Banks, broker-dealers, asset managers and other participants in the US Treasury market are scrambling to comply with a regulatory mandate to step up their use of central clearing.
Clearing will be mandatory for a broad swathe of market participants in both the cash and the repo markets, and the deadlines are approaching – December 2026 for trading in Treasury securities and June 2027 for repurchase transactions.
Today, roughly one fifth of the market’s trading volume is cleared through the Fixed Income Clearing Corporation, the only clearinghouse that currently offers clearing for the US Treasury market. The rest of the market relies on the bilateral model for trading, and many participants have little familiarity with the operational, financial and technological requirements of central clearing.
The adoption of central clearing, therefore, will require market participants to implement a host of changes to their processes, systems and counterparty relationships. Making matters more complicated, two other clearinghouses – CME Clearing and ICE Clear Credit – are preparing to offer clearing for the Treasury market, and each one of the three clearinghouses intends to offer several access models.
The road ahead
For the regulators, the goal is to make the US Treasury market more resilient in case of a shock. Senior officials at the Federal Reserve and the Treasury Department have been concerned for many years about the fragile nature of liquidity in the Treasury market, and they see central clearing as an important step in addressing that issue.
Michelle Neal, the former head of the markets group at the Federal Reserve Bank of New York, expressed that concern in an October 2024 speech given at a forum on Treasury and repo clearing organised by FIA. She explained that in today’s market, the clearance and settlement of trades is “fragmented” across many counterparties, and she emphasised the benefits of migrating more trades into central clearing. She also stressed the complexity of the transition, and she urged attendees to start taking concrete steps immediately.
“Market participants will need to ensure that they have robust risk management frameworks, legal agreements and operational infrastructures in place,” Neal said. “As we have observed with other complex industry transitions, such as the reference rate transition and the implementation of swaps central clearing, all of this takes time. Market participants should be taking concrete steps now to prepare for expanded central clearing in the Treasury market, and the New York Fed and others in the official sector will be monitoring this progress.”
Dodd-Frank redux? Not quite
In some respects, the transition to central clearing in the US Treasury market will be similar to what the derivatives markets went through a decade ago. After the financial crisis of 2008, the US Congress passed the Dodd-Frank Act. That law mandated central clearing for interest rate swaps and other over-the-counter derivatives. Implementing that clearing mandate also required a major overhaul of trading infrastructures and post trade workflows, given that most trades at that time were executed bilaterally between dealers and their clients.
It took time, but the transition to central clearing in the OTC derivatives market was achieved. According to the Bank for International Settlements, the global interest rate swap market moved from roughly one-third cleared in 2010 to roughly two-thirds cleared in 2017. Since then, the ratio has hovered around 80%.
This transition will differ significantly in several ways, however. For starters, there are three clearinghouses competing for a share of the market. Although competition can drive innovation and efficiency, it also makes the transition more complicated because market participants will need to evaluate all the available choices.
Adding to the complications, the SEC’s rules for Treasury clearing are not as prescriptive as the rules were for OTC derivatives clearing. Legal experts predict that this is likely to lead to more variation among the clearinghouses in how they implement the Treasury clearing mandate, and therefore more complexity for firms navigating the various options.
In addition, the cost of clearing may vary from one clearinghouse to another, which in turn will affect the cost of trading. Some market participants have speculated that could lead to the creation of separate order books, with different sets of prices and differing levels of liquidity depending on where a trade will be cleared.
“Done-away” trading – essential for PTFs
Second, there will be more variations in how clients access clearinghouses. In most other markets that have central clearing, the standard model is “agency clearing,” meaning that the clearinghouse member that clears the trade acts as an agent for the client. In the Treasury market, however, the majority of the clearing that happens today is done through “sponsored clearing.” In this type of model, the customer becomes a member of the clearinghouse but relies on one of the full members, typically one of the large dealer banks that it trades with, to sponsor its access.
Although the clearinghouses have not yet finalised their offerings, at least two of them – FICC and CME – have said that they plan to offer both access models.
A second important variation in access models relates to the execution of trades. Currently, most trades that are cleared at FICC are “done-with,” meaning that the counterparty to the trade is also the entity that clears the trade. In effect, this bundles clearing with execution, and the cost of clearing is typically embedded in the bid-ask spread.
In contrast, in other markets with central clearing, the market structure allows “done-away” trading. This model allows market participants to execute anonymously with many counterparties and then submit trades to a separate firm for clearing. All three clearinghouses eyeing the Treasury market – FICC, CME and ICE – are preparing to support this type of access model. The done-away model will be essential for one particularly important customer segment – the principal trading firms that provide liquidity to the market.
These firms account for roughly half of the trading volume in the interdealer segment of the cash Treasury market, which is the source of the liquidity that supports dealer-to-client trading. The PTFs will be required to clear those trades once the deadline arrives, and they say that the done-away model is essential for their continued participation in the market.
Moving to this model will require substantial changes in how the market operates. For example, the market will need new ways to connect customers, executing brokers and clearing firms so that trades can be submitted to clearinghouses no matter whether they are executed electronically or via voice. In addition, the clearing firms will need a way to set limits on the amount of risk they take on board and apply those limits before trades are executed.
A further complexity is that the segregation of customer funds is optional. In today’s Treasury market, there is no segregation of customer funds; customer collateral is mingled with the “house” account of the clearing member. That type of account structure has some advantages, and FICC plans to continue offering it. But it also has some disadvantages, and all three clearinghouses plan to offer various forms of customer fund segregation. The clearinghouse members will need to support both types of account structures, which will increase the operational complexity.
Clearing capacity
What the clearinghouses offer is only half the story, however. For central clearing to work, the clearinghouses need firms that are willing to enter the business of clearing trades for market participants.
There are more than 50 firms that provide this service in the US derivatives markets. But it is far from certain that these firms will add Treasury and repo transactions to their clearing business. Banks, in particular, are running into limits on the volume of trades they are willing to clear, mainly because the capital requirements put in place after the financial crisis of 2008 have made it more expensive to offer this service.
The swaps clearing landscape shows how the constraints on banks have limited the capacity for clearing. Only 15 firms are currently clearing swaps for clients in the US, and the top five have 75% of the market.
Clearing firm executives are now trying to determine if the economics of Treasury clearing justify a commitment to the business. Part of the challenge is capital rules include provisions that recognise the risk-reducing effects of netting across derivatives, but not for netting sets that include both cash Treasurys and derivatives. Clearing firm executives have warned that without some relief from the banking regulators, banks will hesitate to make a big commitment to this new line of business.
On the other hand, the adoption of central clearing could pave the way for a significant reduction in margin requirements for customers that trade both futures and cash. CME and FICC have an agreement in place that allows for cross-margining, meaning that Treasury futures cleared at CME can be combined with Treasury securities cleared at FICC for the purpose of calculating margin.
At present, that programme is only available for firms that are members of both clearinghouses, but the changes that FICC is making to its rules – the introduction of customer fund segregation in particular – will make it possible to extend the benefits of cross margining to customers such as hedge funds.
Heavy lift
Market participants are scrambling to assess their options and determine what steps they will need to take. Those steps include establishing relationships with clearing members, working out what type of account structures work best for their needs, and setting up the systems necessary to calculate margin requirements and post collateral within the timeframes set by the clearinghouses.
Equally important, firms that are planning to offer clearing services need to develop the systems necessary to route trades from execution into clearing, set limits on the amount of risk they are willing to take, collect and post margin at the clearinghouses and manage all the other post-trade processes involved in central clearing.
Several industry trade associations have formed working groups to accelerate the preparations. For example, the Securities Industry and Financial Markets Association, the main trade association for broker-dealers, has issued a 100-page report on the various considerations and activities that market participants should use as they prepare for Treasury and repo clearing. SIFMA also has drafted model documentation for done-with relationships and is working on similar documentation for the done-away model.
Higher cost of trading
What will be the long-term impact of the clearing mandate? With so many uncertainties about how the mandate will be implemented, it is difficult to know for certain. At this point, however, the market is expecting the cost of trading to increase. That was the finding from a 2024 survey conducted by Coalition Greenwich, a consulting and market intelligence firm. The survey, conducted in the second quarter of 2024, found that 72% of the respondents expected the cost of trading Treasury securities to increase, and 53% expected the number of participants in the market to decrease.
With respect to the purpose of the clearing mandate, a clear majority expected the Treasury market to become more resilient and less prone to systemic risk – the outcome desired by the regulators. With respect to the impact on liquidity, however, opinions were mixed – 41% expected liquidity to rise, 38% expected it to fall, and 21% expected no change.
