Evaluating the Benefits and Costs of Central Clearing in the Treasury Markets

• In this blog, we discuss the potential benefits and costs of moving more segments of the U.S. Treasury market to a centralized clearing model.
• It appears that the relative benefits of central clearing in the repo market are greater than in the dealer-to-customer cash market. Mandating central clearing in the cash market could impede market functioning and diversity while simultaneously failing to provide the same capacity benefits that are seen in the repo market.
• Therefore, it is essential that policymakers thoroughly study the costs and benefits of central clearing on different segments of the market before implementing policies that would either incentivize or mandate its adoption.

This week, the U.S. Treasury, Federal Reserve Board, Federal Reserve Bank of New York, the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) will host their seventh annual conference on the U.S. Treasury Markets.^[i] The staff of the agencies previewed some of the main topics for discussion in a progress report released last week, entitled “Recent Disruptions and Potential Reforms in the U.S. Treasury Market” (‘the Interagency Report’).^[ii] The Interagency Report discusses recent market disruptions in the Treasury market—most prominently the pandemic-related disruption in March 2020– and outlines a series of potential reforms, topics that we also discussed in two blogs released earlier this year (see Part I here and Part II here). In this third blog in our series on Treasury market reform, we focus on a topic that has been the subject of significant attention in this debate: the expansion of central clearing in the Treasury markets. ^[iii] We will turn to another key topic, post-trade transparency, in Part IV of the series.

The goals of any reforms in the Treasury market should be to enhance the liquidity resiliency in the market and to increase the market-making capacity of market participants in order to meet the growing demand for, and supply of, Treasury securities. These twin goals must be top-of-mind as policymakers and market participants assess the costs and benefits of any reforms, including incentivizing or mandating greater central clearing.

Background

Before we discuss the benefits and potential drawbacks of more centralized clearing in the Treasury market (which in its most complete form would mean that a central counterparty (“CCP”) intermediates all trades in the market), it is important to distinguish between the different segments of the Treasury market and the different clearing practices in each segment. There are three main segments for consideration:

• The cash market for Treasury securities, which can further be subdivided into the interdealer and dealer-to-client markets;
• The market for Treasury repurchases or “repos” (which can also be subdivided into the triparty repo and bilateral repo markets)^[iv]; and
• The market for Treasury futures.

The adoption of centralized clearing varies widely from segment to segment, from the fully centrally cleared futures market (which occurs almost entirely via the Chicago Board of Trade) to the mostly non-centrally cleared dealer-to-client cash market for Treasury securities.

In the interdealer cash market, Treasuries are settled and cleared centrally via a CCP – the Fixed Income Clearing Corporation (“FICC”).^[v] However, dealer trades with principal trading firms (“PTFs”) – a very large share of this market – are generally cleared bilaterally because most PTFs are not members of the FICC. In the dealer-to-client market (where trading in more seasoned “off-the-run” Treasuries is more common), transactions between dealers and customers are almost entirely cleared and settled bilaterally without being submitted to a CCP. The Treasury Market Practices Group has estimated that 13 percent of cash transactions are centrally cleared; 68 percent are bilaterally cleared; and 19 percent involve some hybrid of the two, with one leg of the transaction centrally cleared and the other bilaterally cleared.^[vi]

By contrast, a large and growing share of the bilateral Treasury repo market is centrally cleared via the FICC. While historically most centrally cleared repo transactions occurred between dealers (as is the case in the cash markets), the introduction in 2005 and progressive expansion since 2017 of the FICC’s “sponsored repo service,” which enables non-FICC member firms sponsored by FICC members to clear transactions through the FICC, has provided access to central clearing to a far wider range of institutional actors, including money market mutual funds (“MMFs”) and hedge funds.  The benefits of this program for both dealers and their sponsors has resulted in significant growth in the number of repo transactions that are centrally cleared, growth that notably has occurred even in the absence of an official mandate. Thus it is not at all clear that mandates are necessary to ensure more widespread adoption of central clearing in this segment of the market.^[vii]

These differences in the uptake of centralized clearing strongly suggest that the incentives for clearing and the underlying costs and benefits differ across different segments of the Treasury markets. Moreover, these differences suggest that the movement towards central clearing need not be an “all-or-nothing” approach, but rather should be focused on those segments of the market where the benefits are most clear.  Policymakers will need to take these differences into account as they consider measures to promote or mandate more widespread adoption of central clearing. As we will discuss, the economic benefits of clearing are far greater in the repo market, while the relative costs of moving to a fully centralized model in the dealer-to-customer cash market could be significant. This change could impede market functioning and diversity in the cash market while failing to provide the same capacity benefits that are seen in the repo market.

Potential Benefits of Central Clearing – More Pronounced in the Repo Market

Those advocating for greater adoption of centralized clearing point to several potential benefits. Darrel Duffie has argued, for example, that a broad central clearing mandate ought to be considered because “the size of the Treasury markets will outstrip the capacity of dealers to intermediate the market.”^[viii] In his view, greater central clearing could free up “the amount of dealer-balance sheet space necessary to maintain liquid markets,” since capital and leverage requirements for dealers would be reduced because of multilateral netting of trades at the CCP. However, as we have noted, these benefits are greater for some parts of the market than for others, and so a move towards centralized clearing in all segments may not be necessary to realize these benefits.

As the Interagency Report notes, these balance sheet savings would likely be greater for repos than for cash transactions, since unsettled cash transactions can already be netted for accounting purposes on dealer balance sheets so clearing would yield limited benefits.^[ix] By contrast, central clearing greatly expands the capacity of dealers to intermediate under existing accounting and regulatory capital rules by netting of repos and reverse repos. Buyside firms benefit because dealers are willing to intermediate cleared repos at narrower spreads, leading to higher rates paid to buyside repo investors on cleared repos and conversely lower rates paid by repo borrowers. These differences in incentives for dealers may help to explain the differences in the uptake of central clearing across these two parts of the market.

Another potential benefit is “standardized, enhanced, and more transparent risk management.”^[x] In theory, in a centrally cleared market, a CCP such as the FICC would be able to enforce standardized risk management requirements across all market participants. This would likely include standardized margin requirements, which would almost certainly lead to significantly more conservative margining practices across-the-board (of note here: the FICC currently does not require its members to collect margin from participants it sponsors under the repo program^[xi]). The CCP can also impose financial and operational standards on its members and mutualize the risks posed by counterparty defaults by requiring members to help cover losses (see more on this below). If extended to all market participants, these requirements would serve to improve transparency and potentially boost market resiliency.

Central clearing should also reduce counterparty credit risks – i.e., the risks associated with failure of a counterparty to deliver on the contractual settlement date – by making those risks and the associated risk management practices more transparent and subject to enhanced regulatory oversight. However, there are some important caveats to this. First: recent stress events do not appear to have been driven by credit risk issues, likely because counterparty credit risk on trades in U.S. securities is significantly lower than in other financial markets (owing to a relatively short settlement cycle and low volatility in prices). Thus, the resiliency benefits of central clearing in this context may be limited. Second: the market impact of a counterparty credit default is likely to be more contained in the dealer-to-customer segment of the market than it would be in the interdealer market, suggesting that the benefits of central clearing from a credit risk perspective are greater in the latter part of the market than the former. Third: more study of the behavior of newer participants in these markets is necessary in order to determine if additional credit risk mitigation measures would be beneficial.

A CCP can also help limit settlement fails. As Duffie notes, one potential reason for this is that “central clearing reduces ‘daisy-chain’ failures, which occur when firm A fails to deliver a security to firm B, causing firm B to fail to firm C, and so on.”^[xii] While settlement fails were certainly higher in the bilateral markets than fails from transactions cleared by the FICC during the March 2020 COVID event, they were still relatively low when compared to settlement fails during the 2008-2009 Financial Crisis.^[xiii] This may owe to post-crisis reforms to settlement practices, such as the implementation of settlement-fail penalties. In short, the reduction in settlement fails from central clearing is an important benefit, but perhaps not quite as significant as it might have been in an earlier era.

Finally, centralized clearing could also facilitate a greater movement toward an even more radical reform – the widespread adoption of “all-to-all” platforms for trading securities, which theoretically could both broaden the pool of liquidity providers and increase balance sheet capacity for dealers by disintermediating them from some trades i.e., providing for direct trading between non-dealer buyers and non-dealer sellers. Questions remain, however, about how much additional liquidity all-to-all trading would provide and what it would mean for the important liquidity providers—the primary dealers.

For example, it’s not at all clear that all-to-all trading would add liquidity to the markets during a “one-way” event such as the March 2020 COVID volatility, or whether new market entrants would be willing to step in and provide liquidity during other stress events. Greater all-to-all trading could also diminish the incentives of being a primary dealer, institutions that have historically been relied upon to provide liquidity during both stressed periods and normal operations.  Importantly (and in light of the expected increases in issuance over the coming years), primary dealers take down (i.e., bid on) around 30 percent of all Treasury auctions, provide backstop bids at Treasury auctions to avoid failed offerings, and provide liquidity and participate in all of the Federal Reserve’s buyback operations. The importance of these activities of primary dealers to the Treasury market should not be minimized (see Part I of this blog series for more on the important role played by primary dealers).

As the Interagency Report notes, the impact of all-to-all trading on market liquidity requires “further evaluation.”^[xiv] Indeed, given that the benefits of all-to-all trading in the Treasury market are unclear, it may be prudent to first allow all-to-all platforms to develop organically as the business/economic case evolves (that is, if demand develops) rather than have the official sector create premature policies incentivizing or mandating this type of trading.  The Treasury market benefits from having multiple dealing protocols (e.g., Request-for Quote or “RFQs”; Central Limit Order Book or “CLOBs”; directed streams etc.) that meet the needs of the wide array of market participants, and it is important to retain these elements to continue to enhance the diversity within the market.

Potential Costs of Central Clearing – Concentration of Risk and Challenges in the Cash Market

Perhaps the biggest concern with moving towards a centralized clearing model is the concentration of risk that would inevitably occur within the CCP. The failure of the CCP would be a global systemic event that the U.S. government (and indeed other governments) would strive to avoid, essentially creating the impression that the CCP was “too-big-to-fail” i.e., that it has an implicit government guarantee against failure. Without appropriate regulation and supervision, this could lead to moral hazard and excessive risk taking. This is particularly important in the Treasury market given that the FICC is the sole CCP for cash and repo Treasury trading.

The biggest concern from a risk perspective would be the substantial liquidity risks that would arise from a member default. As currently designed, in the event of a member default, the FICC would draw on committed credit lines extended to the FICC by its members through its Capped Contingency Liquidity Facility (“CCLF”), which could put strains on the liquidity positions of other FICC members. In this way, liquidity risks from a member default could be easily transmitted throughout the market. To avoid this scenario, regulators will need to carefully monitor the FICC’s credit and liquidity exposures to its largest members, as well as member’s exposures to sponsored participants (including monitoring whether FICC margin requirements are being passed on to sponsored firms). Additionally, as new participants/types of participants enter the market and clear their transactions through FICC they should be subject to the same CCLF requirements as existing members. Importantly, the FICC may also need to be given access to the Federal Reserve’s Standing Repo Facility (“SRF”) in order to guarantee it has adequate liquidity to withstand a member default event.^[xv]

More generally, regulators should review the design and operation of the FICC prior to expanded clearing in the Treasury markets. In addition to examining its management of credit and liquidity risks, this review should examine margining requirements to ensure they are set in a transparent manner and do not act in a procyclical manner during periods of stress. It should also review the FICC’s governance structure and membership criteria, ensuring that any expansion in membership does not lead to a dilution in the robust risk management criteria currently in place for members.

Beyond concentration risk, the most obvious drawback of a move towards central clearing would be increased costs for market participants and the potential negative impact this could have on market liquidity and diversity. Those costs would include higher clearing fees and generally higher margin requirements, although improvements to FICC/CME cross-margining service may create both systemic benefits and incentives to clear. To the extent membership in the CCP would be expanded as part of this process, it could also include the cost of committed funding obligations to the CCP (via a facility like the CCLF), as well as the additional costs involved in meeting the CCP’s operational and risk management requirements (costs that will be more pronounced in the largely bilateral dealer-to-customer cash market). It is important that all market participants be subject to the same set of requirements in order to promote the overall resiliency of the market. A balance will need to be struck between the market-wide benefits and any potential lessening of activity. Whether a significant pullback in activity in these markets would occur will obviously depend on how large the marginal increase in costs would be, a subject that should be studied carefully prior to implementation of any mandatory move to central clearing.

While centralized clearing is often viewed as a way of adding diversity and a broader base of liquidity to the market, it is quite possible that the opposite will occur. If the increased costs of participation in these markets is too high, it would effectively limit access for smaller participants, thereby reducing competition and diversity in the market. This again underscores the importance of carefully examining the cost structure associated with greater central clearing prior to implementation. And even if central clearing ultimately increases participation in the markets, it is important to recognize that there are potential risks as well as benefits. For example, the expansion of centralized clearing in the repo markets has facilitated greater repo lending from MMFs to leveraged firms such as hedge funds, a trend that may have contributed to the market stresses experienced in September 2019.^[xvi]

Prudential Requirements for Banks Will Need to be Reviewed

Finally, any reform will need to be accompanied by a review of the capital and liquidity framework for banks given that existing prudential requirements may be an obstacle to greater adoption of central clearing. For example, the Single Counterparty Credit Limit (“SCCL”) rule could place limits on the trades a bank can conduct with the FICC, potentially leading to liquidity shortfalls in the market. Similarly, the FICC could be classified as the largest counterparty of a bank dealer for the purpose of Large Counterparty Default (“LCD”) component of the Stress Capital Buffer (“SCB”)/Comprehensive Capital Analysis and Review (“CCAR”) stress tests, which would also constrain the ability of bank dealers to conduct trades with the FICC. It is important, then, that prudential regulators review and amend these rules as appropriate prior to the implementation of any central clearing mandate.

Conclusion

Mandatory central clearing is certainly a key focus of the debate around Treasury market reform, though it is not clear it would have solved for any of the recent stress events we discussed in Part I of our blog series. What is clear, as the many reports and papers on this topic have noted, is that any move towards incentivizing or mandating central clearing should be subject to thorough study to assess both its costs and benefits. Those assessments should moreover focus on how different segments of the market (particularly the cash market, where the benefits of central clearing are not as evident) may be impacted by potential reforms.

Dr. Peter Ryan is a Managing Director and Head of International Capital Markets and Prudential Policy at SIFMA.

Robert Toomey is Managing Director and Associate General Counsel, Rates at SIFMA.

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^[i] For more information, see The 2021 U.S. Treasury Market Conference – FEDERAL RESERVE BANK of NEW YORK (newyorkfed.org).

^[ii] “Recent Disruptions and Potential Reforms in the US Treasury Market: A Staff Progress Report,” November 8, 2021. Available at: Microsoft Word – IAWG Treasury Report final.docx (referred to as the “Interagency Staff Report”).

^[iii] This topic has been discussed extensively in academic papers and government reports. See, for example, Darrell Duffie, “Still the World’s Safe Haven? Redesigning the U.S. Treasury Market After the COVID-19 Crisis,” Hutchins Center Working Paper #62, Brookings Institution, June 2020. Available at: WP62_Duffie_v2.pdf (brookings.edu). See also Nellie Liang and Pat Parkinson, “Enhancing Liquidity of the U.S. Treasury Market Under Stress,” Hutchins Center Working Paper #72, Brookings Institution, December 16, 2020. Available at: WP72_Liang-Parkinson.pdf (brookings.edu). Among the government or government sponsored reports on this subject, see the 2021 Interagency Report, particularly pp. 29-31; The Group of Thirty, “US Treasury Markets: Steps Toward Increased Resilience,” July 2021. Available at: G30_U.S_._Treasury_Markets-_Steps_Toward_Increased_Resilience__1.pdf (group30.org); Treasury Market Practice Group (TMPG) “Best Practice Guidance on Clearing and Settlement,” July 2019. Available at: CS_BestPractices_071119.pdf (newyorkfed.org); U.S. Department of the Treasury, “A Financial System that Creates Economic Opportunities: Capital Markets,” October 2017. Available at: A Financial System That Creates Economic Opportunities: Capital Markets (treasury.gov); “The Joint Staff Report on the U.S. Treasury Market on October 15, 2014,” July 13, 2015. Available at: Joint_Staff_Report_Treasury_10-15-2014.pdf.

^[iv] See Part I of blog for more detailed discussion of Treasury repos and the importance of the Treasury repo market.

^[v] The FICC is a division of the Depository Trust & Clearing Corporation (“DTCC”).

^[vi] These estimates are based on data for the first half of 2017. See Treasury Market Practices Group (2019).

^[vii] Bilateral clearing in the triparty repo market has generally remained the norm for that segment, though this may change.

^[viii] Darrell Duffie, “Still the World’s Safe Haven? Redesigning the U.S. Treasury Market After the COVID-19 Crisis,” Hutchins Center Working Paper #62, Brookings Institution, June 2020, p. 1. Available at: WP62_Duffie_v2.pdf (brookings.edu).

^[ix] Interagency Report, p. 30.

^[x] Ibid.

^[xi] Group of Thirty Report, p. 13.

^[xii] Duffie, p. 15.

^[xiii] Ibid.

^[xiv] Interagency Report, p. 31.

^[xv] See Group of Thirty Report, p. 14.

^[xvi] E.g., see see Fernando Avalos, Torsten Ehlers and Egemen Eren, “September stress in dollar repo markets: passing or structural?,” BIS Quarterly Review, December 2019. Available at: September stress in dollar repo markets: passing or structural? (bis.org).

Treasury Market Reform Blog Series

• Blog Series

  Part I: Why is Reform Needed? A Brief History of Recent Market Disruptions

  An overview of the important role that the U.S. Treasury markets play in the financial system and in the transmission of monetary policy. We also provide a brief history of recent disruption events that have led to growing calls for reform of the U.S. Treasury markets.

• Blog Series

  Part II: Proposals for Reforming US Treasury Markets

  Many approaches for reforming U.S. Treasury markets have been discussed on a standalone basis and most had been suggested prior to recent events. Although by no means exhaustive, it does seem that there are four broad categories of reform currently being debated. So they may now be considered holistically as a single package, we summarize four categories and discuss each in brief.

Related Resources

• SIFMA Insights

  US Fixed Income Market Structure Primer

• SIFMA Research

  US Treasury Securities Statistics