The Federal Reserve released a potentially contentious proposed rule yesterday concerning accounts held by US Federal Reserve Banks for significant Financial Market Utilities (FMUs). Most of the rule seems pretty straightforward except for section II.c that says the Federal Reserve will pay interest on FMU deposits equal to the general level of short-term rates. We are not sure this is the right thing to do and want to draw attention to the matter for further discussion.
As part of Dodd-Frank, the US Treasury’s Financial Stability Oversight Council (FSOC) was created and is responsible for determining significant Financial Market Utilities in the US. FSOC has so far declared eight FMUs including the OCC, CME clearing, one ICE clearing division, the DTCC, etc. Not every CCP is an FMU and not every FMU is a CCP. This creates competitive advantages that we discussed in our November 2012 report on CCPs and the Business of Collateral Management. Here’s the list from July 18, 2012.
Dodd-Frank also said that the Fed could open accounts for FMUs but not that the FMUs had to put every last dollar of collateral or funds into the accounts. We have not seen anything since Dodd-Frank that spelled out any requirements on the FMU’s part regarding this issue.
In its release yesterday, the Fed said that “Proposed § 234.7(a) provides that a Federal Reserve Bank may pay interest on balances maintained by a designated FMU in its account at the Reserve Bank in accordance with the provisions of proposed § 234.7 and under such other terms and conditions as the Board may prescribe…. Proposed § 234.7(b) states that interest on balances paid under this section shall be at the rate paid on balances of depository institutions or another rate determined by the Board from time to time, not to exceed the general level of ‘short-term interest rates.'”
Importantly, “short-term interest rates” are defined as securities with maturities of “more than one year, such as the primary credit rate and rates on term federal funds, term repurchase agreements, commercial paper, term Eurodollar deposits, and other similar instruments.” These aren’t overnight treasury repo rates but rather longer dated paper.
Central Banks in other countries that allow CCPs to keep accounts on their books, and who effectively offer a financial backstop in case of a CCP failure (as the FSOC’s FMU’s now have under Dodd-Frank), do not pay interest on these balances. This makes it attractive for CCP clearing members in those countries to post cash in negative interest environments but creates no incentive for the CCP itself to keep additional cash at the Central Bank if interest rates are anywhere near positive. Negative rates = CCP good for cash. Positive rates = CCP bad for cash.
What the Federal Reserve is proposing seems to be a “heads I win, tails you lose situation” for CCPs but not a good deal for the public or necessarily for market stability. Already IOER pays 25 bps, which (taking FDIC fees into account) is just a few bps better than Fed Funds. Still, it is risk free return and these days is better than overnight repo with treasuries as collateral. The Fed’s definition of short-term rates would see the Fed paying 25 or 30 bps in the same environment to CCPs. The CCPs could then take the spread as a management fee and return a lower interest to clearing members. LCH.Clearnet already has this spread built into its fees, but LCH’s benchmark is public while the Fed is proposing something murkier that it would determine each quarter. We understand that LCH is generating its return from market investments. Meanwhile, the Fed is responsible for guaranteeing the short-term interest rate payment to CCPs at the US government’s expense unless it too goes out to the market, in which case it has taken on some new and unjustified credit risk.
This leaves aside the issue of whether a short-term interest rate guarantee would create strange incentives for CCPs and/or clearing members to leave more money at their Fed’s accounts. We’re pretty sure that CCPs would be inclined to take this step although frankly working through every scenario and the mechanics involved is a bit complicated to consider after a long day of work. That will be a topic for another day.
While the Fed is taking necessary steps to guarantee the security of significant FMUs in the event of potential insolvency, we think that guaranteed interest tied to a more than one year short-term interest rate is not a good idea. A better idea would be for the Fed to pay nothing or to pay the same rate as overnight repo backed by treasuries. This would strongly encourage CCPs to leave only the minimum amount required on the Fed’s balance sheet at any given time and keep more government intervention out of the market. The one major exception would be if real interest rates turned negative in the US, in which case the Fed zero bps payout would be very attractive indeed. Hopefully it won’t come to that though.