Wall Street’s top regulator on Wednesday adopted new rules aimed at reducing systemic risk in the $26 trillion U.S. Treasury market by forcing more trades through clearing houses, while offering some concessions following industry pushback.
The five-member U.S. Securities and Exchange Commission voted 4-1 on Wednesday to advance the new rules, proposed over a year ago as part of a broader effort to fix structural issues regulators believe are causing volatility and liquidity problems.
A central clearer acts as the buyer to every seller, and seller to every buyer, guaranteeing trades in case either party defaults.
“Today’s final rules, taken together, will reduce risk across a vital part of our capital markets in normal times and stress times. That benefits investors, issuers, and the markets connecting them,” said SEC Chairman Gary Gensler in prepared remarks.
The reforms 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 new regulations could also increase systemic risks by concentrating risk in the clearing house, he added.
The draft rule, which applied to cash Treasury and repurchase or “repo” 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.
The final rule broadens the scope of which transactions must be cleared and will require clearing houses in the Treasury markets to ensure that their members clear repo and reverse repo transactions, Gensler said in prepared remarks.
That would sweep in more hedge fund-related trades. Most hedge fund activity in repo markets - where banks and other players such as hedge funds borrow short-term loans backed by Treasuries and other securities - is done bilaterally between brokers and customers.
In a nod to worries expressed by industry groups, SEC officials told reporters ahead of Wednesday’s vote they had softened some of the original proposals.
Notably, purchases and sales of Treasuries between broker-dealers who are members of clearing houses and hedge funds or levered accounts need not be cleared. Officials said central clearing in the “repo” market would largely cover related risks.
“The SEC actually went a little soft,” said Tom di Galoma, managing director & co-head of global rates trading at BTIG, noting the SEC stopped well short of a general clearing mandate.
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.
Advocates for central clearing, including the SEC, say the rule makes markets safer, while critics say it adds costs and should allow time to be phased 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.
To safeguard trades, clearers collect collateral from counterpartes. Under the new rule, central clearing agencies would also have to keep the collateral for their members separate from that held on behalf of their members’ customers.
Industry practice suggests that a large share of hedge funds trading in repo markets put up no haircut, indicating that they are fueling activity using enormous amounts of cheap debt.
Another key industry issue is the implementation timeframe. Clearing houses will have until March 2025 to comply with provisions on risk management, protection of customer assets and access to clearance and settlement services.
Their members will have until December 2025 to begin central clearing of cash market Treasury transactions and June of 2026 for repo transactions.
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.
The DTCC said in a comment letter that during times of market stress, 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 benefits to 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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