DISCLAIMER: I was a member of the NY Fed TMPG committee that authored this paper. The opinions expressed here are mine and mine alone. They are not associated with any employer of mine or organization I am associated with.
In 2018 the Treasury Market Practices Group (TPMG), which is a group of industry professionals sponsored by the New York Federal Reserve, authored this working paper on the state of clearing for the US Treasury market:
- Paper – https://www.newyorkfed.org/medialibrary/Microsites/tmpg/files/CS_FinalPaper_071119.pdf
- Blog – https://libertystreeteconomics.newyorkfed.org/2018/09/do-you-know-how-your-treasury-trades-are-cleared-and-settled.html
The paper is an excellent overview of state of how clearing works in the US Treasury market, and the quick answer is… it’s complicated. It is a market structure that has grown up over time organically with different methods depending on who is involved in the trade and where the trade is taking place. While the paper did not advocate any specific changes to the market structure of US Treasury settlement, I would suggest that central clearing would be net positive good for the market overall, and any associated costs would be worth the insurance that investors do not loose faith in the markets ability to function in times of stress.
The US Treasury market is two-tiered, there is an inter-dealer market (IDB) where banks and PTF firms transaction with each other, and a Dealer to Client (D2C) market where dealers trade with their clients.
The IDB market is populated by professionals who are, or certainly should be, keenly aware of the market structure, settlement process and associated risks. The IDB market is a mix of centrally cleared and bi-laterally cleared.
The D2C market is much broader with thousands of end clients transacting US Treasury trades with a smaller number of dealers. Importantly all of the trades between dealers and their clients are settled bi-laterally. This means that from the time of the trade until the trade is settled in the future, the client does not own a US Treasury, but has a promise from a bank or dealer to deliver a US Treasury. In other words they have direct counterparty exposure to the dealer. Most clients in this market have a much broader scope of securities they deal in and thus are less likely than the market professionals in the IDB market to understand that they have taken on credit risk of the dealer.
How would a loss of confidence happen? The problem with a lack of central clearing could arise from the following scenario: When there is a flight to quality during the next banking crisis, clients and retail investors will look for safety by purchasing US Treasuries. Lets assume that end clients do not know which bank will go bankrupt so they unintentionally purchase US Treasuries from the bank that goes bankrupt prior to settlement. Investors will find that they do not in fact own US Treasuries, because prior to settlement all they have is an unsecured claim on a bank to deliver. What was assumed to be a flight to a safe haven in purchasing US Treasuries turns out to be a financial loss for investors. A scenario like this could fundamentally shake investor confidence leading to increased borrowing costs for the US Government and taxpayers.
Similar concerns were felt after the 2008 Banking Crisis and led to mandated clearing of Interest Rate Swaps in the Dodd-Frank act. Today Interest Rate Swaps and futures on US Treasuries are centrally cleared specifically to avoid the scenario of a counterparty default. It is time for the cash US Treasury market to join these other markets and have uniform and consistent central clearing across all market participants, venues and trade types.
Moving to central clearing will help improve investor confidence which will lead to a more efficient and liquid market and lower borrowing costs for the American taxpayer.
