Structural Changes to the World's Biggest Capital Market
What are the implications for capital markets firms?
Change is afoot in the world’s largest and most liquid capital market.
The $26.5 trillion US treasury market, used as the mechanism by which the US Federal Reserve (the Fed) executes monetary policy and through which the US government borrows, is set to undergo some key infrastructural changes that will impact capital market participants. As if the new T+1 trade settlement period later this year wasn’t enough.
Capital markets have experienced their fair share of black swan events in the first quarter of this century. The 2001 9/11 terrorist attacks in the US, the global financial crisis of 2008 and the more recent COVID pandemic are prime examples. However, one shock event that serves as a visceral reminder of the systemic risks within capital markets was the 2019 repo crisis.
Repos play a fundamental role in financing institutional and government liquidity needs. The repo market is essentially a two-way intersection, with cash on one side and Treasury securities on the other. One firm sells securities to a second institution and agrees to purchase back those assets for a higher price by a certain date, typically overnight. Repos are able to generate interest on cash in exchange for typically low risk. However, that low risk was not evident for a brief period in 2019.
On 16 September, 2016, a sudden spike in the interest rates on repos – from 2.43% to 5.25%, before surging to 10% during the intraday market – sent the repo market into panic mode, almost triggering a crisis but for intervention from the Fed. The spike was caused by a combination of factors, including an outflow of cash due to corporate tax payments being due, at a time where new treasury debt was being settled onto the markets. Financial institutions wanted to borrow cash to purchase those securities but the cash outflows led to growing imbalances in supply and demand, leading to a liquidity squeeze and soaring repo rates. This led to the Fed injecting $75 billion of liquidity into the repo market over the following weeks to help stabilise the market and ward off the threat of another systemic crisis.
In response to the crisis, the Fed and the Securities Exchange Commission have sought to implement new rules and measures to safeguard bond markets from possible future crises, although the fruits of their labour, after some five years, is only just starting to be seen. The most consequential of the rules, passed in December 2023, will revamp the Treasury market’s infrastructure, and see more treasury trades passed through clearing houses instead of through the current broker-dealer systems.
Specifically, the new rule will mandate that from December 2025, all purchase or sale trades of US Treasuries with broker-dealers or interdealer brokers must be routed through a clearing house. Repo trades must be centrally cleared from June 2026. The main body for clearing Treasury trades is the Fixed Income Clearing Corporation.
The notion behind central clearing of Treasuries is that it will provide protection for investors and reduce the likelihood of shocks and defaults, although it may create a single point of failure during a market ‘event’. Clearing houses take collateral from both parties in a Treasuries transactions to ensure that cash and security deliveries are executed. The absence of a clearing house means traders that have transacted with a major bank or hedge fund would have no recourse if that entity were to fail.
However, moving to central clearing will likely pose operational and technological challenges for firms dealing in US Treasuries. Some firms will be required to set up new trading systems in order to clear their trades and this may require scoping for new off-the-shelf products that are best suited for clearing functionality. This will be something of a headache for firms, given their preparations for the forthcoming transition to T+1 security trade settlement in the US are already in full swing.
Additionally, centralised security clearing could lead to a rise in trading costs, as it will be a requirement to post collateral to protect against defaults, while also paying fees to the clearing house. Putting up more cash for collateral could tighten liquidity and call for more astute and prudent cash management from firms, again considering the implications of the T+1 period where pre-funding securities transactions may become a prerequisite. Nevertheless, the measures should go a long way in improving efficiency and resiliency of the Treasury market and resign crises such as the 2019 repo crisis to mere memory.
The regulatory landscape in capital markets continues to evolve, calling for radical action and infrastructural changes from market participants. Now, more than ever before, feels like a critical time for financial firms to optimise their trading infrastructure as they seek to meet regulatory demands.