What are the drivers behind the SEC’s new rule changes?
The new rule changes published by the SEC have been primarily driven by the need to enhance market stability and reduce systematic risk. They will bolster the security of the US Treasury market by mandating central clearing for eligible securities, such as repos and reverse repos, inter dealer broker transactions and other cash transactions. In doing so, these rules are intended to reduce counterparty risk, limit contagion and increase transparency in the market.
The lessons learnt from past financial stress conditions and crises, particularly those involving non-bank market participants, have driven these changes. One counterparty defaulting could pass risk on to another party, this in turn could have a cascading effect on liquidity across the market. In addition, currently, the Fixed Income Clearing Corporation (FICC) is indirectly exposed if one of its members makes a trade with a non-member and subsequently defaults on the transaction.
With these changes, there will be a dramatic increase in the amount of daily US Treasury clearing activity processed through the FICC.
What aspect of the proposals should institutions be most conscious of?
Primarily, institutions must be aware that the SEC has introduced a regulatory change to redefine what constitutes a ‘dealer’. This is done to increase oversight of Proprietary Trading Firms (PTFs), which play a significant role in providing liquidity in the US Treasury market.
PTFs engage in trading with their own capital rather than on behalf of clients and will have to register with the SEC and FINRA as dealers. If PTFs do not want to register as dealers, they must establish a Sponsored Member arrangement.
While this is a significant change for PTFs, they already have experience delivering similar large-scale projects following the change to the T+1 settlement in May 2024 which can be applied to the upcoming dealer redefinition and central clearing changes.
How will fixed income trading desks be impacted by these proposals?
Central clearing is likely to help ease counterparty credit limits due to better risk management and transparency provided by the CCPs and migrate previously uncollateralised bilateral contracts to the CCPs. In particular, counterparty default and fire sales risk should be much lower.
This could improve market liquidity by removing existing trading restrictions and mitigating counterparty and bilateral trading risk. This will be particularly beneficial in times of stress, as these factors will ensure that dealers don’t withdraw liquidity.
At the same time, the cost of central clearing and risk management activities will likely increase the overall costs of transactions for participants who don’t currently centrally clear transactions. These costs will be passed on from FICC members to non-FICC members.
Similarly, highly leveraged or low-margin trading strategies, like basis and relative value trades, may become uneconomical as a result of these proposals. This means that less PTFs will trade them, leading to a reduction in liquidity on the underlying asset classes, such as US Treasury actives and this is likely to counteract the previously mentioned benefits.
Are any specific strategies being developed to accommodate these changes?
For existing members of the FICC, providing sponsorship services to non-member firms represents an opportunity that could lead to significant revenue for the FICC members, as they can charge fees for this service.
Sponsoring Members could also benefit from collateral netting between them and Sponsored Members. This strategy reduces the amount of collateral needed overall by offsetting obligations against each other and achieves economies of scale on collateral management, aggregating across several balance sheets.
Another strategy being developed to accommodate changes is investment in technology. This is largely to mitigate the costs of central clearing. This includes investment in scalable transaction reporting systems, which reduce the need for manual intervention, minimise the risk of failures and reduce the marginal cost per transaction. Overall, investing in technology will make it more economical for firms to comply with the new rule changes.