MNI EXCLUSIVE: Fed Could Relax Rules to Boost Dealer Capacity

The Federal Reserve may extend regulatory relief for banks and push for wider clearing of Treasuries to help dealers provide liquidity during market volatility, former Fed officials, researchers and market sources told MNI.

A one-year emergency measure allowing the largest banks to exclude cash and Treasuries from supplementary leverage ratio calculations is likely to be extended indefinitely, at least for cash, sources said.

The capital surcharge on Globally-Systemically Important Banks and the global market shock component of the Fed's capital stress test also likely contributed to March's wild markets and should be reconsidered, said Pat Parkinson, a former top regulator at the Fed.

"The problem was not liquidity (requirements); it was capital requirements," said Darrell Duffie, a Stanford University professor and outside adviser to the Fed, in an interview. "The capital requirements of the dealers prevented them from absorbing the flows of Treasury liquidations coming from investors in March."

"There are various aspects of the existing regulatory framework that don't contribute much to resiliency and interfere with dealer liquidity in times of stress," Parkinson, now a special adviser to the Bank Policy Institute, told MNI. "I think they need to confront it, and if they do, they will find opportunities to make adjustments to support market liquidity without making the banking system less resilient."

WIDER CLEARING

An expansion of central clearing of Treasury cash and repo markets would also increase primary dealers' capacity, as netted transactions have more favorable capital treatment than uncleared transactions, and allow more dealers to participate, according to Duffie and others.

Sources also argued for the establishment of a standing repo facility but said March's shocking Treasury market distortions may require a broader rethink of the growing reliance on collateralized money markets.

"Central clearing can be a very robust architecture for the market," said Jamie McAndrews, former head of research at the New York Fed who retired in 2016 after 28 years in the Fed system. "It wouldn't necessarily eliminate all pressures that might occur because of excess supply or demand at a particular time of crisis, but it would certainly assist the market in counterparty credit risk management and also liquidity risk management."

Involving more parties in central clearing would reduce the gross settlement amounts and reliance on large banks, alleviating the need for additional bank balance sheet space, Duffie said.

REVISITING GUIDANCE

A recent report by the Futures Industry Association, which has drawn the attention of regulators, said the doubling of initial margins for some derivatives transactions in the first quarter generated a couple of hundred billions of dollars' worth of liquidity pressures. Pro-cyclical margin-setting runs counter to guidance that clearinghouses should not lower margins in times of low volatility so as to be compelled to increase them in times of stress.

"They'll be revisiting that guidance and the way center counterparties have implemented that guidance to see exactly what went wrong," Parkinson said. "It's not the single most important factor in the market meltdown but a significant one, and one where it may be relatively easy to get consensus that something needs to be done."

But adding non-banks to the roster of 24 primary dealers would not do much to provide additional capacity to sop up flows when Treasuries are liquidated, sources said.

"It sounds appealing that more primary dealers would mean more intermediation capacity but that's not really very much the case," Duffie said. "There is a confusion between the role of a primary dealer in being able to trade with the Fed and the role of a primary dealer in being able to absorb customer flows."

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