Grygo is the chief content officer for FTF.
The U.S. Treasury market could see “rapid and dramatic change” that could result in a clearing monopoly being replaced by “a more competitive European model,” according to a new report from market research firm Greenwich Associates.
The report, dubbed “Invisible Frontiers: How Clearing Shapes U.S. Treasury Market Structure,” argues that “the market structure for U.S. Treasury securities has been dominated by its clearing arrangements” that are not clearly understood by most market participants.
The U.S. Treasury market “is bifurcated between an interdealer market and a dealer-to-customer market. The two markets have evolved into completely different structures. The interdealer market is nearly fully electronic and the dealer-to-client market is still roughly 50 percent voice,” according to the Greenwich Associates report.
“The divide between the two has historically been reinforced by clearing arrangements that served as a moat separating the two,” according to the new report. The clearing arrangements in the U.S. Treasury market “have a history, and that history is the key to understanding the current structure of the market,” says Ken Monahan, senior analyst for the market structure and technology group of Greenwich Associates, and author of the report.
Some of that history is reviewed in a separate but related report from the Treasury Market Practices Group (TMPG) that was released in July. Sponsored by the Federal Reserve Bank of New York, the TMPG consists of senior business managers and legal and compliance professionals. (Greenwich Associates acknowledges the TMPG report.)
“Trading in the dealer-to-dealer segment of the Treasury market is generally conducted through interdealer brokers (IDB) … Prior to 2000, all IDB platform users were members of a central counterparty (CCP) and trades were centrally cleared and, as such, benefited from the transfer of counterparty credit risk to the CCP through novation, multilateral netting of exposures, and other risk mitigation features like margining,” according to the TMPG report.
“Since that time, the IDB segment has been at the center of innovation with the introduction of highly advanced trading technology and the entrance of new market participants on the IDB platforms,” according to the TMPG.
But clearing has not yet had its innovation jolt. In fact, the TMPG researchers cite some disturbing trends:
- “TMPG estimates that roughly three-quarters of IDB trades clear bilaterally, which, on balance, has increased the amount and duration of bilateral counterparty exposure in the system;”
- “For bilaterally cleared trades, … intraday and overnight credit risk remains with the original trading counterparties from trade execution to settlement and is subject to risk mitigation practices that are less standardized and less transparent to the broader market than those involving centrally cleared trades.”
- “A majority of trades in the secondary Treasury market now clear bilaterally, a trend that is contrary to the direction of recent regulatory requirements in other markets (i.e., swaps) that for some products mandate clearing and for others encourage it through higher margin requirements on bilaterally cleared transactions.”
- “Market participants may not be applying the same risk management rigor to the clearing and settlement of their U.S. Treasury activities as they do to other aspects of risk taking. This may be in part due to the risk-free nature of the underlying instrument and in part due to the typically short settlement cycle.”
- “Given changes in trading activity and participation, the counterparty credit risk incurred indirectly through the clearing chain may not be transparent to participants in the market … Where transparency is impaired, market participants cannot accurately identify, measure, and manage their counterparty risk exposure.”
- “Risk management practices for clearing and settlement of bilaterally cleared as well as centrally cleared trades may not have kept pace with market evolution. Margining has not been a common practice for regularly settling bilaterally cleared transactions, and even for centrally cleared transactions, margining typically occurs twice a day, creating the potential for rapid accumulation of unintended exposures given the speed of execution.”
The Greenwich Associates researchers acknowledge that the TMPG report “comes at a time when the U.S. Treasury clearing landscape is shifting dramatically, taking the rest of the market structure with it. Those implications are profound and have had a marked effect on the wider market structure. A firm can only trade with a firm with which it can clear. In a market like U.S. Treasurys, where there is no universal clearing utility, this has the effect of channeling trading liquidity along the paths cut by clearing relationships.”
The Greenwich Associates report “concludes that clearing, long a monopoly in the U.S., may move toward a more competitive European model and that changes at the incumbent central counterparty (CCP) may also make the secondary market structure more competitive.”
A link to information about the Greenwich Associates report is here and the TMPG report can be found here.
Need a Reprint?