There is an increased need for the US treasury market to adopt central clearing to reduce risk and improve resiliency, as Depository Trust & Clearing Corporation’s (DTCC) suggests in a new paper that fragmentation is creating contagion risk.
Treasury market activity is split between two disparate clearing processes: bilaterally cleared transactions, and centrally cleared transactions via DTCC’s Fixed Income Clearing Corporation (FICC).
The paper, ‘More Clearing, Less Risk: Increasing Centrally Cleared Activity in the US Treasury Cash Market’, examines growing concerns around the increased adoption of bilateral clearing for Treasury activity and details the benefits of unifying the market under a central clearing model.
According to DTCC, if a non-FICC member defaults, there could be larger systemic impacts. Interdealer brokers (IDBs) are frequently executing transactions between FICC members and non-FICC members, in which one side of the trade is centrally cleared and the other is bilaterally cleared.
The white paper highlights that the issue of fragmentation has taken on greater urgency due to ongoing market volatility, prompting discussion among industry participants and regulators on the need for an ideal market structure.
Prior to 2000, all outright purchases and sales of treasuries through IDBs were centrally cleared. The Federal Reserve estimates that up to 60 per cent of outright purchases and sales of Treasuries through IDBs involve principal trading firms (PTFs), who generally don’t participate in central clearing.
According to the white paper, greater use of central clearing in the US treasury market would deliver industry-wide benefits, including reduced market risk through margin processing, which is collected twice a day.
DTCC says this promotes orderly control, wind-down and liquidation in the event of a member default, reducing the risk of liquidity drain and fire sales in a stress event.
Further benefits include added liquidity by allowing trades to be netted across all CCP members, lowering net settlement exposures and freeing up capital.
DTCC suggests that the market could also see improved financial stability by increasing transparency in this important area of the treasuries market.
FICC does not have visibility into its members’ treasury market activity that clears bilaterally away from FICC.
The US treasury market is the largest in the world, and its performance is critical to the strength and stability of the overall US economy, according to Murray Pozmanter, head of clearing agency services and global business operations at DTCC.
However, Pozmanter notes the bifurcation of treasury clearing activity, where a part is bilaterally cleared and part is centrally cleared, is introducing greater risk into this growing market.
“DTCC continues to engage the industry to encourage further adoption of central clearing, to lower this risk and better protect the industry,” he says.
Pozmanter affirms: “Central clearing would allow greater transparency into the bilateral treasury cash market while lowering counterparty and systemic risk and increasing resiliency.”
He adds: “However, we believe many firms will not adopt this critical risk management capability unless there is a mandate from the official sector, such as a regulatory requirement for firms that make markets in US Treasury securities to centrally clear their cash activity.”
