article reported that industry executives viewed the proposal as likely to be “very material,” with one head of clearing commenting that they “would be surprised if any U.S. GSIB can continue offering client-clearing services, certainly to any scale” if the rule was adopted as written.^[11] In short, if adopted as is, this revised calculation could significantly inhibit liquidity in the Treasury futures market.

Central Clearing and Enhanced Public Disclosure Requirements Could Further Reduce Market Liquidity and Raise Costs

Recent market structure reforms could compound the impacts of the prudential agency proposals and further reduce liquidity and raise costs in the Treasury markets. This week, the Securities and Exchange Commission (“SEC”) finalized a rule that would substantially increase central clearing in the secondary Treasury securities markets (i.e., the “cash” and “repo” markets), as well as impose new margining requirements. As discussed in a prior blog, enhanced central clearing is often seen as at least a partial solution to the problem of constrained dealer balance sheet capacity, since it could reduce capital and leverage requirements for dealers under some circumstances. However, in comments on the SEC’s proposal in December 2022, SIFMA and other industry groups noted that the SEC’s broad-reaching proposal likely would likely reduce rather than enhance liquidity in the Treasury securities market, increasing costs and causing participants to exit the markets—particularly smaller market participants— while doing little to affect overall dealer balance sheet capacity.^[12]

These observations were supported by a September 2023 study by SIA Partners.^[13] SIA Partners surveyed market participants as part of that study, finding that there was a widespread expectation that “balance sheet, leverage, and risk appetite for the dealer community [will] be negatively impacted” by both the central clearing rule and the additional margining required under the proposed SEC framework. The study also found that investment and trading activity would likely decline as a result of the higher costs of clearing; the loss of netting/cross margining capabilities across assets; potential increase in capital costs for clearing (similar to OTC derivatives); and the loss of marginal business from smaller market participants.^[14] While as a general matter greater central clearing may provide benefits to the Treasury markets, the final rule may negatively impact market resiliency by increasing costs for market participants, compounding the effects of the banking agency proposals.

Enhanced public transparency has also been proposed as a potential way to enhance market resiliency. In June 2022, the U.S. Treasury Department issued a request for information (“RFI”) on enhanced public disclosures of U.S. Treasury secondary market transactions.^[15] SIFMA and other industry associations commented on that RFI^[16], expressing support for additional nonpublic disclosures to the official sector that would support their market monitoring, policymaking, and supervisory functions. At the same time, the industry highlighted how certain public disclosures, particularly in less liquid market segments, could inhibit market liquidity and present risks to the Treasury’s goal of financing the U.S. debt at the lowest cost to taxpayers over time. As SIFMA has noted, any steps “to increase public transparency into this market should therefore be done carefully, incrementally, and with appropriate mitigants to ensure that beneficial activities will not be curtailed.”^[17]

Thus far, public policy actions to improve public dissemination have been confined to more liquid market segments, such as FINRA’s recent proposal to revise the TRACE reporting rules to include end-of-day reporting of on-the-run nominal coupon security transactions (with caps for large trades).^[18] However accelerated or more widespread dissemination of trade data, particularly in the less liquid off-the-run portions of the market, could compound the negative impacts of the other regulatory actions discussed above.

Conclusion

The U.S. Treasury markets are the bedrock of the global financial system, and their ongoing resiliency is critical for the ability of the U.S. government to finance itself at the lowest possible cost, global financial stability, and U.S. economic growth. Given that we expect the volume of Treasury issuance to continue to grow in the coming years, it is crucial that policymakers take steps to improve capacity and strengthen liquidity across all Treasury market segments. Unfortunately, the sweeping Basel III Endgame proposal, as well as the GSIB Surcharge proposal, would likely do the opposite, leading to constrained dealer capacity, increased transaction costs, and significant disruptions across all market segments. These negative effects could be compounded by market structure reforms that could lead to higher costs and impact market liquidity, most notably the SEC’s recently finalized rule expanding central clearing in the Treasury securities markets. It is crucial that U.S. regulators thoroughly evaluate the costs and benefits of these proposals – and make material revisions as needed – to ensure that they promote rather than undermine the future resiliency of the U.S. Treasury markets.

—

Author

Peter Ryan is Managing Director and Head of International Capital Markets and Strategic Initiatives at SIFMA.

Footnotes

^[1] For more details on the facility, see Federal Reserve Bank of New York, “The Fed’s Latest Tool: A Standing Repo Facility,” Liberty Street Economics, January 13, 2022. Available at: The Fed’s Latest Tool: A Standing Repo Facility – Liberty Street Economics (newyorkfed.org).

^[2] 88 Fed. Reg. 64029 (September 18, 2023).

^[3] For more see Guowei Zhang, Peter Ryan, and Carter McDowell, “The Federal Reserve Should Remove “Gold-Plating” in the Basel 3 Endgame, November 8, 2023. Available at: https://www.sifma.org/resources/news/the-federal-reserve-should-remove-gold-plating-in-the-basel-3-endgame/.

^[4] A recent study found that market participants were concerned that the U.S. Basel III Endgame proposal would meaningfully impact their derivatives business and would likely increase the capital costs associated with their repo transactions.[4] See SIA Partners, “Central Clearing of U.S. Treasuries & Repo: A Follow Up Review on Market Developments: Challenges and Considerations for the Way Forward,” September 2023. Available at: s72322-253419-582122.pdf (sec.gov).

^[5] European Banking Authority, Policy Advice on the Basel III Reforms on Securities Financing Transactions (SFTs), (Aug. 2, 2019), available at https://www.eba.europa.eu/sites/default/documents/files/documents/10180/2886865/870bbd5e-ae8f-4933-9f36-784c7183c7f4/Policy%20Advice%20on%20Basel%20III%20reforms%20-%20SFTs.pdf (EBA SFT Policy Advice). The Prudential Regulation Authority (PRA) in the United Kingdom stated that it “is not consulting in this [Consultation Paper] on the implementation of minimum haircut floors for securities financing transactions (SFTs) in the capital framework – one of two approaches envisaged in the FSB’s report Regulatory framework for haircuts on non-centrally cleared securities financing transactions. The PRA will consider whether implementation in the capital framework is appropriate in due course, taking into account data available under SFT reporting.” Prudential Regulation Authority, CP16/22 – Implementation of the Basel 3.1 Standards, (Nov. 30, 2022), available at https://www.bankofengland.co.uk/prudential-regulation/publication/2022/november/implementation-of-the-basel-3-1-standards.

^[6] Question 55 of the proposal asks “what alternative definitions of “in-scope transactions” should the agencies consider? For example, what would be the pros and cons of an expanded definition of “in-scope transactions” to include all eligible margin loan or repo-style transactions in which a banking organization lends cash, including those involving sovereign exposures as collateral? How would the inclusion of sovereign exposures affect the market for those securities? What, if any, additional factors should the agencies consider concerning this alternative definition?”

^[7] 88 Fed. Reg. 60385 (Sep. 1, 2023).

^[8] For a fuller discussion of these links, see the Inter-Agency Working Group report entitled “Recent Disruptions and Potential Reforms in the U.S. Treasury Market: A Staff Progress Report,” November 8, 2021, p.4. Available at: Microsoft Word – IAWG Treasury Report final.docx.

^[9] 82 Fed. Reg. 40,154 (Aug. 24, 2017).

^[10] See Futures Industry Association and International Swaps and Derivatives Association, “Comments on Proposed Agency Information Collection Activities (FR Doc. 2017-17939),” October 11, 2017. Available at: 2017-10-11-FIA-ISDA-GSIB.pdf.

^[11] Luke Clancy, “Fed Throws Curveball with Agency Clearing Surcharge Proposal,” Risk.Net, Aug. 21, 2023. Available at: Fed throws curveball with agency clearing surcharge proposal – Risk.net.

^[12] SIFMA and IIB, comments on proposed “Standards for Covered Clearing Agencies for U.S. Treasury Securities and Application of the Broker-Dealer Customer Protection Rule With Respect to U.S. Treasury Securities,” December 22, 2022. Available at: Standards for Covered Clearing Agencies for U.S. Treasury Securities and Application of the Broker-Dealer Customer Protection Rule With Respect to U.S. Treasury Securities (sifma.org).

^[13] SIA Partners, “Central Clearing of U.S. Treasuries & Repo: A Follow Up Review on Market Developments: Challenges and Considerations for the Way Forward,” September 2023. Available at: s72322-253419-582122.pdf (sec.gov).

^[14] Ibid., p. 7

^[15] 87 Fed. Reg. 38259 (June 27, 2022).

^[16] SIFMA, SIFMA Asset Management Group, Institute of International Bankers, and American Bankers Association – Securities Association, “Comments on Request for Public Comment on Additional Transparency for Secondary Market Transactions of Treasury Securities: Docket No. TREAS-Do-2022-0012,” August 26, 2022. Available at: SIFMA, SIFMA AMG, ABASA, IIB submit comments to the Treasury re: Request for Public Comment on Additional Transparency for Secondary Market Transactions of Treasury Securities: Docket No. TREAS-DO-2022-0012.

^[17] SIFMA and SIFMA Asset Management Group, comment letter on Securities Exchange Act Release No. 34-98859; File No. SR-FINRA-2023-015, November 30, 2023. Available at: SIFMA and SIFMA AMG submit comments to the SEC on the SEC’s FINRA proposal on public dissemination for Treasury cash transactions.

^[18] Financial Industry Regulatory Authority, “Notice of Filing of a Proposed Rule Change Relating to Dissemination of Information on Individual Transactions in U.S. Treasury Securities and Related Fees,” Release No. 34-98859; File No. SR-FINRA-2023-015, November 3, 2023. Available at: Notice of Filing of a Proposed Rule Change Relating to Dissemination of Information on Individual Transactions in U.S. Treasury Securities and Related Fees.

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Revisiting U.S. Treasury Market Capacity and Resiliency: Part I

Related Resources

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Part I: Why is Reform Needed? A Brief History of Recent Market Disruptions
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Part II: Proposals for Reforming US Treasury Markets
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Part III: Evaluating the Benefits and Costs of Central Clearing in the Treasury Markets