The Effects of Mandatory Central Clearing on the U.S. Treasury Market

The market for U.S. Treasury securities has grown from roughly $5 trillion in mid-2008 to approximately $27 trillion today. Default-free, tradable, and dollar-denominated, Treasuries play an essential role in the functioning of financial markets.

Recent shocks to the Treasury market, most notably the one that occurred at the onset of the COVID-19 pandemic, prompted several proposals to strengthen its foundations. These include a transformative 2023 SEC rule designed to subject most trades involving Treasury securities to central clearing.

In a paper forthcoming in the University of Chicago Law Review, Yesha Yadav and Joshua Younger examine the impact of the rule on the Treasury markets, spotlighting the potential benefits and trade-offs to be considered as the rule takes effect over the next two years.

The central clearing mandate represents a significant shift for the structure of the Treasury market

Central clearing, where a well-resourced and informed central counterparty (CCP) backs a transaction in a bid to minimize counterparty risk, already features prominently in equity, bond, and derivative markets – far more so than in Treasuries. Less than 20% of the secondary market for Treasuries and roughly 20-30% of repo markets (short-term lending markets that commonly use Treasuries for collateral) are centrally cleared.

Under current practice, the Fixed Income Clearing Corporation (FICC), the only CCP in the Treasury market, clears Treasury trades that occur between two netting members of FICC, constituting a small subset of market participants. The new rule will require FICC members to clear the vast majority of cash and repo trades, regardless of counterparty. Estimates suggest that as much as $4 trillion in daily transaction volume will need to be centrally cleared.

Central clearing offers several potentially important payoffs…

The authors detail four most important benefits central clearing may provide.

First, it should reduce settlement risks, by lowering the frequency of settlement failures (i.e., when trades fail to complete.) Such fails can result from miscommunications between parties, back-office issues, or periods of highly active trading.

“Because CCPs have visibility into the activity of all their members, trades can be compared and netted before settlement, reducing the likelihood that one idiosyncratic fail triggers a chain of additional fails,” the paper explains.

Second, central clearing should ease pressure on the balance sheets of major Treasuries dealers which could reduce capital requirements and promote balance sheet elasticity.

Third, margin requirements on Treasury derivatives, which can be volatile and lead to rapid liquidation events in the current structure, would be stabilized or possibly reduced through stress periods, by the “cross-margining” of offsetting case and derivative positions.

“In these arrangements,” the authors explain, “two CCPs develop a mechanism to transfer or share their claim to collateral posted by the trade counterparties which in principle allows margin requirements to reflect the overall economic risk of the exposure rather than simply the side visible to each CCP individually.”

Lastly, central clearing should provide a volume of “comprehensive, reliable, and constant data” that has long been missing from Treasury markets. CCPs will collect granular transaction-level data from entities that may not otherwise be required to report (e.g. hedge funds and high-frequency traders) and improve data quality through standardization and vetting.

“A deeper and more intricate picture of repos and the Treasury secondary market can facilitate a fuller understanding of Treasury ecosystem more broadly as well as probe how disruptions in one segment impacts the other,” the authors write.

But the SEC’s clearing mandate comes with potential challenges as well

The paper highlights three concerns that may create serious trade-offs for the new rule.

First, central clearing will not, by itself, solve the liquidity issues that have plagued Treasury markets in recent years and whose damaging effects clearly visible in the market’s breakdown in March 2020 as well as during other disruptive trading episodes.

Secondly, central clearing comes with the possibility of evasion.

The clearing mandate comes with exceptions – meaning that here are ways around the clearing requirement. For example, trades that are carried out between two non-members of a Treasuries clearinghouse are exempt. Additionally, repurchase transactions without a fixed maturity fall outside of the mandate. Further, repo trades can be packaged as “securities lending transactions,” pushing them outside of the rule. The extraterritorial reach of the new mandate is also not clear, such that parties may may relocate their Treasury trades “to offshore jurisdictions and into entities that fall outside the scope of the SEC’s mandate and the visibility of U.S. authorities.”

This type of activity, the authors write, may complicate risk management of CCPs and increase blind spots for regulators and CCPs alike.

Second, the mandate shifts more risk onto the CCPs as more Treasury market activity requires central clearing. While the authors detail throughout the article how CCPs “have well-established techniques for mitigating this risk,” the failure of a Treasury CCP could have significant systemic consequences.

“If the instability of a Treasury CCP were to significantly impair market functioning (which is more likely if a greater fraction of the market is cleared), liquidity constraints on other CCPs could adversely affect their perceived stability,” the authors write. “This dynamic increases the risk of contagion.”

While they add that such a risk “may seem exceedingly remote,” they caution against complacency, pointing to near misses like the stock market crash on Black Monday, which led to the near-failure of U.S. clearinghouses, as well as actual failures overseas.

“There is clear value in research that sets out realistic expectations for how a broad clearing mandate might improve the resiliency of Treasury market functioning to a broad variety of shocks,” the authors conclude. While a central clearinghouse can address many of the Treasury market’s foundational issues, “it is not able nor designed to address every element of the demonstrated fragility of Treasury market structure by itself.”

“The introduction of the clearinghouse represents a major intervention for reforming the Treasury market – but far from the last word on the topic.”

Central Clearing the US Treasury Market” is forthcoming in the University of Chicago Law Review. Yesha Yadav is the Associate Dean and Robert Belton Director of Diversity, Equity & Community, Milton R. Underwood Chair of Law, and Faculty Co-Director of the LL.M. Program at Vanderbilt Law School.