US Treasuries Central Clearing: Fund Managers’ Juggling Act in 2024

US fund managers will be spending the new year preparing for the operational and legal challenges arising from central clearing of most secondary trades in Treasury cash and repurchase agreements now that the Securities and Exchange Commission has approved the phased move.

The mandated switch to central clearing for many transactions in US Treasuries will represent either an evolutionary or revolutionary change depending on their current process, trading volume, and level of automation. “Trading desks, collateral operations managers, legal counsel,  risk managers, and compliance managers will be involved with the transition to central clearing,” says Stephen Morris, a partner with the law firm of Katten Muchin Rosenman in New York. The buck will stop with compliance managers who must ensure their firms follow the SEC’s guidelines.

The final version of the SEC’s new mandate, proposed in September 2022, was recently adopted just in time to give market players some holiday cheer as the US regulatory agency partially accommodated their wish list. Cash trades involving a hedge fund or “leveraged account” or any other fund will be excluded from the new central clearing rule. However, cash trades between a direct participant of the Fixed Income Clearing Corp. — the clearinghouse– and an interdealer broker or registered broker-dealer will be in scope. Repo and reverse repo transactions must be also centrally cleared while trades with sovereign entities, such as central banks, will be exempt.

In another concession to market players, the SEC agreed to a staggered approach of implementing the new rule although the timetable was still too aggressive for some, such as the Managed Funds Association and the Asset Management Group of the Securities Industry and Financial Markets Association. As the only clearinghouse for US Treasuries — the Fixed Income Clearing Corporation–will be required to adapt its policies and risk management procedures to accommodate the SEC’s mandate as of March 31, 2025. Central clearing of cash transactions would follow by December 31, 2025, and central clearing of repo transactions by June 30, 2026. The SEC acquiesced to the request of buy-side and sell-side firms to change its Customer Protection Rule to allow broker-dealer members of the central clearinghouse to include a debit on their customer reserve formula for Treasury trades processed through the clearinghouse. As a result, broker-dealers can use customer collateral, rather than their own, to meet margin obligations to the clearinghouse.

One major sore spot for some fund managers remained in the final version of the rule. “The SEC rejected the mutual fund industry’s request to exclude triparty repos from the clearing mandate,” explains Todd Zerega, a partner with the law firm of Perkins Coie in Washington, D.C. In its lengthy discussion about the ramifications of the new rule for registered funds, the SEC said that although the current triparty process works well, it does not incorporate the same risk management as a clearinghouse. The SEC decided it would not take enforcement action for a registered fund for five years if the fund posted collateral with FICC to clear triparty repo transactions and a multitude of conditions were met. Among those are that the FICC could only withdraw margin to be used in the event a particular registered fund manager defaulted or went bankrupt. The FICC also could not use the margin for “loss mutualization or allocation” which means if another fund manager defaulted or went bankrupt. The five-year timetable is intended to give FICC sufficient time to develop and file any rule changes required to facilitate a registered fund’s ability to post margin to the FICC. The clearinghouse’s current rules do not require registered funds margin to be posted with FICC; instead, a sponsoring member posts margin to the FICC on behalf of a fund.

It remains to be seen what effect, if any, the SEC’s mandate for central clearing of US Treasuries will have on two key regulatory proposals. One, which relates to dealer rulemaking, includes categorizing certain proprietary trading firms within the definition of a “dealer” and a “government securities dealer.” The other proposal is the Office of Financial Research’s recommendation it collect of data on non-centrally cleared bilateral repo agreements. A higher level of bilateral transactions are expected to be centrally cleared.

As a clearinghouse, the FICC is responsible for netting positions and requires its members to post margin to guarantee a trade won’t have to be unwound if a counterparty defaults or becomes bankrupt. As of 2005, the FICC allowed its members to clear Treasury repo trades on behalf of eligible institutional clients through a limited form of sponsorship. In 2021, the FICC expanded the program to permit members to clear triparty repo trades for indirect participants.  However, relying on such voluntary means has left most of the secondary trading volume in US Treasuries to be processed outside of the clearinghouse with too much potential systemic risk at stake. The SEC estimates that currently 80 percent of the Treasury cash market and 70 percent to 80 percent of the Treasury repo market does not fall within the FICC’s purview.

Now valued at about US$26 trillion, the US Treasury market is the world’s largest debt market and the most liquid. The Congressional Budget Office forecasts the market will almost double in size over the next decade to reach about US$46 trillion and as trading volumes continue to rise so does the SEC’s concern that the default or bankruptcy of one player– typically a large broker-dealer — could have a domino effect on others. Three of the main sources of contagion risk, according to the SEC are: interdealer brokers and principal trading firms; hedge funds; and the repo markets. Interdealer trading represents about half of the cash Treasury market and hedge funds the other half. Hedge funds are also active in the Treasury repo market. About half of the interdealer market involves trading by principal trading firms, many of which rely on an interdealer broker– an FICC member– to clear their trades. Therefore, the FICC is indirectly exposed to the default or bankruptcy of a non-FICC member in the event the interdealer broker lacks sufficient resources to contain the loss. The October 2014 flash rally, the September 2019 repo market disruption and the March 2020 market shock were enough to prompt the SEC to believe central clearing of Treasuries is essential to preserving the stability of the Treasury market. However, market players are not convinced that central clearing would have fixed the liqudity hiccups during these events and are accepting the SEC’s new mandate with some hesitation.

Cash trades reflect the purchase and sale of Treasuries, which are settled on a delivery versus payment basis, while repos reflect the sale of Treasuries with the promise to repurchase them at a specified later date and price. Currently, many secondary trades in US Treasuries are processed either bilaterally or through triparty agreements. The bilateral approach to clearing– practically-speaking a misnomer — is considered riskier than the triparty approach, because in the bilateral way the fund manager can be harmed more often by the default or bankruptcy of a broker-dealer counterparty. Because the two parties work out the terms of collateral requirements between themselves there may be insufficient collateral.

The SEC left it up to the FICC to determine how fund managers would access the clearinghouse. lt is likely fund managers will rely on either correspondent clearing firms or prime brokers. The FICC will hold the sponsoring firm liable in case the fund manager defaults or becomes bankrupt. “Because the sponsoring firm takes on the credit risk of its client, it will likely reserve the right to ask for more collateral than the amount calculated and required by FICC to clear the trade,” says Akshay Belani, a partner at the law firm of Troutman Pepper in New York. “The collateral requested is also likely more than what is currently needed in bilateral or triparty repo transactions and will ultimately cause a drag in performance return.” The burden to fund managers could be reduced should the FICC decide to cross-margin between US Treasury transactions and other fixed-income transactions cleared by FICC with respect to a sponsoring member or its customers. However, it is unclear whether mutual fund managers could benefit from cross-margining, due to regulatory constraints.

The possible need to post extra collateral will translate to higher costs for fund managers, whose trading desks must determine whether a trade should be executed. Some industry players are concerned about a potential liquidity squeeze if trading volumes decline. Collateral managers, in turn, must determine which trades are in scope and find additional collateral for any Treasury trade and transfer it to the right party at the right time. Therefore, they need to agree with counterparties on when collateral will be valued. Relying on collateral optimization platforms is crucial to ensuring the best– most cost-effective– use of collateral. Ideally, collateral management will also be centralized in a single operating unit rather than multiple ones depending on the type of financing transaction.

Sponsoring firms could decide to cap the volume of business done with each fund manager, so fund managers may have to use multiple sponsors and won’t reap the benefit of consolidating collateral with a single provider. Fund managers will also not be able to execute trades with one firm and give them up for clearance to another firm because FICC’s members currently do not accept “give-away” transactions for US Treasuries. However, the FICC has said that it might change its policy to require them to do so.

The extra costs involved with trading Treasury cash and repos are just one of a fund manager’s problems. Because the collateral of all customers of the FICC clearing or sponsoring member is commingled or combined in a single omnibus account, if any customer defaults or becomes bankrupt other customers of the sponsoring member could be subject to losses. The reason– shortfalls in the collateral pool would be allocated to all of the customers. “The SEC’s rule does not require that a central clearinghouse safeguard one indirect participant from losses resulting from another indirect participant, otherwise known as fellow customer risk,” explains Michele Navazio, a partner at the law firm of Seward & Kissel in New York. However, as he notes, the FICC has stated that it intended to establish such protection when creating its account structure after the central clearing mandate became effective.

Fund managers also need to be concerned that the default or bankruptcy of their sponsors could cause their trades to be unwound by the FICC.  Although central clearing for US Treasury transactions is often compared to that for derivatives there is one notable difference. In the case of futures and options, the positions of the defaulting or bankrupt clearing member can be ported, or transferred, to another clearing member, says Navazio. That policy currently does not apply to US Treasuries, but the FICC has said it will consider changing its rules.

Because risk mitigation is key to the new clearing mandate, risk managers could end up with the heaviest challenge. “The market and non-market risk factors involved in clearing, including the sponsoring/clearing member’s credit risk; the risk to sponsored and customer assets in the event of a sponsoring member’s default as well as the availability of porting positions; the operational and legal risk of FICC as the sole clearinghouse, and the allocation of risk under the sponsoring/clearing member’s documentation, are critical factors for risk managers to consider,” says Morris. Troutman Pepper’s Belani recommends that fund managers rely on reputable, well-capitalized banks or broker-dealers as sponsoring conduits to access FICC’s clearing service.

As often happens with new SEC requirements, repapering of legal agreements will be needed. Fund managers must renegotiate the terms of their contracts with the banks and broker-dealers clearing their trades at FICC to reflect new collateral, indemnification, and lien requirements. Unless standardized language is adopted, fund managers must have a separate discussion with each service provider and customize their documentation, says Morris. Such a process could take months to successfully achieve; the International Swaps and Derivatives Association has proposed developing standard client clearing documentation, akin or what it did when mandatory clearing was introduced in the derivatives market. Given that fund managers will have so many tasks to juggle, they can only hope they won’t drop any balls.US Treasuries Central Clearing: Fund Managers’ Juggling Act in 2024