After numerous episodes, monetary leaders have unveiled measures to fortify the U.S. Treasury market. The internals of the most systemically important market, already undergoing rapid change, will once again transform. The Treasury Market Evolutionâą is about to begin... 1/
In the mid-2000s, the complexity of the secondary Treasury market was almost nonexistent. Major dealers dominated volumes in the interdealer segment, where they traded among themselves, while distributing most of the liquidity to clients in the dealer-to-customer region...
But just as the market appeared to have peaked in sophistication, a new type of player emerged from the shadows: principal trading firms (PTFs), high-frequency traders seeking to profit through arbitrage while providing liquidity to dealers...
Upon developing a range of high-frequency trading algorithms, PTFs began to conquer interdealer markets â the largest segment by volume, taking market share from the most prominent players. A new age of complexity in the Treasury cash market was thus destined to emerge...
Before PTFs began to take over in the late 2000s, the interdealer market consisted mostly of the Fed's primary dealers and other dealers, the largest of which were all members of the FICC (Fixed Income Clearing Corporation), the sole central clearer (CCP) of U.S. Treasuries...
The majority of secondary market transactions involved dealers trading via the electronic platforms of interdealer brokers (IDBs), the major intermediaries in the interdealer market. As all parties were FICC members, most secondary market trades involved central clearing...
Though that was about to change. While gaining a large market share, PTFs did not meet the strict requirements needed to become FICC members, failing to gain direct access to central clearing. Subsequently, the first "centrally cleared era" of the Treasury market was ending...
The rise in the number of FICC non-members (PTFs, smaller dealers, and "buy-side firms" i.e. hedge funds) compared to FICC members (primary dealers, large dealers, banks, and IDBs) caused a surge in âbilateralâ trading...
Instead of centrally clearing through the FICC, these trades were cleared and settled through various entities, from clearing agents to the Federal Reserve and its Fedwire service...
This prompted a sharp decline in the share of centrally cleared trades, slowly reducing the marketâs exposure to FICC safeguards, and thus eroding Treasury market resiliency...
Fast forward to today and countless market hiccups later, around 70-80% of secondary market transactions are now bilaterally cleared. According to a recent G-30 report, only â20% of commitments to settle U.S. Treasury security tradesâ are cleared through the FICCâs platform...
Monetary leaders, however, have finally responded. Vowing to end the longstanding âuncleared eraâ in Americaâs sovereign debt market, the SEC (Securities and Exchange Commission) has announced that more secondary market trades must be centrally cleared by December 31st, 2025...
Market players must now adjust to comply with a new centrally cleared regime, prompting an extensive rewiring of the Treasury marketâs plumbing...
With centrally cleared trades, a central counterparty (CCP) guarantees settlement of cash and securities via a process called novation. The FICC, acting as the Treasury market's CCP, novates trades by signing contracts with both buyer and seller to absorb losses from default...
While uncleared (i.e. bilateral) trades expose the buyer and the seller to each otherâs credit risk between trade booking and settlement, centrally cleared trades prevent settlement failures when either entity defaults on its obligations...
In return, participants must follow the FICCâs strict rulebook, contribute capital to a âdefault fundâ, pay clearing fees, and post (cash) margin to secure trades numerous times a day...
In a common transaction, an FICC member purchases a Treasury from another FICC member via an IDB. The FICC novates both legs, one between the buying FICC member and the IDB and one between the IDB and the selling FICC member...
The FICCâs platform handles the logistics of each leg, from clearing and settlement to netting (i.e. removing redundant trades) and risk management. As the new regulatory deadline approaches, centrally clearing trades like these will become the norm...
In fact, itâs clear now that the regulatory endgame involves centrally clearing almost all secondary market transactions, inserting the FICC between entities forming the financial chains of the most influential market globally. The latest reforms are merely the initial phase...
These actions will increase fees and capital requirements, plus require significant investment to onboard a wider number of market participants onto the FICCâs platform. Still, these are the consequences that authorities have been willing to bear...
In response to a backlash, they have somewhat offset the impact by relaxing margin requirements for FICC members when facilitating customer trades, making it easier for most parties to transact indirectly through the FICCâs platform...
In what theyâve called an âincremental first stepâ, monetary leaders have mandated central clearing for entities that likely endanger the stability of the Treasury market and the FICC...
This includes dealers and their customers in the dealer-to-customer market, such as primary dealers providing liquidity to hedge funds (and other leveraged accounts) participating in highly leveraged âbasis tradesâ...
Low risk-takers, such as unlevered players purchasing Treasuries as investments, are some of the few players that wonât require central clearing â at least, not in this phase...
Meanwhile, in the interdealer market, any entity that brings buyers and sellers together on trading platforms must use the FICC. This will encourage practically every leg of an interdealer trade to be centrally cleared, helping to prevent a buildup of counterparty risk...
Risk, of course, can only be transferred, not eliminated. Nevertheless, regulators are betting on central clearing to improve market liquidity and stability, knowing the FICC will likely become more of a single point of failure...
The central clearing giant, however, maintains multiple layers of protection before it can fail, such as holding sufficient buffers to survive two of its largest members defaulting simultaneously...
But if it does come close to collapse, the FICC will have become the key wheel greaser of the Treasury market. Already designated as systemically important, the FICC holds accounts with the Federal Reserve and could gain access to emergency central bank liquidity...
With no other CCPs able to provide central clearing, and the FICC becoming the new glue holding the Treasury market plumbing together, monetary leaders will likely keep the central clearing giant alive, at whatever expense.
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