US Treasury market braces for overhaul as vote on clearing looms

By Laura Matthews and Carolina Mandl

NEW YORK (Reuters) – U.S. Treasury market participants hope the securities regulator will heed pleas for a careful phase-in of a rule it is due to finalize on Wednesday that would force more central clearing of transactions in a seismic overhaul of the $26 trillion market.

The top five Securities and Exchange Commission (SEC) officials are scheduled to vote at 10:00 a.m. ET on the rule. It was proposed over a year ago in a broad effort to boost Treasury market resilience during liquidity crunches, when buyers and sellers find it hard to complete transactions.

If adopted, the reforms would mark the most significant changes to the world’s largest bond market, a global benchmark for assets, in decades.

“This is going to significantly change the Treasury market landscape,” said Angelo Manolatos, macro strategist at Wells Fargo Securities, citing “a lot of costs.”

The rule could also potentially increase systemic risks by concentrating risk in the clearing house, he added.

A central clearer acts as the buyer to every seller, and seller to every buyer. Overall, just 13% of Treasury cash transactions are centrally cleared, according to estimates in a 2021 Treasury Department report, referring to the outright purchase and sale of those securities.

The draft rule, which applied to cash Treasury and repurchase agreements, was partly aimed at reining in debt-fueled bets by hedge funds and proprietary trading firms. These firms have accounted for a growing chunk of the market over the past decade but are lightly regulated, allowing few insights into their activities.

Many details about the final rule remain unknown, including the effective date, whether it would be adopted in phases, the scope of instruments, and parties included.

Advocates for central clearing, including the SEC, say the rule makes markets safer, while critics say it adds costs and are concerned about the possibility of a hurried phase-in.

“It is critical that policymakers do not blindly tinker with (the Treasury market’s) underpinnings,” wrote Jennifer Han, head of Global Regulatory Affairs at the Managed Funds Association in a Dec. 4 letter.

The MFA stressed the market infrastructure needs to be more fully developed and recommended improving the way clients access clearing.

Hedge fund and market maker Citadel said in a comment letter that the clearing requirement for cash transactions should be expanded beyond hedge funds to include a broader range of investors, leveling the playing field.

Another key issue is whether the SEC will require minimum “haircuts” on collateral pledged against trades, which would raise trading costs and potentially reduce market liquidity. A haircut is a percentage deduction from the collateral value.

Industry practice suggests that a large share of hedge funds trading in repo markets put up no haircut, suggesting that they are fueling activity using enormous amounts of cheap debt.

The Depository Trust and Clearing Corporation’s (DTCC) FICC subsidiary clears Treasuries and could be tasked to come up with rules.

“The implementation timeline is quite important,” said Gennadiy Goldberg, head of US rates strategy at TD Securities USA. “And what are the haircuts? Those are the two big questions that the market is going to be asking.”

STEADYING THE MARKET

The rule is part of a series of reforms designed to boost Treasury market resilience following liquidity crunches. In March 2020, for example, liquidity all but evaporated as COVID-19 pandemic fears gripped investors.

“While central clearing does not eliminate all risk, it certainly does lower it,” said SEC Chair Gary Gensler in the 2022 press release announcing the proposed rule.

The DTCC said in a comment letter that during times of market stress, market participants submit a greater volume of transactions for clearing to limit their credit risk.

Jason Williams, director of U.S. rates research at Citi, said there were pros in having additional margin in the system but balancing that are higher costs.

“It’s going to be an interesting juggling act,” he added.

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