The $24 trillion Treasury deal has more trouble: This time, it’s central clearing

Efforts to reduce risks within the nearly $24 trillion U.S. Treasury market, the world’s deepest and most liquid securities market, are causing anger among market participants.

The concern is centered on the concept of central clearing, a method used to reduce and manage risks in the financial markets. In September, the Securities and Exchange Commission proposed rules that would mandate central clearing of a large number of Treasury transactions. Only a small percentage of these transactions have been centrally cleared in recent years.

The biggest concern about central clearing is the cost of participating in it, according to a panel discussion at the 2022 US Treasury Market Conference held at the New York Fed on Wednesday. While panelists generally agreed that the efforts would help improve the resilience of the Treasury market, they said some players may not be able to absorb the additional costs and it is unclear how well the central clearing system during turbulent times.

“The cost of transactions in the Treasury market is going to rise and, as dealers, we are concerned about that,” said Kavi Gupta, co-head of global rates trading and counterparty portfolio management for BofA Securities. While larger players may be suited, smaller ones may not be and the topic is “something our clients actively talk about.”

Concerns about liquidity in the Treasury market have been increasing in recent months, especially as the Federal Reserve’s quantitative easing process takes hold. In October, BofA Securities warned that the “fragile” market was at risk of a “large-scale forced sell-off” or a surprise collapse. And earlier this month, the Fed confirmed fears of low liquidity in what has historically been one of the most stable corners of the financial system.

Liquidity refers to the ease with which securities can be bought and sold, and the lack of such securities means that Treasurys cannot be liquidated without significantly affecting the underlying prices of government debt. The liquidity woes have been exacerbated by the departure of regular big buyers and the Fed’s aggressive rate hikes to fight inflation, which has generally encouraged investors to sell bonds this year.

If the cost of trading Treasurys becomes prohibitive for smaller dealers, then the question becomes “are you indirectly reducing liquidity” for the market, said panelist Lynn Paschen, senior portfolio manager at Schwab Asset Management. “That is my main concern.” In addition, some funds are required to invest in Treasurys and additional costs may need to be passed on to shareholders, she said.

Gerald Pucci, Jr., managing director and global head of repo at BlackRock BLK,
said he is concerned about rising costs for the firm’s pension fund clients. “I think any central clearance, on the periphery, is a positive thing,” but if it was done too quickly “there could be problems.”

Most Treasury yields slipped on Wednesday, despite strong October retail data. The 10-year rate TMUBMUSD10Y,
fell below 3.7%, sending a popular bond market gauge of impending recessions to its most negative level in more than 40 years.

Earlier on Wednesday, New York Fed President John Williams told conference participants that Treasury market liquidity problems could affect the central bank’s ability to transmit monetary policy to the economy. Meanwhile, Nellie Liang, Undersecretary for domestic finance at the Department of the Treasury, said there is a need to monitor the UST market for vulnerabilities, given the risks of a possible shock.

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