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In a rare unanimous vote, the SEC issued a proposal on September 14, 2022 expanding the use of central clearing for U.S. Treasury securities for secondary market transactions, including: 

  • All repurchase and reverse repurchase agreements collateralized by U.S. Treasury securities to which a direct participant is a counterparty
  • All purchase and sale transactions of U.S. Treasury for direct participants who are acting as interdealer brokers 
  • All purchases and sales of U.S. Treasury securities between a direct participant and a registered broker-dealer, government securities dealer, or government securities broker; a hedge fund; and a levered account

To address a jump in margin requirements resulting from increased central clearing, the proposal also would update the broker-dealer customer protection rules to permit margin required and on deposit at a covered clearing agency (CCA) to be included as a debit item in the customer reserve formula, subject to certain conditions. 

The SEC cited the March 2020 COVID-19 market disruptions and the increased U.S. Treasury trading by principal trading firms (PTF) and hedge funds1 that are not centrally cleared as the primary reason for the changes. Comments are due 60 days after publication in the Federal Register.  

Background 

Currently, only one CCA—the Fixed Income Clearing Corporation (FICC)—provides central counterparty (CCP) services for U.S. Treasury securities transactions. As a CCP, FICC novates transactions between two counterparties, effectively becoming the buyer to every seller and the seller to every buyer, and guarantees transaction settlement. A CCP nets positions and then requires counterparties to post margin to guarantee the trade's execution if either party defaults. Currently, most of FICC’s direct participants are banks and broker-dealers while registered investment companies, investment advisers, and asset owners rely on FICC’s direct participants to access central clearing indirectly and are not direct participants of FICC.

The U.S. Treasury market consists of two components: the primary market and the secondary market. The secondary market is where subsequent trading occurs, including the cash market, for outright purchases and sales of securities, and the repo market, where one participant sells a U.S. Treasury security to another participant, along with a commitment to repurchase the security at a specified price on a specified later date. This proposal would cover only secondary market transactions. 

A majority of secondary cash trading is done by PTFs that trade as principals for their own accounts. These trades are not required to be centrally cleared and are settled bilaterally. A 2021 Treasury Department report notes that just 13% of Treasury cash transactions are centrally cleared, while 68% are cleared bilaterally, firm to firm. 

Similarly, a growing percentage of repo trades are not being centrally cleared; a Federal Reserve report indicates that for primary dealers, 38% of repo and 60% of reverse repo activity are not centrally cleared.

The SEC noted that trades cleared and settled outside of a CCP may not be subject to the same risk management associated with central clearing, which includes publicly disclosed requirements that apply objectively and uniformly to all CCP members, loss mutualization, and liquidity risk management. 

Treasury Clearing 

The proposal would require U.S. Treasury security CCAs to develop the following policies and procedures:

  • Require direct participants to submit for clearing certain eligible secondary market transactions. This would include when-issued trades the day after auction and all U.S. Treasury repo and reverse repos, among others. Transactions by sovereign entities, e.g., central banks and the Bank for International Settlements, and international financial institutions2 would be excluded 
  • To calculate, collect, and hold margin for direct participants’ proprietary transactions separately from transactions submitted on behalf of indirect participants 
  • To ensure they have appropriate means to facilitate access to clearance and settlement services of all eligible secondary market transactions, including those of indirect participants, and have the policies and procedures reviewed by their board of directors annually. 

While this is not a mandate, CCP members would be more likely to push dealers, hedge funds, and PTF U.S. Treasury transactions through central clearing. 

Broker-Dealer Customer Protection Rule (Rule 15c3-3)

Rule 15c3-3 is designed to protect customer funds and securities by forbidding brokers-dealers from using customer assets to buy securities for their own account. Rule 15c3-3 requires a broker-dealer that maintains custody of customer securities and cash (carrying broker-dealer) to take two primary steps to safeguard customer assets: 

  • Maintain physical possession or control over customers’ fully paid securities
  • Maintain a reserve of fund or qualified securities at least equal in value to the net cash owed to customers. The reserve is calculated by a prescribed formula in Rule 15c3-3a  

The steps ensure that if the broker-dealer fails, the customer securities and cash should be readily available to be returned to the customers. 

The clearing changes noted above are likely to cause a substantial increase in the margin broker-dealers must post to a U.S. Treasury securities CCA. Currently, broker-dealers are not permitted to include a debit in the customer reserve formula for U.S. Treasury securities because FICC is not required to segregate U.S. Treasury margin for customer obligations. 

The proposal would allow the broker-dealer to include a debit in the customer or proprietary accounts of broker-dealers (PAB) reserve formula when delivering customer cash or U.S. Treasury securities to meet the margin requirement at an entity providing CCP services in the U.S. Treasury market if certain conditions are met. The conditions include that a broker-dealer must: 

  • Use customer assets exclusively to meet the customer position margin requirement
  • Use a particular customer’s assets exclusively to meet the amount of the customer position margin requirement resulting from that customer’s cleared U.S. Treasury securities positions
  • Have delivered the customer’s assets to the U.S. Treasury securities CCA

The debit would be limited to customer position margin required and on deposit at the U.S. Treasury securities CCA. A broker-dealer could not include in this debit item amounts that exceed the broker-dealer’s margin requirement resulting from its customers’ cleared U.S. Treasury securities positions. 

Conclusion 

FORVIS will continue to follow this developing situation. If you have questions about these changes, contact one of our professionals today.
 

  • 1The proposal notes that hedge funds are increasingly large players in the U.S. Treasury market with notional exposure of $1.76 trillion, of which only 15% is cleared centrally.
  • 2The proposal specifies the following entities: African Development Bank, African Development Fund, Asian Development Bank, Banco Centroamericano de Integración Económica, Bank for Economic Cooperation and Development in the Middle East and North Africa, Caribbean Development Bank, Corporación Andina de Fomento, Council of Europe Development Bank, European Bank for Reconstruction and Development, European Investment Bank, European Investment Fund, European Stability Mechanism, Inter-American Development Bank, Inter-American Investment Corporation, International Bank for Reconstruction and Development, International Development Association, International Finance Corporation, International Monetary Fund, Islamic Development Bank, Multilateral Investment Guarantee Agency, Nordic Investment Bank, and North American Development Bank.

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