Reform of US bond trading in balance
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Regulators are considering plans to push more central clearing of all trades in US government bonds — while trying to decide if such a move would shore up the world’s most important financial market, or risk further gumming it up.
Clearing houses are the unobtrusive utilities that sit between the two parties to a trade and prevent a default by one party from cascading through the market. After the 2008 financial crisis, global regulators turned to them to shore up the vast global swaps market, where deals were often negotiated privately.
Now, the watchdogs are considering ways to bring a similar level of stability to the $22tn market for US government bonds, the trading of which underpins global finance. “It is the base upon which so much of our capital markets are built,” noted Gary Gensler, chair of the Securities and Exchange Commission in early November. “I’ve asked [agency] staff . . . how to bring about more central clearing in the Treasury cash and repo markets.”
But any regulatory initiative to do this would set the investment banks that have traditionally dominated the market against the lightning-fast proprietary trading firms that have become the most active daily players in the market.
Gensler’s intervention follows a decade in which the resilience of the US Treasury bond market has been repeatedly tested, notably by a “flash rally” in 2014, and spikes in the repo market in 2019. But the volatility of Covid-panicked bond markets in March 2020 has prodded regulators to take a closer look.
As investors sought to convert holdings to cash as fears over the pandemic grew, dealers were unable to handle the waves of sales of Treasury securities — leading to a marked deterioration in the functioning of the bond market. The US Federal Reserve ended up buying large amounts of Treasuries and unleashed a range of initiatives to ease the strain on capacity.
A report in December by the Group of 30, an international body of financiers and academics, described a market where deals were settled bilaterally, without a clearing house. There was “essentially no central clearing” of deals between banks and their customers, the report found.
Its conclusion was unsentimental: “In short, US Treasuries did not serve their traditional safe haven role. Instead, dysfunction in the Treasury market exacerbated the crisis.”
Another study, for the Federal Reserve Bank of New York, laid out the impact that clearing would have made: dealers’ daily gross settlement obligations would have fallen by roughly 60 per cent, or $330bn, in the weeks around March 2020. Those obligations soared to $800bn when trading was at its highest. Clearing would also have cut down the number of deals that failed to settle, which reached nearly $85bn a week at its peak.
Among the recommendations the G30 study made was mandatory clearing for all deals in the interdealer markets, where deals between banks are struck by broking middlemen. But it stopped short of extending enforced clearing to the whole market.
That reflects officials’ caution in tampering with such a critical market, reckons Kevin McPartland, head of market structure and technology research at Coalition Greenwich.
“On the one hand, it’s more liquid and more standardised than a lot of other markets that have been clearing for years,” he says. “But it’s so big, so important, with so many participants from around the world there’s a lot of plumbing that will need to be rerouted.”
In the past decade, the market has evolved considerably. Historically, most of the market was cleared because it was a requirement for primary dealer banks and most trades took place in the interdealer market. Most of the members of the clearing house — the Fixed Income Clearing Corporation — are banks.
However, daily activity has since shifted to a group of high-speed traders using algorithms on electronic platforms. They have entered the market as tougher rules on leverage have forced banks to curb their market-making activity, at a time when the volume of outstanding US debt has mushroomed.
These traders typically settle their trades bilaterally, rather than going through a central clearing house. And few would want to become members of a clearing house because the cost is prohibitive to them.
As a result of this shift, only 13 per cent of US Treasuries are now centrally cleared and 19 per cent partially cleared, according to an inter-agency report this month.
But the Depository Trust & Clearing Corporation, owner of the FICC, has warned policymakers about remaking the US Treasury market in the image of the cleared swaps market — noting differences between the two worlds.
“A number of market participants who do not engage in the swaps market are critical liquidity providers to the US Treasury market,” it pointed out in a white paper last month.
Policymakers “might risk cutting off access to critical market participants in order to solve for problems that do not exist,” it said.
The DTCC also cited concerns that money market mutual funds — which participate in both cash and repo Treasury markets — would fall foul of SEC rules on using customer funds. Other rule reforms were needed to expand central clearing, it said.
FIA Principal Traders Group, which represents the high-speed traders that make up the bulk of the daily market, support central clearing but are wary of a mandatory requirement without wider reforms. The FICC’s current rule book works against them, they argue.
For example, the rule book allows clearing member firms to limit the number of counterparties that high-speed traders can use. And it does not allow high-speed traders to benefit from an arrangement that cuts down the amount of margin they need to support their deals, in both cash and futures Treasuries markets.
The DTCC says it provides fair and open access to its market and has an obligation to do so. But the PTG warns in its own study that imposing a clearing model without other rule changes, “would, in practice, compel market participants to exit the market.”
Authorities are wary of piling on costs that might force principal traders to pull out of the market, creating further potential dysfunction. Gensler said the SEC is looking at ways to ensure that significant trading firms are registered as dealers. But a coherent policy to incentivise clearing is not yet in place.