MNI: US Treasury Clearing To Limit Contagion, Create New Risks

A plan to vastly increase central clearing of U.S. Treasuries and repos will make markets safer but more expensive to participants, as well as potentially creating a new concentration of risk, current and former Federal Reserve economists, market participants and their advisers told MNI.

The proposal by the Securities and Exchange Commission would lessen the chances of contagion from failed trades and improve overall market resilience, and support a move to "all-to-all" trading where investors like pension funds and mutual funds can transact directly with each other without relying on big banks.

But it will do little to improve declining Treasury market liquidity, a key concern for the global financial system -- while potentially creating new problems by concentrating risk in clearinghouses.

"How do we get to better liquidity? There are lots of pieces to that, and better risk management is one of them," said Sam Schulhofer-Wohl, senior adviser to the president of the Federal Reserve Bank of Dallas and author of several papers on central clearing. "You want the liquidity itself to be resilient. Central clearing enhances risk management to make the market more resilient overall."

The Treasury market has been "long overdue" structural changes to make it easier to trade in higher volumes, said former Boston Fed President Eric Rosengren. "We probably need to find ways to expedite the process," he said.

LIQUIDITY CONCERNS

The New York Fed will gather stakeholders this week to discuss central clearing and other Treasury market topics after the SEC issued draft rules in September that would mandate central clearing for big banks' repo and cash trades, including those with hedge funds whose heavy selling contributed to March 2020 market turmoil.

The proposal has met with pushback over its ambitious scope -- it would extend clearing to roughly half of Treasury trades from an estimated 13% now -- and higher costs, which could chase smaller hedge funds out of the market, resulting in fewer providers of liquidity. A number of proprietary trading firms may also face new requirements under separate SEC proposals to register as exchanges or dealers, another costly step.

Central clearing also concentrates settlement risk. The default of a big member could cause the clearinghouse to raise margin requirements, exacerbating liquidity crunches in a crisis.

"There are some advantages of clearing. I just think it’s not a solution to improving liquidity," said Priya Misra, global head of rates strategy at TD Securities and a member of the Fed's Treasury Market Practices Group. "It prevents a type of crisis in the future but could lead to something else -- some other crisis.”

RESHAPING COMPETITION

Regulators hope central clearing will ultimately improve liquidity by increasing the diversity of market participants or reshaping competition among them by shifting the advantage "from those that have big balance sheets to those that have smaller balance sheets," SEC Chair Gary Gensler said last month.

Much as the post-financial crisis Dodd-Frank law mandated central clearing of swaps, central clearing of Treasuries "is a net positive add to the market," said Ryan Sheftel, global head of fixed income at GTS, a quantitative trading firm, and another member of the Treasury Market Practices Group. "Dodd-Frank saved the derivatives market. It’s smart to realize that we may not have had a blow-up event around Treasuries in 2008, but a lot of the problems caused in other markets could very easily affect the Treasury market going forward."

The derivatives market is "thriving" as a result of post-crisis changes around transparency and central clearing, which also allowed nonbank firms like Citadel to emerge as top market makers in an arena long dominated by big banks, Sheftel said.