MNI INTERVIEW: Clearing Rule To Boost Treasury Liquidity

An expansion of central clearing of U.S. Treasury trades promises to be "transformative" in reducing systemic risk and improving liquidity for the world's most important bond market, Stanford Graduate School of Business economist Darrell Duffie told MNI.

The Securities and Exchange Commission's adoption last week of broader clearing rules for the Treasury market will improve price transparency, boost competition and expand the capacity of primary dealers to handle trades during stress, Duffie said. That will go far to shore up resilience for a fast-growing market that has seen increasingly frequent episodes of instability in recent years.

The clearing overhaul could even pave the way to so-called "all-to-all" trades, in which any market participant can trade Treasuries with another, bypassing balance-sheet-constrained dealers altogether and adding capacity to the market.

"It’s highly transformative. it’s a big reorganization of the lines of counterparty risk in the market and the way the market is margined and settled. So that’s a big plus," Duffie told MNI's Fedspeak podcast. "It’s lowering systemic risk. From the viewpoint of liquidity, I think it’s also improving resilience."

EXEMPTIONS AND HAIRCUTS

About 80% of Treasury trades are not currently centrally cleared, including those of hedge funds which are now some of the most active participants in the Treasury market. The SEC rule applies broadly to repo trades. In the cash market, most hedge funds and leveraged investors were exempted after they argued the added legal and operational costs, clearing fees and margin requirements were prohibitive.

Duffie said he would have preferred to see those trades included, as the benefits of central clearing increase exponentially with added participants. "It’s a nonlinear effect," he said. "The more the others are doing it, the greater the benefits are for you for doing it."

More hedge fund trades could eventually be captured in the central clearing mandate, if a separate proposal under consideration by the SEC to include additional leveraged investors as brokers or dealers becomes law.

Another concern is the clearing mandate does not set a floor on repo haircuts. About 74% of hedge funds' total repo borrowing volume transacted at zero or negative haircuts, according to Fed Board research, which could exacerbate the effects of severe market stress.

"The fact that there's no haircut for a large part of the market -- it would be nice to address that," Duffie said. "On the other hand, the SEC's authority is not unlimited, so perhaps they were also concerned that the cost of putting up margin would be something important to a sufficient set of market participants." (See: MNI: US Treasury Clearing To Limit Contagion, Create New Risks)

The regulators did say last week they viewed the Fixed Income Clearing Corp., the Treasury market clearinghouse, as having sufficient incentive to set margins appropriately. And the SEC could always step in later, Duffie said.

ALL-TO-ALL

In March 2020, dealers were hitting capacity in terms of their ability to handle Treasury transactions. Market-wide centralclearing would have lowered dealers' daily settlement obligations by as much as 70% when trading was at its highest in March 2020, according to a New York Fed analysis, Duffie said. "They’ll have less loading on their balance sheets, so they’ll have more remaining capacity to handle a surge of trading demands in a stress situation."

And if central clearing is done well, trade platform operators could set up some all-to-all trades so investors would not have to rely on large dealers to handle all trades, "a safety valve in terms of the resilience of the market," he added.

"I’m not 100% confident that all-to-all trade will come quickly or take a significant share of trade. But it’s an opportunity for trade platform operators to compete for the provision of liquidity to the market," Duffie said.