Is a Treasury Clearing Mandate the Path to Increased Central Clearing?
Following stresses in the market for U.S. Treasury securities in March 2020, several observers suggested that increased central clearing of Treasury transactions could help the market function better and called for investigating the costs and benefits of a clearing mandate. This post examines more basic questions: Would structural changes to the market be required to increase central clearing of Treasuries? And what mechanisms, voluntary or mandatory, could result in increased clearing? We argue that the effectiveness of a clearing mandate is unclear absent broad changes in the design of the Treasury market. Additionally, we argue that the changes in the design of the Treasury market necessary to facilitate a clearing mandate could increase clearing even without a mandate. Analysis of the costs and benefits of expanded clearing therefore needs to consider the specific costs and benefits of these broader changes.
What is central clearing and why might it help the Treasury market?
Central clearing is a method used to reduce and manage risk in financial markets. For example, in the Treasury market, it is conventional for cash and securities to change hands one business day after the trade is agreed to. Although this convention has a range of benefits for market functioning, it introduces the possibility that a participant will not hand over money or securities when due. With central clearing, a clearinghouse or central counterparty (CCP) steps into the middle of transactions and ensures their completion.
As discussed, for example, by Robert Steigerwald, central clearing offers a number of benefits to post-trade risk management and operations that can enhance the functioning of cash securities and derivatives markets. Central clearing can mitigate counterparty credit risk by guaranteeing positions and can simplify the operational and legal complexities of transactions.
In addition, a CCP can net out offsetting obligations and reduce the total amounts of money and securities that must change hands. For example, suppose that at 9 a.m. Monday, Ava agrees to sell a certain Treasury bond to Bill for $100; at 10 a.m., Bill agrees to sell the same bond to Carlos for $100; and at 11 a.m., Carlos agrees to sell the very same bond to Ava for $100. Without a CCP, when it comes time to settle the transactions on Tuesday, the bond must be passed in a circle from Ava to Bill to Carlos and back to Ava, and the $100 must move around the circle in the opposite direction. But if all of the transactions are submitted to a CCP, the CCP can calculate that the settlements cancel out and that, on net, Ava, Bill, and Carlos don’t need to make any payments at all. Even with more complicated trading patterns, netting at a CCP typically greatly reduces the cash flows needed in financial markets.
Only some Treasury transactions are currently centrally cleared and receive these benefits. (We focus here on outright purchases and sales, not on the collateralized financing transactions known as repurchase agreements or repos.) The market for Treasury securities effectively has two segments, one segment that trades bilaterally and one segment that trades through platforms operated by interdealer brokers (IDBs). The bilateral segment typically involves securities dealers trading Treasuries with their customers, such as investment managers or other institutional investors. These trades are generally cleared and settled bilaterally, without a CCP. In the other market segment, securities dealers as well as specialized “principal trading firms” (PTFs) that trade for their own accounts transact with each other on IDB platforms. Each transaction at an IDB is split into two pieces: a leg between the buyer and the IDB and a leg between the IDB and the seller. If the buyer or seller is a dealer, the respective leg is centrally cleared through a CCP, the Fixed Income Clearing Corp. (FICC). Transaction legs involving PTFs are generally cleared and settled bilaterally.
Observers including Darrell Duffie and Nellie Liang and Pat Parkinson as well as FICC have suggested four main reasons that a clearing mandate or expanded clearing could make the Treasury market more robust. First, if transactions with customers or PTFs were cleared, these transactions could be netted at the CCP against one another and against the interdealer trades that are already cleared. As dealers may hold capital against unsettled trades or take other steps to manage risks associated with them, increased netting might free up space on dealers’ balance sheets for additional trades that could help keep the market liquid. Indeed, Michael Fleming and Frank Keane calculate that universal central clearing of outright trades would have reduced dealers’ daily settlement obligations by nearly $800 billion, or 70%, at the height of the March 2020 stress. (However, dealers may not always hold capital against typical unsettled outright Treasury trades.) Second, expanded clearing could reduce the number of transactions that fail to settle on time, by eliminating chain reactions in which Ava’s failure to deliver a bond to Bill leaves Bill unable to deliver to Carlos and so on. Third, if traders knew that a transaction would be centrally cleared, they might be less concerned with the reliability of the counterparty to the deal, which might support broader “all-to-all,” anonymous trading similar to that on stock exchanges, in contrast to the current system where customers typically trade with their own dealers. (However, the swaps market has not broadly adopted anonymous trading despite the establishment of a clearing mandate in that market after the Global Financial Crisis of 2008.) Finally, broader central clearing could enhance and standardize risk management.
Can more trades be centrally cleared with the market’s current structure?
Expanding central clearing while retaining the market’s existing structure, including how trading occurs and the relationship between dealers and their clients, could be challenging. To understand why this is, we first have to examine how CCPs interact with market participants.
CCPs clear trades only for their members, which are firms that meet stringent risk-management standards, such as capital requirements, operational capacity, and the commitment to share in certain losses if another member defaults. Membership requirements are an important part of a CCP’s tools for guaranteeing the completion of trades, as it would be difficult for a CCP to ensure the performance of traders that do not meet its risk management standards.
All significant dealers and IDBs in the Treasury market are members of FICC, whose rules require its members to submit trades with other members for central clearing. Thus, Treasury trades between two dealers that are FICC members or between a FICC member dealer and an IDB are centrally cleared. Other important market participants, notably major PTFs, are not members of FICC; as discussed above, transactions with these participants on one side are not centrally cleared.
Market participants may choose not to join FICC for a variety of reasons. Some may not meet the membership requirements, which are designed to ensure that members can meet their risk management obligations to FICC. Other market participants may prefer not to develop and maintain the operational capabilities to clear and settle trades at FICC, instead relying on dealers to provide those services. A subset of market participants, such as certain money market funds, face legal obstacles to joining FICC because they are prohibited from mutualizing losses from other clearing members in the way that FICC rules currently require.
Although central clearing could be expanded by requiring certain market participants to become FICC members, such a requirement could also drive some participants to exit the market if they were unable or unwilling to meet the membership standards and obligations. FICC could change the risk management obligations that deter membership; however, any decrease in those standards could be highly problematic and unlikely to be approved by regulators. Centrally clearing all Treasury trades would therefore likely require finding ways to centrally clear more trades by non-members.
Instead of joining FICC, non-members can centrally clear their trades by finding a member who will take responsibility for the transactions and submit them for clearing through FICC’s Prime Broker or Correspondent Clearing services. Although FICC rules allow this process for non-member trades, in practice it is used only on a limited basis because submitting typical non-member trades would offer limited benefits. As one of us discussed in recent research, if a dealer were to buy a security from its own customer and submit this transaction to FICC, there would be no effect on the dealer’s net position at, obligations to, or guarantees from FICC, nor on the amount of trades that are, in fact, centrally cleared. The reason is that FICC nets members’ trades for their own accounts against trades by the members’ customers, so the dealer’s and customer’s sides of the trade would cancel out in the netting process. For example, if Ava, a customer, sold a Treasury bond to a dealer for $100, clearing this transaction through FICC would theoretically require four steps (before netting takes place): 1) the dealer would give $100 to FICC; 2) the dealer would obtain the bond from Ava and give it to FICC; 3) FICC would return the $100 to the dealer, but for credit to Ava rather than for the dealer’s own benefit; and 4) FICC would give the bond to the dealer. FICC’s netting process would net out all four of these steps, with the end result that the dealer would not send or receive money or securities to or from FICC, as illustrated in table 1. That is, the flows from the dealer to the CCP would exactly cancel out the flows from the CCP to the dealer. The same would be true if an IDB submitted its own trade with a PTF. Thus, a mandate for members to submit their trades with non-members to FICC for clearing would not, on its own, increase the amount of centrally cleared trades; broader changes in market design would be needed.
Table 1: Netting of a dealer-to-customer trade if passed through FICC
| Item | Securities from dealer to FICC | Securities from FICC to dealer | Cash from dealer to FICC | Cash from FICC to dealer |
|---|---|---|---|---|
| Payment of purchase price (by dealer) | $100 | |||
| Delivery of bond (by dealer on behalf of customer) | 1 | |||
| Receipt of purchase price (by dealer, for credit to customer) | $100 | |||
| Receipt of bond (by dealer) | 1 | |||
| Total | 1 | 1 | $100 | $100 |
| Net | 0 | 0 | $0 | $0 |
What changes could increase clearing?
While a variety of broader changes in institutions and market structure could increase the amount of clearing, this analysis evaluates two such changes. These changes could result in additional voluntary clearing or could be paired with mandatory clearing requirements. First, the client clearing model of the futures or options market could be implemented at FICC. Second, trading venues could be created in which FICC non-members trade directly with other non-members, without involving a dealer or interdealer broker as principal to the transaction. Both of these possibilities could have costs as well as benefits.
Adapt clearing and segregation model of other markets: CCPs in some other markets, such as futures, options, and swaps, do not net members’ trades for their own accounts against trades for members’ customers. Adopting this type of model in the Treasury market would require significant changes in the market’s structure and regulation. In particular, Securities and Exchange Commission customer protection regulations would need to be modified to allow dealers to post customer assets to FICC as collateral for customers’ obligations. The costs and benefits of any such change would need to be weighed carefully.
If members’ “house” positions were segregated from their customers’ positions, then submitting a dealer-to-customer trade for clearing would change the dealer’s net position at the CCP. Table 2 illustrates how a dealer-to-customer trade would be accounted for at FICC if, contrary to current rules, FICC segregated dealers’ house and customer positions. It may appear at first that separating house and customer positions means there is less netting and clearing, not more, since the two sides of the dealer’s trade with its customer no longer cancel out on the dealer’s books. However, once a dealer’s house and customer trades are separated, the dealer’s position vis-à-vis its customer can be netted against the dealer’s position vis-à-vis other dealers, which was not possible previously. Separating house and customer positions at FICC would therefore allow for centrally clearing more Treasury trades whether dealers voluntarily submitted dealer-to-customer trades or were required to do so. Recent research by one of us finds that a transition to segregated clearing of customer securities trades would have a wide range of costs, primarily from increasing the amount of assets needed as collateral at the CCP, as well as benefits, primarily from requiring customers to more directly bear the cost of risk management for their trades.
A related approach would be an expansion of FICC’s sponsored membership program, which allows non-members to transact through FICC under the umbrella of a guarantee provided by a FICC member. The transactions of a sponsored participant are segregated from those of the member that is its sponsor. Sponsored membership is currently used largely for repurchase agreements, which are short-term financing transactions, rather than outright purchases and sales of securities. In addition, sponsored membership is currently available only to firms managing substantial amounts of assets. It might be possible to expand the sponsored membership program to include more outright purchases and sales and more market participants. However, because sponsored clearing requires FICC members to sponsor firms and FICC members may not be willing to expand their sponsorship to capture all trading, mandatory clearing with a sponsored membership approach would risk shutting out certain segments of the current market from trading. This could be addressed by limiting the scope of a clearing mandate, but would need careful consideration.
Table 2: Netting of a dealer-to-customer trade if FICC changed its rules to segregate dealer and customer accounts
| Item | Securities from dealer to FICC | Securities from FICC to dealer | Cash from dealer to FICC | Cash from FICC to dealer |
|---|---|---|---|---|
| Dealer’s house account | ||||
| Payment of purchase price | $100 | |||
| Receipt of bond | 1 | |||
| Total | 1 | $100 | ||
| Net | 1 | $100 | ||
| Dealer’s customer account | ||||
| Delivery of bond | 1 | |||
| Receipt of purchase price | $100 | |||
| Total | 1 | $100 | ||
| Net | 1 | $100 | ||
Expand all-to-all trading platforms that link directly to a CCP: In the stock market, all-to-all trading is commonplace, and essentially all trades are centrally cleared at a CCP, the National Securities Clearing Corp., even though the market has no clearing mandate. Dealers and non-dealers commonly trade stocks with each other on stock exchanges, which automatically submit trades for clearing. If market participants were able to transact on anonymous Treasury trading venues linked to FICC in the same way that they can transact on stock exchanges, a significant expansion of central clearing could be achieved. To settle such trades, the seller’s dealer would need to collect the securities from the selling customer and deliver them to the buyer’s dealer, while the buyer’s dealer would need to collect the cash from the buying customer and deliver it to the seller’s dealer. As a result, there would be an obligation between the two dealers that would be cleared at FICC. The model of an exchange linking directly to clearing could thus both facilitate growth of all-to-all trading in the Treasury market and produce more centrally cleared trades, even without a clearing mandate.
All-to-all trading would be a substantial change from the current market structure in which customers trade with their own dealers. (The Treasury market’s nearest equivalents to stock exchanges are IDBs’ electronic trading platforms, but these differ from exchanges because IDBs stand as principals to all transactions on their platforms, creating uncleared trades whenever a FICC non-member transacts. Additionally, as principals, IDBs limit their users’ trading, which may affect market participants’ ability to scale up trading in response to market volatility.) As such, all-to-all trading would likely affect market liquidity and pricing in a variety of ways. These effects would depend on what regulations governed the trading venues and the CCP. In addition, as one of us discussed in recent research on clearing of stock trades, all-to-all trading without segregation of customer positions at the CCP can create large liquidity demands on dealers.
Conclusion
The two possible approaches described here demonstrate that expansion of Treasury clearing is not impossible. Other approaches may also exist. Regardless of the approach, however, expansion is not as simple as merely mandating clearing and would likely require significant adjustments in overall market structure and regulatory approach. These adjustments carry a wide range of additional benefits and costs beyond the direct effect of clearing more trades at a CCP and fewer trades bilaterally. For example, such changes could affect the cash demands on dealers and other market participants and other implicit and explicit costs of trading. Moreover, market structure changes could organically increase the amount of clearing even without a mandate, as has been the case in the Treasury repo market with the growth of sponsored activity. The costs and benefits of broader central clearing in the cash Treasury market therefore depend on the specific method used to increase the amount of clearing.
Note
Marta Chaffee is senior associate director in the Division of Reserve Bank Operations and Payment Systems at the Board of Governors of the Federal Reserve System. Sam Schulhofer-Wohl is senior vice president and director of financial policy and outreach at the Federal Reserve Bank of Chicago.
