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Introduction
The SEC has proposed to force bond trades through a clearinghouse. The intent is to protect investors from market dysfunction like that of the 2019 repo crisis. A clearinghouse introduces margins and risk-sensitive margin management, among other safer practices.
This article proposes a debt clearinghouse that would introduce these important capabilities.
Clearinghouse listed and traded securities.
Simultaneous listing of multiple maturities.
Futures-style clearing of cash securities.
The intent is to greatly simplify institutional risk management while improving debt market safety.
New SEC Regulation
The SEC recently passed a rule intended to remodel the Treasury market’s plumbing by forcing bond trades through a clearinghouse (read here). The SEC’s objective is to avoid market dysfunction, like that in the 2019 repo crisis and the March 2020 market meltdown, which required emergency intervention from the New York Fed. Why clearing?
A market with a central clearinghouse is safer than the standard OTC market for several reasons.
The clearinghouse requires participants to post margin, providing a cushion against customer failures.
Clearing ensures uniformity, reducing information costs.
If the clearinghouse margin is adjustable in response to changes in risk, the market can be better protected from the kind of turmoil that the SEC fears.
A clearinghouse and its associated rules open the market to access by institutions and retail investors on an even footing with repo dealers.
Alternatives
The standard clearinghouse choice is the Fixed Income Clearing Corporation (FICC), a subsidiary of the Depository Trust and Clearing Corporation (DTCC). Like all the clearing operations of the DTCC, the FICC usually clears every trade in the market and competes with nobody. The result is that the FICC is a high-cost inefficient operation.
The SEC is encouraging competition with the FICC, and both the New York Stock Exchange and CME Group are studying the opportunity. This article describes issues an exchange considers in constructing a competitive clearinghouse.
Brief History
The Crash of the Treasury bond market of 2020 led the Fed to introduce the Standing Repo Facility. Under the Standing Repo Facility (SRF), the Desk conducts open market operations at a pre-announced bid rate set by the FOMC. Treasury, agency debt, and agency mortgage-backed securities are eligible to settle repo transactions under the SRF.
A second Fed facility to provide bond market crisis protection introduced in 2020 is the Primary Market Corporate Credit Facility (PMCCF). It provides companies access to credit during funding crises.
The problem that Fed crisis-protection facilities create is a moral hazard. Risk management knowledge that the Fed will bail it out of crises gives institutions less incentive to protect themselves.
The Fed has provided rescue facilities for both public and private debt, which suggests that the SEC rule might be extended to clearing commercial paper as well. The remaining discussion applies to both.
Reasons for a Futures-Style Clearinghouse
The proposal for a bond clearinghouse from the NYSE will likely offer the NYSE’s clearinghouse to clear the NYSE’s listed bonds. The CME already clears Treasuries, so there is no reason to expect a new offering.
My earlier post describes an alternative to the three new clearinghouses above. The key differences between that alternative and the others:
Clearinghouse listed and traded securities. If the clearinghouse is to provide safer liquid securities trading while capturing a substantial share of the debt market, it will need to list securities that expand the liquid maturities in the term repo market.
Futures-style clearing of cash securities. Both the CME and the NYSE are captives of parochial clearing mechanisms. To use futures-style clearing of securities is not in their best interest. It would likely replace their existing clearinghouses.
Simultaneous listing of multiple maturities. The objective is to capture a maximum share of debt repo trading while listing a minimum number of instruments. The standard on-the-run Treasury maturities are the result of the Treasury’s opinion of the debt the market wants to trade. Listing debt-based repos at these maturities is a way to inventory debt while listing only the maturities investors want.
Other Properties of the Proposed Marketplace
Trading
Physical delivery. Futures contracts will be settled by delivery, creating a collateral portfolio that supports listed instruments.
Risk Management Issues
Asset side fixes. Illiquid debt issues that linger in institutional portfolios increase risk management difficulty since they can only be sold at a discount.
That problem is addressed now by using off-the-run Treasuries to collateralize overnight repurchase agreements, but the risk created by large overnight positions in institutional portfolios is itself substantial. Liquid term debt repo would produce higher-yield, more liquid investments, consistent with the insurance companies’ policy commitments.
Liability Side Fixes. An insurance company could finance its term assets by selling term repo with like maturities into the exchange term repo delivery facility.
Weekly Listing
Weekly listing would permit users to match the maturities of clearinghouse-issued debt with institutional demand.
Why Are Deliverable Debt Repo Futures a Good Idea?
There are three key reasons to trade these instruments.
They take advantage of the strengths of futures markets.
They potentially create a broader, safer market for institutional investors and retail investors.
If approved by the CFTC, debt market regulation would be more transparent and innovation-friendly than current regulation.
Strengths of futures markets. This proposed clearinghouse is a safe way to open the debt repo market to retail investors because of two key properties – risk-based margins and futures-style clearing.
Futures’ risk-based margins have proven effective risk protection in every financial crisis since financial futures were introduced in the 1970s. For example, when the Lehman bankruptcy disrupted both interest rate swaps trading and money market mutual fund investing in August 2007, futures contracts managed an eight-billion-dollar Lehman position by transferring the bank’s positions to Barclays’ futures subsidiary before Lehman’s lawyers made the bank aware of its impending bankruptcy.
Futures style clearing is a key part of the futures exchange risk management arsenal. Since the clearinghouse is the counterparty to both sides of an open position, the clearinghouse is exposed to a party’s failure, not another market participant. The capital of the clearing members is accessed to offset failures.
Because futures run an all-to-all book – read here for an explanation of all-to-all trading – there is no market separation into insiders and outsiders. All-to-all, clearing assures us that markets provide an equal playing field for both retail and wholesale traders.
A Broader, Safer Debt Repo Market
Futures-style debt clearinghouse listing enables an exchange to list securities that have greater appeal to investors. Futures markets are not, like securities exchanges, focused primarily on the needs of the sell side of the market. Securities listed on futures exchanges are focused on the buy side instead. Repo trading is now limited to large institutions. Profitability throughout the market would be enhanced by opening the market to retail investors and expanding available maturities.
Regulation would be more innovation-friendly than with SEC regulation. The CFTC is open to change. In the early 1980s, the CFTC required exchanges to provide an extensive justification for any futures trading change — consistent with the then-in-vogue theory that for a futures exchange to do anything new was a bad thing, requiring the exchange to demonstrate that there would be an offsetting benefit.
CFTC regulation takes a laissez-faire approach, which makes the futures markets the place to introduce innovation in the market structure.
A Useful Deliverable Security
Unaffected by Financial Crises
Two recent crises, the UK pension disaster of 2022 and the US regional banking crisis of 2023, were primarily the result of asset/liability maturity mismatches.
UK pension disaster. In the case of the UK pension disaster, overnight repos funded long-term investments (primarily gilts). The excuse for this extreme mismatch was that there is no market for term repo funding.
The resulting mismatch was inadequately hedged using various derivatives. The inadequacy of derivatives hedging is in part the result of its complexity, but perhaps also in part because of some institutions’ intent to bet on the future course of interest rates. Futures hedging easily disguises regulated institutions’ intern to take risks from their regulators.
The proposed repo futures would enable UK pension funds to sell gilt-based term repos directly to the exchange. This way, issuer access to the entire investment universe would be available instead of the current single bank source.
US regional banking crisis. In the US regional banking crisis, extreme mismatch was also the problem, but the missing market-based solution was the absence of demand for term commercial paper issued by the struggling banks. A solution is for the commercial paper listing exchange to buy the banks’ term commercial paper at terms comparable to the banks’ loans.
Stable
More stable than the supporting assets. The commercial paper-backed assets deliverable on these contracts share several useful properties with the defunct Eurodollar futures contract. The deliverable instrument is not redeemable. The instrument, like deposits, is supported by assets changed by the issuer throughout the buyer’s holding period with no impact on the value of the delivered security.
Assessable
The issuing cycle and listed issues will be set to meet the needs of commercial paper buyers and issuers. This proposed term commercial paper market would provide broad access to retail traders and institutional investors on an equal footing with the Fed’s government securities dealers.
Conclusion
The proposed term clearinghouse for repo debt is assessable to retail and institutional investors on an equal footing with dealers. The proposed marketplace matches maturities with those demanded by issuers and buyers.
The proposed clearinghouse offers several capabilities unavailable now.
It takes advantage of the strengths of futures markets.
It potentially creates a broader, safer market for institutional investors and retail investors.
If approved by the CFTC, debt market regulation would be more transparent and innovation-friendly than current regulation.
