Central Clearing for US Treasuries: Pipedream or Reality?

The have and have-nots.

That is how operations and compliance executives at some fund management firms speak about the bifurcated system for how trades in US Treasuries clear. Fund managers tell FinOps Report they want a level playing field with broker-dealers.

That means that buy-side trades in US Treasuries, such as bills, notes and bonds, should be processed through the clearinghouse Fixed Income Clearing Corp. (FICC), the same way sell-side trades are. All fund managers would need is a clearing broker.

Will the status quo change? Fund managers are hopeful that the Treasury Market Practice Group (TMPG), a committee of buy and sell-side firms and trading platforms, will recommend central clearing of US Treasury transactions for all market players. Yet broker-dealers who spoke with FinOps aren’t so optimistic.

The TMPG is planning to publish a white paper with its analysis of the US Treasury market later this year, say attendees of an invitation-only meeting held by the TMPG at the Federal Reserve Bank of New York last November. The analysis will include a description of the different roles in the market– fund managers, high-frequency traders, broker-dealers, trading platforms and FICC, a subsidiary of US market infrastructure Depository Trust & Clearing Corp (DTCC).

Broker-dealer members of the TMPG, sponsored by the Federal Reserve Bank of New York and chaired by Thomas Wipf of Morgan Stanley, include Goldman Sachs, JP Morgan, BNY Mellon, Citigroup and Bank of America Merrill Lynch. Buy-side firms include TIAA Investments, Citadel and BlackRock. Also participating are Global Trading Systems and NEX Group.

Although TMPG has previously provided successful recommendations for reducing the rate of settlement fails in the US Treasury market, it is unclear whether it will go as far as to advocate central clearing for all players. Sources close to the TMPG predict that the group will most likely provide only an informational overview of the US Treasury market rather than make any recommendations. That is because broker-dealers want to keep the status quo. In a best case scenario, the TMPG could suggest strict margin requirements for buy-side trades in US Treasuries. Or it might seek further industry input.

Fund managers and others familiar with the US Treasury market speculate that broker-dealers don’t want to offer fund managers the ability to clear trades through FICC, because they don’t want the fund managers to use some electronic trading platforms operated by BrokerTec, Nasdaq and Tradeweb. Those platforms, whose trades clear through FICC, would likely provide fund managers with more liquidity and could reduce broker-dealer profits.

Status Quo’s Shortcomings

“The current bifurcated system for US Treasuries limits the vast majority of  buy-side firms to a smaller pool of liquidity than dealers have access to,” asserts Michael Koegler, a principal at ViableMkts, a New York-based consultancy specializing in financial technology and market structure. “Buy-side firms can’t benefit from trading on all-to-all anonymous order books, which reduce bid/offer spreads.”

What’s more, says Koegler, the buy-side suffers from information leakage and price-tiering by dealers since fund managers are forced to participate on platforms offering only fully-disclosed request for quotes. “Central clearing for US Treasuries for all participants would make the market structure more efficient and better facilitate all-to-all order book trading for fund managers,” he says.

Operations managers at several fund management shops gripe that because their trades in US Treasuries cannot be cleared through FICC they are at a competitive disadvantage to broker-dealers. In addition to suffering from reduced liquidity and potentially higher trading spreads, fund managers face plenty of risk through bilateral clearing. Should the broker-dealer go bust, the fund manager is out of the money. By contrast, primary dealers are members of FICC which serves as a middleman to guarantee the trade. Primary dealers all contribute to a fund which can be tapped in the event of a counterparty going bust.

Why can’t trades in US Treasuries executed by fund managers clear through FICC through a clearing member? They do for corporate debt and equity trades through clearing member firms. And they also do for Treasury futures contracts through clearing member firms of the CME’s clearinghouse.

FinOps could uncover no explanation of the anomaly in the US Treasuries other than to offer the explanation of “that’s how the market has historically worked.” DTCC declined to comment on the possibility of central clearing of US Treasuries for all players and wouldn’t even discuss the workings of its central counterparty service for primary dealers in US Treasuries. Murray Pozmanter, managing director of equity and fixed-income clearing services at DTCC, is a member of the TMPG.

So far, one trading platform seems to have come up with a hybrid solution for US Treasuries, which allows for all-to-all trading or participation from both fund managers and broker-dealers. Launched in April, OpenDoor Trading provides an anonymous auction-based system which includes asset managers, pension plans and sovereign wealth funds to participate.

“Fund managers and other clients can post bids and offers without their identity or trade size being revealed,” explains Josh Holden, chief information officer. “A computerized matching system will match up bids and offers for an order to be executed.” He declined to specify how many users OpenDoor has recruited so far.

There is just one catch. Fund managers using the OpenDoor platform must still pick a sponsor-dealer to clear their trades. The dealer is informed of the trade after it is executed and earns clearing fees. OpenDoor is also limited to trading off-the-run Treasuries or those bonds and notes issued before the most recent issue of a particular maturity. Off-the-run trading represents an estimated 98 percent of the value of the US$14 trillion in US Treasuries outstanding, but only 30 percent of the market’s US$500 billion in daily turnover.

Holden stopped short of advocating central clearing for US Treasuries for all players. However, OpenDoor’s Chief Executive Susan Estes has publicly predicted that in 2018, the Fed could mandate central clearing for US Treasuries. Central clearing will allow new trading venues to emerge as well as improve risk management for US Treasuries, she says.

“Without central clearing to tie the market together and enable portability of order flow, the future of US Treasury trading looks a lot more like F/X where a few large firms dominate because they can be selective about where they provide liquidity,” says Jim Greco, founder of defunct Treasury trading platform Direct Match in a blog entry appearing in June 2017. His firm’s all-to-all trading platform was to include fund managers and was set to go live in March 2016.  It was was forced to shut down at the last minute, when its clearing partner backed out of an agreement. Direct Match never identified the clearing firm, but it was reportedly State Street.

In commenting about the potential for central clearing of US Treasuries for high-frequency trading firms, Greco says that FICC’s current model would be too cost prohibitive for HFTs. “The official sector should explore ways in which the costs of central clearing can be distributed more evenly and reduced by more effectively pricing the settlement risk inherent in the marketplace and promote greater access to the market structure,” he says.

Such a scenario could mean that fund managers and HFTs might participate in the FICC’s clearing process without taking part in mutualized risk — or covering the losses of other clearing members.

Addressing central clearing for all US Treasury trades wouldn’t be the first time the TMPG has tackled risk reduction measures. However, in each case it had the support of its broker-dealer constituents. In 2009, the group recommended penalties for firms that fail to settle trades in US Treasuries on time and in 2012 issued two-way margin rules for forward-settling mortgage-backed securities typically transacted as to-be-announced trades. The broker-dealer self-regulatory agency Financial Industry Regulatory Authority (FINRA) subsequently issued stricter margin requirements for TBAs.

Given that broker-dealers might resist any change to the current method of bilateral clearing of US Treasuries with fund managers, the TMPG could face difficulties in getting its membership to agree on a recommendation for change. It could ultimately take a mandate from the Fed to get the ball rolling, predict some fund managers.