US SEC draft rules could boost resilience of $24 trillion Treasury market

Proposed rules by the US Securities and Exchange Commission (SEC) to boost central clearing in Treasuries could help to shore up resiliency in the $24 trillion market and may pave the way for more trading that bypasses the large banks that have traditionally dominated the market.

The SEC's proposed reforms, unveiled on Wednesday, are part of an effort by multiple regulators, the Treasury Department and the Federal Reserve to increase liquidity and reduce volatility in the world's largest bond market.

In recent years the market has suffered from reduced liquidity, with trading seizing up in March 2020 when COVID-19 restrictions roiled financial markets.

The SEC proposed expanding the number of market participants that are required to centrally clear Treasuries to hedge funds, principal trading firms and some other types of leveraged accounts. The regulator also will require central clearinghouses and their members to develop rules and methods that expand clearing access to all investors. 

Clearinghouses mitigate systemic risks by sitting in the middle of trades and guaranteeing payments. They take margin from each counterparty to help reduce risks.

It will take months if not years to refine and implement the final details of the rules. However, they should improve "the financial stability of the market, its transparency and arguably cost," said Darrell Duffie, a finance professor at Stanford University.

The Treasury market is currently bifurcated between bilateral trading, where an investor deals directly with a big bank, and 'all-to-all' platforms where banks, principal trading firms and some hedge funds trade anonymously with each other through a centralized order book - similar to stocks and futures exchanges.

With a central clearing house guaranteeing more trades, more of the Treasury market could migrate to "all-to-all" trading venues, which may offer better liquidity and lower trading costs. Large dealers that trade bilaterally with most fund managers are facing more balance sheet constraints at the same time as the market is rapidly expanding.

The Treasury market has grown from $5 trillion in 2007 and is expected to reach $40 trillion by 2032, according to estimates by the Congressional Budget Office.

"Central clearing is an important step that can enhance the stability and resiliency of the market, improve efficiency, expand intermediation capacity and allow further evolutions to occur with respect to trading," said Stephen Berger, global head of government and regulatory policy at Citadel Securities, one of the largest market makers in Treasuries.

Pacific Investment Management Company (Pimco) said in a note last week that it wants the entire Treasury market to move to all-to-all trading, saying that intermediated trades make the market "more fragile, less liquid, and more susceptible to shocks."

COMPLEX, COSTLY

Still, the bond trading giant said it did not agree with a clearing mandate, arguing that Treasuries do not have "meaningful" counterparty risk and that the costs of clearing could discourage some participants from entering the market.

The DTCC-owned Fixed Income Clearing Corp is the only clearinghouse that currently clears Treasuries, but it focuses on trades between its members. The SEC's proposal would require the FICC and its members to enable clearing by other market participants, such as fund managers who are typically not direct members.

"In order to have mandatory clearing as proposed, we first have to open up clearing to all," said Graham Harper, head of public policy and market structure at DRW. Success will largely depend on how the FICC implements the changes and how its members interpret and implement those changes with respect to their clients, he said.

The DTCC said that they welcome "further discussions" with the industry and regulators regarding the clearing proposals.

For many investors, meanwhile, the benefits of clearing will need to be weighed against the costs, including clearing fees, additional margin, and the expense of building the technology and legal infrastructure.

"The cost of operations, technology and compliance upgrades in the medium term could be substantial. The benefits could outweigh the costs in the long term, but the road to that point will be complex," said Kevin McPartland, head of market structure and technology research at Coalition Greenwich.