The U.S. Treasury market is the deepest and most liquid in the world, dwarfing every other in size. The Depository Trust & Clearing Corporation (DTCC) has long advocated for the greater use of central clearing of U.S. Treasuries through DTCC’s subsidiary, Fixed Income Clearing Corporation (FICC). As the primary CCP for U.S. Treasury securities, FICC has the established infrastructure for supporting this activity and maintaining the market's safety, soundness and resiliency.
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We believe the adoption of a centralized clearing model would cut risk and improve resiliency, which is critical to the strength and stability of the entire U.S. economy. DTCC produced two white papers in 2021, both of which have generated significant discussion among clients, regulators, and the industry this year. In our first white paper, published in May, we discussed first how central clearing can limit default risk and enable smoother functioning and transparent markets. In a follow-up white paper in October, we expanded on how FICC’s long-standing “open-access” approach can provide the flexibility necessary to allow a wide variety of market participants access to central clearing – all while also ensuring impartiality and fairness.
More Clearing, Less Risk
Central clearing in the U.S. Treasury market evolved organically over the past four decades as the industry sought to improve the safety and soundness of the market, streamline the processes for clearance and settlement of U.S. government securities transactions and mitigate the risks associated with the failure of one or more major firms. FICC, designated as “systemically important,” pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), is regulated by the U.S. Securities and Exchange Commission, and, under Dodd-Frank, the Board of Governors of the Federal Reserve System also has certain oversight authority.
FICC offers a suite of services for the submission, comparison, risk management, netting and settlement of trades executed by our members in the U.S. government securities market. FICC also provides a guaranty of settlement of all compared trades and serves as the central counterparty (CCP) for the settlement obligations it novates. On an average day, FICC clears over $4.2 trillion in U.S. Treasury activity, including both outright and financing. Securities transactions processed by the GSD include Treasury bills, bonds, notes, zero-coupon securities, fixed rate government agency securities and inflation-indexed Treasury securities as well as agency mortgage-backed securities in our General Collateral Finance Repo (GCF Repo®) service. In 2020, FICC’s GSD processed more than $1.5 quadrillion in transactions.
Greater use of central clearing in the U.S. Treasury market provides the following benefits:
- Reducing counterparty credit risk by replacing the original parties to each trade with a central counterparty (CCP) that is subject to comprehensive regulation.
- Reducing settlement risk by netting across all CCP members so that each member has a single delivery or payment obligation.
- Limiting the ability of sudden market movements to cause a default by collecting margin twice daily (or more frequently as needed) through standardized processing.
- Reducing the risk of market disorder and fire sales by centralizing responsibility for liquidating a defaulting member’s positions in a single organization.
- Enhancing market access and increasing market liquidity by reducing the capital needed to engage in U.S. Treasury market activity.
- Enhancing the ability of smaller banks and independent dealers to compete through direct CCP membership.
FICC’S OPEN ACCESS APPROACH TO CLIENT CLEARING IS DESIGNED TO PROMOTE THE AVAILABILITY OF CENTRAL CLEARING SERVICES TO THE DIVERSE ARRAY OF PARTICIPANTS IN THE U.S. TREASURY MARKET."
The “Open Access” Model
Market volatility can happen, but we were all surprised by the unexpected volatility early in the pandemic in March 2020, when clearing volumes in U.S. Treasury activity in FICC soared to over $6 trillion daily, an almost 43% increase over the usual daily average. FICC effectively maintained orderly processing and settlement throughout the volatility, and even the decision to cease to act for a member at the height of the crisis did not result in an adverse market impact nor any loss allocation to members. Considering the increasingly broad consensus on the benefits of increased central clearing of U.S. Treasury transactions, the focus now turns from whether to adopt a clearing mandate to how to implement such a mandate.
Unlike many derivatives clearing organizations, FICC does not have a vertically integrated proprietary exchange. Rather, FICC offers an “open-access” model in which it accepts for clearing eligible transactions executed by its members through multiple trading modalities. FICC’s open access approach to client clearing is designed to promote the availability of central clearing services to the diverse array of participants in the U.S. Treasury market. FICC offers a variety of client clearing models for U.S. Treasury cash and repo transactions, including correspondent clearing, prime broker clearing and Sponsored clearing (via FICC’s Sponsored Service), to allow market participants to select the model that best addresses their needs.
- Like the cleared swaps model, in FICC’s correspondent clearing and prime brokerage clearing models, the client does not have a legal relationship with FICC. FICC only has central counterparty obligations to the correspondent clearer or prime broker itself, as applicable, who is an FICC member. In light of this, FICC net margins the activity in the accounts of correspondent clearers and prime brokers, respectively.
Sponsored Members participating in FICC’s Sponsored Service, on the other hand, are members of FICC’s Government Securities Division (GSD) and upon novation of their U.S. Treasury transactions, FICC becomes obligated to such Sponsored Members. Recognizing that its central counterparty and guarantor obligations run to Sponsored Members as well as their Sponsoring Members, FICC gross margins Sponsored Member activity to ensure it is able to perform to individual Sponsored Members even in the event of their Sponsoring Member’s default.
While designed and developed at different times for different original use cases, each of FICC’s client clearing models can support both U.S. Treasury cash and repo transactions executed by a client either bilaterally or on an anonymous IDB platform. Each of FICC’s client clearing models can also support an arrangement where, after execution, the transaction is effectively “given up” to a clearing member that is different from the trading counterparty.
That said, FICC does not limit the ability of a member to be both a client’s counterparty and the client’s clearing member. In our view, any such limitations would threaten to shut out from the market important liquidity providers, while providing minimal benefits to the market. A host of considerations factor into whether and how a client and its clearing member access central clearing for U.S. Treasury cash and repo transactions through FICC, including:
- the business models and objectives of the client and its clearing member;
- the total costs of clearing to the clearing member and whether the client is willing and/or capable of reimbursing the clearing member for those costs; and,
- how much value the client and the clearing member would derive from having the client become a Sponsored Member and face off directly against FICC as its post-novation counterparty.
In certain cases, these factors will lead a client to becoming a Sponsored Member and enter into transactions strictly with its Sponsoring Members. Indeed, this is the only practical way for MMFs and many other heavily regulated buy-side participants in the U.S. Treasury market to access central clearing. These institutions elect to become Sponsored Members and trade exclusively with their Sponsoring Members, who are compensated for the costs of clearing their clients’ activity via their ability to make a spread on such trading activity. Based on FICC’s conversations with these MMFs and other market participants, it is not pressure from dealers that leads MMFs to adopt this model. Rather, many MMFs are represented by large money managers that have significant negotiating power, especially considering the substantial number of dealers that now operate as Sponsoring Members. Instead, MMFs elect to access clearing in this manner because any other kind of clearing arrangement, including any “give up” style clearing model, would likely require these firms to pay clearing fees that they are not permitted to pay and require that they post margin and satisfy mark-to-market and liquidity commitments, which would be challenging, if not impossible, for them from a regulatory and/or operational perspective.
Accordingly, prohibiting this model of clearing would not serve to increase access and fairness in the market, but, rather, would shut out an important segment of the market, with detrimental effects for those buy-side participants and the liquidity of the market more generally.
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The Road Ahead
As we approach the end of the year, we’re pleased with the ongoing progress of this initiative and the discussion it has generated. And notably, the experiences and the lessons learned from the unprecedented market volatility of the COVID-19 pandemic continue to provide insight into ways to make our financial services operations more efficient, transparent, and resilient.
U.S. Securities and Exchange Commission Chair Gary Gensler spoke about the risk-mitigating benefits of central clearing at a recent Fed conference, and FICC is well-positioned to support increased central clearing in the U.S. Treasury market given its open-access approach to central clearing. The task ahead of us is to work together to deploy solutions that can broaden participation in central clearing to best manage risk and improve efficiency and transparency in the U.S. Treasury market, and thus make greater adoption of central clearing in U.S. Treasuries a reality. We plan to continue our work with the industry to ensure that all firms looking to access clearing either on a voluntary, or potentially mandatory, basis can do so in an impartial and fair way.
This article originally appeared in the January 2022 edition of Thomson Reuters’ Futures and Derivatives Law Report.