The US’ Securities and Exchange Commission’s (SEC) proposal to expand the central clearing of treasury securities, announced in September last year, is expected to reduce counterparty credit risks and improve liquidity. In an article about the upcoming change, Nate Wuerffel, head of market structure at BNY Mellon, gives an in-depth overview of the preparations involved pre-adoption, and the likely impacts post-adoption. He concludes that the proposal is “a big bullet, but not a silver one”.
In addition to reducing risks and increasing liquidity, SEC’s proposal should also protect any treasury market CCP “from contagion risk that could arise from a counterparty default in the non-centrally cleared portion of the market”, writes Nate Wuerffel. Currently, this applies only to the Fixed Income Clearing Corporation (FICC), which is the singular CCP in US’ treasury market. The three main sources of contagion risk identified by SEC are interdealer brokers and principal trading firms, hedge funds, as well as the repo markets.
The proposal thus addresses these sources of risk by requiring members of the FICC (and any treasury market covered clearing agency) to centrally clear the following:
• All repo and reverse repo transactions
• All purchase and sale transactions with registered broker-dealers, government securities dealers, hedge funds, and levered accounts
• All purchase and sale transactions when acting as an interdealer broker
The cost of change
Nate Wuerffel suggests four steps in the preparation for central clearing: assessing the eligibility of transactions, determining an access model and provider, adjusting risk management practices, and finally, managing change.
Citing a survey by FICC that estimated the additional margin from centrally clearing more indirect participants to be as high as USD27 billion, he writes that “transaction costs will increase as clearing costs go up for many market participants that do not centrally clear their transactions today”.
On the other hand, an analysis by the Federal Reserve Bank of New York (New York Fed) has found that “central clearing could reduce the gross settlement obligations of primary dealers by as much as 70 percent”.
On paper, expanded central clearing “should increase the market’s resilience by lowering systemic risks in the event of market stress or a counterparty default”. Nate Wuerffel explains that “consistent and transparent risk management should make market participants less likely to pull back from counterparties in times of stress, allowing the market to remain more liquid under such conditions. In the event of a default, the default management process, and margin and liquidity resources, should help avoid contagion and fire sales, and perhaps may forestall the need for official sector intervention.”
In practice, however, he believes that market participants would feel these changes more profoundly. Those who participate in interdealer cash markets would see pricing change “as the requirements of clearing are passed along to non-FICC liquidity providers”. Highly levered or low-margin trading strategies “may become uneconomical at current levels”, leading to basis widening, which in turn, reduces the demand for treasury securities, “contributing to upward pressure on bid-ask spreads or outright yields”. As for the repo markets, additional margin and costs of sponsorship might increase the cost of repo funding and leverage.
In conclusion, “central clearing alone will not be sufficient to ensure the market’s resiliency in the future”, writes Nate Wuerffel. “Reforms of the treasury market will need to extend beyond central clearing and will require investment from both the public and pirvate sectors”.