SEC Adopts Expanded Mandatory Central Clearing of Treasury Trades and Repos

There is a lot of complexity, uncertainty and risk associated with these new requirements. Here are a few compliance concerns and policy questions: 

• The proposal treats cash deposited by a broker-dealer with the FICC on behalf of customers in connection with cleared USTs as a deduction from the reserve account requirement. That means that cash received from customers is an addition to the reserve requirement. (The two amounts are not inherently equal.) The conditions that are imposed on the broker-dealer being able to deduct the customer cash (set out in Note H to the formula) are new requirements that appear complicated to implement.  
• To the extent that a broker-dealer must deposit its own cash or securities on behalf to its sponsored cleared UST customers, that amount will be a drain on the broker-dealer's own liquidity.  
• Does the complexity for broker-dealers of complying with Rule 15c3-3 as to cleared USTs serve to drive this business out of broker-dealers and into banks that are not subject to that Rule?
• The exemption for transactions between a clearing member and its affiliates is fairly narrow. An affiliate of a clearing member that elects not to clear its repo transactions with the affiliated clearing member must, as a condition of its exemption, clear all of its other repo transactions. Does that largely vitiate the value of the exemption?
• The adopting release suggests that the current FICC standards for entities that are eligible to sponsor others may need to be reduced. Doesn't that increase credit risk to the FICC and the other clearing members?
• Does the fact that repos and futures will effectively be subject to separate margin requirements means that "basis trades" will become more expensive?  Does that result in a widening of the bid-offer spread?
• Does the central clearing requirement drive repo business away from clearing members (and potentially from their affiliates)?
• What happens to the interest rates on USTs if a meaningful number of investors can not obtain a sponsor willing to clear their trades?  
• What happens if the FICC suffers a significant cyber attack or other operational problem?  

More broadly, while the time allowed to comply with the rules appears substantial, is it really long enough? Compliance with this rule is dependent, as an operational matter, on the FICC rules that are yet to be proposed, and they will have to go through their own notice and comment process. Work on the Rule 15c3-3 operational requirements is unlikely to start until the FICC has adopted its rules and firms are finished readying themselves for T+1 trade settlement. Work on documentation between firms is unlikely to be started until there is some market agreement on standard forms to use, which will take time. Not to mention, is it really a good idea to have a rule such as this come into effect on the last day of the year?

Email me about this

The SEC rule adoption provided some limited carve-outs in response to comments on the original proposal. It is clear, however, that the rule requirements do not adequately address many of the critical issues raised by dozens of market participants and regulators.

One of the most important concerns raised is that the core capacity of the sponsorship (and other access models) may not withstand the additional 80 percent of the repo and Treasury market that will require mandatory clearing. Firms that we've spoken to highlight that the economics are not attractive; the execution fees won't accompany the clearing business, liquidity will likely diminish and flows of business will decrease.   

Second, industry participants warned that the FICC should not be owning the full risks associated with potential operational, cyber and risk meltdowns and that similar derivatives should be joined by other covered clearing agencies in this effort. 

Third, market participants warn that the failure of the rule to provide for cross-margining between SEC-regulated trades and CFTC-regulated derivatives will prove problematic. While the adopting release notes the high numbers of repo trades that are not subject to a margin requirement, it slights the extent to which these trades are hedged by futures or swaps, and thus are, in fact, adequately risk-managed. Those trades will now, in many instances, need to be unwound and re-documented without the benefit of a hedging offset.

Ultimately, if these new requirements do not work as the SEC argues that they will, and if participants are driven from the market, or trading costs increase, those costs will be borne by the U.S. government and the taxpayer.   

Email me about this