Chicago Fed Insights

Eighth Annual Central Counterparties Risk Management Conference—A Summary

January 31, 2022

On October 19, 2021, the Financial Markets Group of the Federal Reserve Bank of Chicago hosted its eighth annual Central Counterparties (CCP) Risk Management conference. The conference opened and concluded with remarks from Alessandro Cocco, vice president and head of the Chicago Fed’s Financial Markets Group. The event featured a panel on the U.S. Treasury market structure that was moderated by Ketan Patel, policy advisor and head of financial markets risk analysis, Financial Markets Group, and a fireside chat with Commissioner Allison Herren Lee of the U.S. Securities and Exchange Commission (SEC) and Maggie Sklar, senior policy advisor and director of international engagement, Financial Markets Group. This blog post summarizes the discussions.

The panel on the U.S. Treasury market structure featured five experts from central counterparties, banks, and a proprietary trading firm. This event was held under the Chatham House Rule to encourage an open and candid discussion; as a result, a recording of the event is not available. However, a summary is provided below. Our conversation with SEC Commissioner Allison Herren Lee is publicly available, and we encourage you to watch the entire fireside chat on our website.

U.S. Treasury market structure

The panel discussion among our five panelists produced some consensus and some nuanced debate on the following topics: the Federal Reserve’s standing repo facility, supplementary leverage ratio (SLR) constraints, viable options to access clearing, cross-margining structure, and making the Treasury market more resilient.

The conversation began with the Federal Reserve’s standing repo facility. A panelist stated that markets welcomed the expansion of the facility beyond primary dealers to depository institutions. This panelist also noted that adding additional counterparties with access to the Federal Reserve repo facility would provide enhanced liquidity to the Treasury market. The conversation on this topic ended with an acknowledgement among speakers that independent broker-dealers believe they should be added to the list of counterparties that can access the facility.

The next topic the panel touched on was SLR constraints. The SLR measures tier 1 capital of a bank, primarily common stock and preferred stock, relative to that bank’s total leverage exposure, which includes on-balance-sheet assets, such as loans, securities (including Treasury securities) and reserves, and off-balance-sheet exposures, such as certain aspects of derivatives and repo contracts. In April 2020, the Federal Reserve Board temporarily modified the SLR calculation to exclude U.S. Treasury securities and central bank reserves to ease strains in the Treasury market resulting from the Covid-19 pandemic and promote lending to households and businesses. This temporary modification expired in March 2021. There was widespread acknowledgement among panelists that the SLR is constraining dealers’ balance sheets and having a negative impact on their commitment to the Treasury market, and that the exclusion of central bank reserves and Treasury securities from SLR calculations granted in April 2020 is what helped ease pressure on dealer balance sheets and increased dealers’ intermediation capacity in the Treasury market. One panelist pointed out that since 2007, Treasury securities as a share of primary dealers’ balance sheet have been constant but the Treasury market itself has expanded, reducing the primary dealer’s overall share in this market. Some panelists advocated for permanently excluding central bank reserves from SLR calculations to expand dealer intermediation capacity in the Treasury market.

The panel then turned to a discussion on the multiple viable options for various market participants to access clearing. A panelist noted that there is not one single method for clearing and that clearing could be done directly with CCP membership for broker-dealers or through client clearing solutions for end-users. This panelist also added that for client clearing solutions, a closer look at the clearing structure would be needed to ensure a viable model exists before a mandate to clear were introduced. Such a mandate has already been proposed and was one of the topics discussed among the panelists during this part of the panel. Turning to risks that come with additional clearing, a panelist laid out two major concerns: Concentration of risk in CCPs and the need to consider the increased cost of clearing for end-users. A different panelist argued that to manage additional clearing risks, the market structure for U.S. Treasury securities needs to resemble that of the derivatives market, where a client’s margin can be transferred over to CCPs to ensure appropriate collateral exists. Under current SEC Rule 15C3-3, broker-dealer members of CCPs cannot post client margin deposits to a CCP. The current exception to this rule has been the Options Clearing Corporation (OCC), as the SEC has permitted broker-dealers to pass margins received from clients to the OCC.

Throughout the session, conference participants were polled on the topics covered. Our first poll question asked: “Which structural change in clearing would constitute an incentive to clear U.S. Treasury trades?” Of the 30 people who responded, 50% answered, “Adjustments to client access models to clear;” 37% answered, “improved cross-margining arrangements for cash, repo, and futures trades;” and 13% answered, “changes to broker capital rules to allow for client margin on securities trades to be posted to the CCP.”

Later, the conversation turned to the cross-margin structure. Margin is the amount of collateral in cash or liquid securities that a trader or investor must have in their portfolio to enter a position. A trader or investor may have separate portfolios with offsetting positions at different CCPs. The practice of cross-margining allows a trader or investor to combine portfolios with offsetting positions to reduce the amount of total margin owed. Thus, a cross-margin structure allows greater capital flexibility, as the total margin owed from combined portfolios with offsetting positions will likely be smaller than the total margin owed from separate portfolios. As a result of this benefit, the Fixed Income Clearing Corporation (FICC) and the Chicago Mercantile Exchange (CME) are working on a cross-margin arrangement that would more accurately reflect the overall risk position of a market participant across different CCPs. Depending on the makeup of a market participant’s portfolio, this arrangement to enhance the existing cross-margin structure may have a positive impact on the cost of clearing, as a market participant’s position at one CCP could be offset by a position held by that same market participant at another CCP. Furthermore, FICC is exploring a customer level cross-margining structure for customers who might want to clear their transactions, either as direct members or as clients of direct members.

Before heading into a discussion of all-to-all trading, we asked participants: “All-to-all trading for U.S. Treasury securities is…?” Of the 30 people who responded to this question, 70% answered, “only practical if coupled with clearing;” 20% answered, “most practical if focused on the more liquid securities;” and 10% answered, “not needed.”

Finally, the panelists discussed what is required to make the Treasury market more resilient. The conversation focused on all-to-all trading and whether it should be a feature of the Treasury market. In an all-to-all trading system, market participants of all types would be able to trade directly with each other rather than trading solely with broker-dealers. One panelist stated that all-to-all trading is not needed for U.S. Treasury markets due to lack of demand from clients. This panelist also expressed that the comparison between the U.S. corporate bond market and the U.S. Treasury market is misleading, as the corporate bond market lends itself more easily to all-to-all trading. In the corporate bond market, approximately 16,000 securities trade daily, while in the U.S. Treasury market only about 200 securities trade daily. In the credit markets, due to the number of securities actively trading, buyers and sellers can interact using an all-to-all protocol and settle on a price for the security, based on factors such as supply and demand and publicly available information.

Prior to concluding the panel discussion, we asked our final poll question: “Which change, or enhancement could have the most beneficial impact on U.S. Treasury market structure?” Of the 31 people who responded to this question, 13% answered, “increase access to standby Federal Reserve repo facilities;” 32% answered, “adjustments to SLR treatment of reserves and U.S. Treasuries held by banks;” 23% answered, “clearing mandate for cash and repos transactions;” 23% answered, “requirements to trade U.S. treasuries on all-to-all trading platforms;” 6% answered, “other changes;” and one person answered, “no major changes are required.” Given the dispersion of views among those who answered the poll question, attendees expressed different views regarding which solution would have the most impact on the U.S. Treasury market structure.

Fireside chat with Commissioner Allison Herren Lee

Our conference ended with a fireside chat with Commissioner Lee. The fireside chat focused on a broad list of topics that have affected financial markets over the past 18 months, including retail trading, Treasury markets, cryptocurrency, swaps, and diversity. On retail trading, Lee acknowledged that there is an increase in the number and nature of retail participation and that a growing number of firms are using mobile investing apps to interact with retail investors. She added that the SEC needs to take a closer look at customer order handling practices and broker conflicts of interest. Speaking about the Treasury market, Lee said that regulators should consider expanding central clearing into the Treasury market as it can provide clear benefits, reduce risks, increase transparency, and facilitate liquidity. Turing to cryptocurrency, she noted that digital assets raise several issues, but unequivocally, they provide less investor protection and less oversight than traditional securities markets. Lee said that while certain issues are beyond the SEC’s purview, the digital asset space more broadly includes securities, making it important for the SEC to work closely with fellow regulators. Lee also stated that the SEC needs to finish their Title VII Dodd Frank rules but that they have already added provisions for the registration and regulation of swap execution facilities. Finally, Lee and Sklar talked about the need to improve diversity and inclusion in U.S. financial markets. Lee noted that fundamental fairness is crucial for investors, markets, and the economy, as it allows our country to tap into all its resources and fully compete on a global stage.

A video of the fireside chat is available on our website.

The views expressed in this post are our own and do not reflect those of the Federal Reserve Bank of Chicago or the Federal Reserve System.

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