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Fostering Liquidity and Resiliency in US Treasury Markets

Conversations from the ISDA/SIFMA Treasury Clearing Forum

The U.S. Treasury market is the largest and most liquid  bond market on the planet. Its smooth functioning is essential to the overall efficient operation of the global financial system. The market has grown significantly in recent years and is likely to continue growing rapidly in the future. Notably, several market disruption events have raised structural questions and concerns about the capacity of the system to intermediate the trading of these instruments.

At the recent ISDA/SIFMA Treasury Forum in New York City, market participants gathered to discuss the market outlook and initiatives to reform its structure.

The Outlook for US Treasury Markets

The U.S. federal government finances its operation, in part, by selling various types of securities. All these Treasury securities – including Treasury bills, notes, and bonds – are debt obligations issued by the U.S. Department of the Treasury and are backed by the full faith and credit of the United States government.

Because of the United States’ creditworthiness and status as the world’s leading economy, U.S. Treasury securities are considered by market participants as the benchmark credit against which all other debt securities are compared. They are widely held and actively traded by public and private institutions including central banks, corporations, individuals, and institutional investors. The U.S. Treasury market underpins every other financial market and is the bedrock of the global financial system. It accounts for nearly 60% of outstanding securities in U.S. fixed income markets.

U.S. Treasuries outstanding are $27 trillion, up from $12 trillion just a decade ago. Issuance is at record highs and outstanding debt is expected to hit $48 trillion by 2034, according to the Congressional Budget Office (CBO).

In addition to financing the U.S. government and serving as the benchmark credit for all other debt securities, asset managers and other buy-side investors transact in U.S. Treasury securities for short-term investing or to post those U.S. Treasury securities as collateral for other financial products. The U.S. Treasury repo market also serves as a significant source of financing for banks as asset managers transfer excess cash to the banks in exchange for U.S. Treasuries as collateral. In addition to focusing on structural issues in cash trading, proposed reforms look to transition the largely bilateral U.S. Treasury repo market to a centrally cleared structure.

An Overview of the Regulatory Agenda

Treasury market reforms are all focused on improving the capacity and resiliency of this important market – and to mitigate risks arising from extreme volatility events we have seen over the last 10 years.

There are four broad categories of Treasury market structure reforms that are being considered. These are:

  1. Regulatory Changes: Changes to prudential banking regulation that disincentivize the holding of U.S. Treasury securities by intermediaries;
  2. Clearing: Greater use of centralized clearing;
  3. Transparency: Increased public dissemination of Treasury market transaction data; and
  4. Official sector activities: A standing repo facility (instituted by the New York Fed) provides a backstop to moderate sources of extreme volatility in the Treasury repo market and a buyback program by the U.S. Treasury enhances the liquidity profile of the less liquid portions of the market.

The latest report from the Inter-Agency Working Group on Treasury Market Surveillance (IAWG) – which is composed of staff from the U.S. Department of the Treasury, the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, the U.S. Securities and Exchange Commission, and the U.S. Commodity Futures Trading Commission – details how these measures are moving forward.

At the ISDA/SIFMA event, Josh Frost, Assistant Secretary for Financial Markets at the U.S. Treasury provided details on the Treasury’s buyback initiative and noted its intent to buy old and infrequently traded “off-the-run” securities in an effort to foster market liquidity and market-functioning. With the Treasury as a regular buyer, dealers should have more confidence to make markets in off-the-run securities. It should also serve to free up dealer balance sheets. Frost has noted that the idea of a sovereign debt buyback is not new. There have been two major periods of debt redemptions for U.S. Treasury securities: first in the 1920s and later in the early 2000s, both at times of budget surpluses.

A Question of Capacity

As U.S. government debt issuance has grown, new bank capital requirements have constrained dealer balance sheet capacity and therefore their ability to intermediate in U.S. Treasury markets. Recent proposals, including elements of the Basel III Endgame, proposed trading book capital increases through the Fundamental Review of the Trading Book (FRTB), as well as the proposed global systemically important bank (GSIB) surcharge, would likely result in a further contraction of dealer balance sheet capacity. In addition to these additional capital-based capacity constraints, the proposed minimum haircut framework for securities financing transactions (SFTs) could severely disrupt the functioning of the Treasury repo market.

Indeed, Forum attendees noted the cost of capital for banks as the biggest risk to Treasury market stability.

The market’s response to capital proposals has overwhelmingly been that prudential regulations must be implemented in a manner that does not overly penalize banks’ capital markets activities, and thus reduce liquidity in U.S. Treasury markets as well as corporate and other funding markets, thereby hurting growth in the real economy. For a detailed discussion on the causes and impact of constrained dealer capacity on Treasury market resiliency, please see SIFMA’s two-part blog, Revisiting U.S. Treasury Market Capacity and Resiliency.

As the agencies consider the negative effects of these prudential reforms, they must also consider the risk that the negative effects could be compounded by other new market structure rules. Notably, this includes measures designed to increase public transparency in less liquid market segments, requirements that certain additional classes of market participants be registered as broker-dealers, and the SEC’s central clearing mandate – more on that next.

Preparing for Mandated Clearing

Today, U.S. Treasury transactions are either settled bilaterally or cleared centrally through DTCC’s Fixed Income Clearing Corporation (FICC). The Securities Exchange Commission’s (SEC) new rules, finalized in December 2023, will require most market participants to centrally clear cash and repo U.S. Treasuries, imposing significant changes to market structure.

“Treasury cash clearing is required to go into effect by the end of 2025, and repo clearing is required to go into effect by June 30, 2026,” explained Michelle Neal, Head of the Markets Group for the Federal Reserve Bank of New York. “While these dates may sound far off now, the time will pass quickly given the complexities involved.”

These deadlines present challenges to the industry given the significant regulatory, market structure, documentation, and operational hurdles to be simultaneously addressed – and overcome – in a very limited timeframe. SIFMA has mobilized its members on several workstreams aimed to efficiently and expeditiously advance the transition to this new market structure.

A key workstream is developing market standard documentation for repo clearing that is intended to accelerate the on-boarding of market participants by broker-dealer clearing house members. SIFMA is also engaging with market participants to address market structure issues in transitioning the existing cleared repo market in which participants trade with, and clear through, a single clearing member, to one more akin to the futures or cleared swaps market where participants can trade with anyone with those trades given up for clearing by the clearing member.

Another significant workstream will develop an operational implementation timeline with key milestones to aid market participants. We are also working to resolve other significant interpretive issues that could be impediments to a smooth transition.

To learn more, listen to our recent podcast, The Path to Clearing U.S. Treasuries and visit our new Treasury Clearing Resource Center.

Conclusion

In conclusion, the U.S. Treasury market remains the most important financial market in the world. It is therefore critical that the impact of any proposed initiatives and reforms must be to enhance market resiliency and increase market-making capacity.

A sincere thanks to our colleagues at ISDA for co-hosting this valuable Forum and to those who joined us in New York. The next several months, and this summer in particular, will be a busy time for all of us and it is critical for the markets that we keep an open dialogue.

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Robert Toomey is Head of Capital Markets/Managing Director and Associate General Counsel at SIFMA.

William Thum is Managing Director and Associate General Counsel, Asset Management Group at SIFMA.

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