We're still a year and a half from the effective date of the US Treasury Clearing mandate for cash trades and two years from the effective date for US Treasury repo transactions. But participants in the largest and most liquid financial market in the world – over $900 billion in daily cash transactions and $8 trillion in daily repo – are starting to feel the pressure of those deadlines.
The punch list to get to full implementation is daunting:
- There is currently one covered clearing agency authorized under Section 17ad-22 of the Securities Exchange Act of 1934 to clear eligible secondary market transactions in US Treasury securities: the Fixed Income Clearing Corporation(FICC). Two more – CME Securities Clearing and ICE Clear Credit – have applied for authorization or are in the process of applying. There are material differences among the models proposed for mandatory clearing at FICC, CME and ICE, and each of the CCPs – including FICC – still has significant work to do to finalize rules and procedures fleshing out those models.
- Custom and practice in US Treasury clearing evolved at FICC such that clearing services are available to clients almost exclusively on a "done-with" basis (that is, clients were expected to execute with the FICC netting member that would clear the transaction). The vast majority of market participants subject to the clearing mandate expect, based on their experience of clearing in equities, futures, options and swaps, to be able to execute trades through a variety of brokers, for give-up to one or more "prime" brokers for clearing. As a result, the "done-with"/"done-away" distinction has become a fixed point of industry discussion about implementation. Inevitably, the CCPs will have to accommodate the demand for "done-away" services – but this will require construction of market infrastructure that doesn’t exist today (e.g., operational connectivity between the interdealer platforms where execution will occur, limit check functionality at the point of execution or on middleware platforms for voice and electronic execution, and interoperability among the several CCPs).
- Uncertainties about market structure and CCP rules mean that the standard documentation currently available to market participants is focused primarily on the FICC model of Treasury clearing – i.e., full-service (done-with) execution and clearing through the same netting member, under either the longstanding sponsored member service or the recently rebranded "agency clearing" service. Documentation for "done-away" clearing that includes the CME and ICE services alongside FICC is in flight and ongoing, but those lingering uncertainties may make completion difficult.
- Critical questions remain open concerning the precise contours of the clearing mandate:
- What is the scope of the inter-affiliate exemption (as formulated, it ends up scoping into mandatory clearing inter-affiliate trades that have been excluded by the Commodity Futures Trading Commission (CFTC) under the clearing mandate for swaps)?
- What are the limits of the clearing mandate's extraterritorial reach? Will every eligible secondary market transaction, in every corner of the globe, be required to clear? How is the US regulatory mandate intended to interact with non-US regulatory regimes that may conflict with it?
- Repos come in many flavors; most of them involve some admixture of US Treasuries. Are all of those "mixed CUSIP" deals in the scope of the mandate?
- The implementation of the clearing mandate for swaps included a legal fiction that swaps practitioners fondly refer to as "void ab initio" (void from the beginning). Promulgated ex cathedra in 2013 by the CFTC Divisions of Market Oversight and Clearing and Risk, it means that any trade executed on a swap execution facility or designated contract market that is intended to clear or subject to mandatory clearing, and that fails to clear, in effect, never happened. Though not obviously grounded in statutory or regulatory precedent, the concept was a gift to the incipient cleared swaps industry. A trade that never occurred does not carry liability or "breakage" costs when it fails to clear. This obviated the need for painful negotiation over the allocation of those risks. Currently, there is no comparable principle in place for Treasury clearing. In the absence of something comparable, the industry will likely have to draft an additional standard document for cleared US Treasury transactions, along the lines of the FIA-ISDA Cleared Derivatives Execution Agreement.
- Finally, and perhaps most challenging: how will Treasury clearing services be priced? It's a question that presents with several components:
- Cross-margining of Treasury futures and eligible transactions (cash and repo). CME and FICC currently permit joint clearing members to cross-margin house exposures in Treasuries cleared at FICC and interest rate futures cleared at CME. They are planning to extend this program to clients of such joint clearing members by the end of 2025. The potential cross-margining savings are substantial (up to 80 percent for eligible portfolios).
- Changes to the Regulatory Capital Framework. Under current Basel capital requirements, banks and their futures commission merchant (FCM)/broker-dealer affiliates face prohibitive constraints to their ability to facilitate access to Treasury clearing for their clients who will require it, and to make cross-margining savings available to eligible portfolios carried for those clients. (For most banks, under current standards, the greater those cross-margining savings, the higher the related capital charge.) There are fixes under consideration and in flight. Indeed, the prudential regulators have recently proposed modifying the enhanced supplementary leverage ratio (eSLR) applicable to the largest banks (US bank holding companies identified as systemically important – that is, the GSIBs). Although the proposal is not quite what the banks were seeking (excluding Treasury securities from the leverage ratio), it will significantly mitigate the risk of the eSLR becoming a binding capital constraint as a result of increased Treasuries intermediation activity – a salient risk under the current capital regime. The changes to regulatory capital rules necessary to facilitate the offering of cross-margining are more complex – the rules make it difficult or impossible for banks to recognize the benefits of cross-product netting. Absent revisions, banks will be faced with a Hobson’s choice between denying their clients the benefit of available cross-margining arrangements and making the benefit available and taking punitive capital charges on the resulting exposure.
- Accounting Treatment. In order for banks to reap the capital benefit of a revised eSLR regime (as well as the SLR applicable to all large banking organizations, including the GSIBs), their outside auditors and internal accounting policy teams will need to approve the treatment of exposures resulting from client-cleared transactions (done-with and done-away) as off-balance sheet. This analysis is not uncomplicated and will need to be undertaken separately for each of the three Treasury clearing services.
The prudential regulators' recent eSLR proposal is a promising sign of their engagement and willingness to facilitate banks' support of mandatory clearing. But with just 18-24 months remaining until go-live, there's a long road ahead before banks are fully equipped to do so.
The prudential regulators' proposal to modify the eSLR is available here; a SIFMA backgrounder on why reforming leverage ratios is necessary is available here; an ISDA/FIA/SIFMA white paper on cross-product netting under the US capital rules is available here; additional detail about the CME-FICC cross-margining proposal is available here; additional information about SIFMA's Treasury Clearing Documentation project is available here.
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