The Securities and Exchange Commission (SEC) is in the process of introducing noteworthy rule changes to the clearing of fixed income securities, a development which is set to reshape the landscape for fixed income trading. These changes are designed to improve market stability, increase transparency, and mitigate systemic risks in bond markets, affecting everything from Treasury securities to corporate debt.
For trading desks, the new rules will result in a range of operational and regulatory shifts. Clearing obligations will become stricter, with enhanced oversight of margin requirements and risk management processes.
Despite these new potentially arduous compliance pressures, trading desks are also likely to benefit from reduced counterparty risk and improved market confidence thanks to the changes. Day-to-day trading activities, liquidity, and risk management on fixed income desks are all things that could be impacted by these new rule changes. As with any regulatory change or evolution, industry participants will need to adapt their strategies and systems to navigate the shifting fixed income landscape.
“As numerous policymakers, academics, and market participants have recognised, greater central clearing of US Treasury transactions would improve the safety, soundness, and efficiency of the US Treasury market, promote competition, enhance transparency, and facilitate all-to-all trading,” notes Laura Klimpel, managing director, head of fixed income and financing solutions at The Depository Trust and Clearing Corporation (DTCC).
“Increased central clearing can also reduce clearing costs and credit risk by incentivising direct participants to submit more balanced portfolios that have a lower risk profile and thus carry lower clearing fund and liquidity facility requirements.”
In addition, with the introduction of balance sheet netting and favourable regulatory capital treatment, central clearing could result in an increase of dealers’ capacity to transact and potentially improve some market liquidity constraints.
The SEC’s new rule changes are primarily aimed at improving market stability and minimising systemic risks. They aim to strengthen the security of the US Treasury market by requiring central clearing for eligible instruments such as repos, reverse repos, inter-dealer broker transactions, and other cash transactions. The objective of these rules is to reduce counterparty risk, curb contagion, and enhance market transparency.
“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,” highlights Edoardo Pacenti, head of trading tools for fixed income at ION.
“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.”
As it currently stands, two compliance dates exist which firms should be most conscious of. If no extensions are actioned, 31 December 2025 marks the beginning of the mandate for cash transactions, while on 30 June 2026 the repo transaction mandate will commence.
Institutions should also note that the SEC has implemented a regulatory change to redefine the term ‘dealer,’ aimed at increasing oversight of proprietary trading firms (PTFs), which are key liquidity providers in the US Treasury market.
PTFs, which trade using their own capital rather than on behalf of clients, will now be required to register as dealers with both the SEC and FINRA. Alternatively, if PTFs prefer not to register as dealers, they must set up 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,” adds Pacenti.
Another key consideration for institutions is the increase in clearing volume that will occur as a result of these rule changes.
“Our understanding is that seven trillion or so is the daily average volume that is traded in these markets. Based on our engagement with market participants, we’re expecting that it’s going to be an increase in demand for capital – maybe a 20-30% increase,” notes Kevin Khokhar, head of investment funding at T. Rowe Price. “Firms will have to look at the infrastructure, systems and processes, to see if they can absorb this large market structure regulatory change.”
Khokhar continues to highlight that margin and portfolio funding impact should be another key focus for institutions as they adapt to these rules. When considering bilateral transactions, which typically occur in the treasury trading space, when shifting into a cleared model, there will be increased rules and regulations around the type of assets you can pose for margining, to optimise and normalise FI trading books.
“Being able to understand the impact of your liquidity profile in your trading portfolios will be one of the key factors, something that the market needs to consider as you get into clearing market structures,” he adds.
Competition
The new fixed income clearing rules could potentially have a significant impact on competition in the bond markets, particularly for new entrants. By mandating central clearing for a wider range of transactions and increasing oversight on market participants, the new rules could raise the operational and compliance costs for smaller firms and new market entrants. Despite this potentially leading to barriers to entry, it could also enable a more level playing field by reducing counterparty risk and increasing transparency.
“Transparency is always good for competition, right? It narrows bid ask spreads. It makes things easier to trade and encourages more to be involved because there’s more information,” notes Brian Rubin, head of US fixed income trading at T. Rowe Price.
“The new rules should make markets more liquid. We’re always looking for greater transparency.”
Established firms, which have more robust infrastructure and regulatory expertise, may find it easier to adapt to these changes, while newer players will need to navigate increased regulatory expectations to compete effectively.
The new rules also have the potential to shift the ways in which transparency exists within the fixed income landscape. Particularly, with a shift from transparency solely being held by broker dealers, to the buy-side.
“As you move from more of a bilateral transaction-based market to more of a cleared based model, market participants including buy-side participants will potentially see more transparency into what the transactions levels look like, what overall trading volume trends are, and also some of the post-trade aspects that impact FI Treasury and repo markets,” emphasises Khokhar. “That gives market end users more transparency on the buy-side to see what potentially may be happening from the dealer/broker community.”
Impacts on trading
Central clearing is expected to alleviate counterparty credit limits through improved risk management and transparency offered by central counterparties (CCPs) and shift previously uncollateralised bilateral agreements to CCPs. This transition should notably reduce the risks of counterparty defaults and fire sales.
“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,” notes Pacenti.
“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.”
Likewise, highly leveraged or low-margin trading strategies, such as basis and relative value trades, may become less viable due to these proposals. As a result, fewer PTFs may engage in these trades, causing a decline in liquidity for the underlying asset classes, like US Treasury actives. This could offset some of the anticipated benefits of the new rules.
Anticipating the changes
DTCC’s Klimpel tells The TRADE that as a covered clearing agency, FICC has been taking the necessary steps under the SEC rule requirements to prepare for this significant market structure initiative.
“FICC offers a variety of both direct and indirect membership models for buy- and sell-side market participants. As we prepare for the upcoming mandate, FICC continues to work with the industry to educate firms, assess offerings, and ensure readiness,” she states.
“Our guidance to market participants is to begin preparations now by evaluating direct and indirect access models to determine the best approach for their organisations and clients to achieve successful implementation by the SEC compliance dates.”
Another strategy being developed in response to these changes is increased investment in technology, primarily to offset the costs of central clearing. This involves investing in scalable transaction reporting systems, which reduce reliance on manual processes, lower the risk of errors, and decrease the marginal cost of each transaction.
“Overall, investing in technology will make it more economical for firms to comply with the new rule changes,” adds Pacenti.
With rule changes such as these, the impacts will be felt across institutions, spanning across different areas of their operational structure. Having open and more transparent communication among the different strands of a business will have a positive impact on efforts to make compliance successful.
“We have to understand the impact from a fixed income trading perspective, but also post-trade services and capabilities. We need to assess the impact to operations, risk, and other business units as well as our external providers for sourcing portfolio liquidity,” argues Khokhar.
“Another aspect is having operational strategies, where market participants should implement a governance structure across all potential impacted business units to fully understand the impact to your front-to-back trading platform.”
Despite some hopes that the implementation of these fixed income clearing rules will be delayed, institutions should act as though the set dates are expected to go ahead as planned to ensure adequate adjustments are made to ensure successful compliance. Clearing obligations will undoubtedly become more prominent, requiring an increase in viewpoints of margin requirements and risk management processes. As with any key regulatory change, the sooner institutions can prepare, the better the outcome will be for the industry at large.