Central Clearing in the US Treasury Market
Yesha Yadav
Vanderbilt University – Law School
Josh Younger
Columbia University
he market for U.S. Treasuries is arguably the largest, deepest, most liquid, and most systemically important in the world. Transactions in U.S. Treasuries and Treasury-backed repurchase contracts (repos) have, to this point, primarily been cleared bilaterally. In other words, the two counterparties to the trade face each other directly and are exposed to each other’s creditworthiness. But recent episodes of dysfunction in the Treasury market have revealed flaws in that market structure. Some have argued that central clearing, in which a third party stands in between trade counterparties to set market standards, reduces the risk of non-performance, and mutualizes any potential losses arising from defaults, offers a more resilient market structure. To that end, the Securities Exchange Commission recently finalized rules which subject most of the Treasury market to mandatory central clearing.
This Essay analyzes this clearing mandate to detail its likely benefits – as well as to highlight reasons for caution. On the plus side, central clearing should bring several gains: (i) fuller information, especially with respect to bilaterally traded Treasury-backed repos; (ii) reduced counterparty risk; and (iii) potentially greater flexibility for Treasuries traders to create balance sheet space through set-off and netting of trades. That said, the mandate also threatens risks of unknown and unpredictable magnitude. First, as mainly a fix for counterparty default risk, central clearing is unlikely to cure Treasury’s market degraded liquidity, leaving the market exposed to periodic shortfalls and price dislocations. Secondly, the mandate includes several exemptions – for example, where trades do not involve members of a clearinghouse on either side, or where a repo contract does not come with a fixed maturity. This leaves a swath of trades outside of central clearing. It can also motivate traders to evade the mandate by structuring transactions to try and avoid it. Finally, a Treasuries clearinghouse will represent a one-of-a-kind firm of immense importance. Its future governance and risk management raise complex questions about how best to ensure that such a firm can operate without jeopardizing the integrity of the financial system. In concluding, we survey such questions and recognize the value of caution in implementing the mandate given its transformative potential for the keystone U.S. Treasury market.
The full paper is available here.