New Bond Market Requirements Meant to Fix US Treasury Market Volatility

The U.S. Treasury Market is about to undergo a major change, one that could drastically change how hedge funds do business. Until now, buyers and sellers of treasury bonds could deal directly with each other. Recently, the Securities and Exchange Commission Chair Gary Gensler supports the idea that treasury bonds should go through a central party clearinghouse, which he refers to as “the plumbing of the treasury market.” The SEC projects the transition to a central clearinghouse will be completed in 2026.

There have been a few shocks to the treasury market in recent years that have pushed the issue of a central clearinghouse. The clearinghouse requirement is supposed to increase the resiliency of the U.S. Treasury Market and create a safety net for treasury investors. The SEC is also proposing to make principal trading firms register as dealers. This would require them to keep reserves of capital on hand and to meet certain bookkeeping requirements.

What is the U.S. Treasury Market?

The U.S. Treasury market is the largest sovereign debt market in the world. Treasuries issue debt in order to raise capital. Corporations, institutional investors, and central banks may choose to buy debt to add diversification and a (typically) safe investment to their portfolios.

What Will the Clearinghouse Do for Investors?

Because the clearinghouse is responsible for the transaction, it has an incentive to perform its due diligence and to weed out any financial institutions that present too much risk. Clearinghouses are ultimately responsible for making sure a transaction clears, and they are far less likely to take chances. When a clearinghouse performs its due diligence, it may decide it requires collateral for riskier transactions. Because of the increased need for collateral, however, there will be less liquidity in the financial market, as fewer potential sellers will want to trade. On the plus side for investors, if a financial institution cannot complete its transaction, the clearinghouse will be able to complete the payments using money from its reserve deposits.

Fixed Income Clearing Corp (FICC)

Today, only approximately 13% of Treasury trading takes place through Fixed Income Clearing Corp, which is the only Treasury clearinghouse. With the new clearinghouse regulations, the FICC is poised to become the main clearinghouse for these types of transactions, although it is possible that alternative clearinghouses could enter the market.

The Repo Market and Hedge Funds

The clearinghouse requirement may present a major change for hedge funds. Many hedge funds make money using basis trades which require the use of short-term bond loans.

How Does Basis Trading Work?

Basis trades take advantage of the price differences between futures and the underlying commodities. Futures are agreements to buy or sell commodities at a certain price at some point in the future. They are essentially bets that the price of a commodity will change. The difference in price between the futures contract and the underlying commodity is called the basis.

• Short positions assume that the difference in prices will decrease, while long positions assume the price differences between the commodity and the future contract will increase.

By purchasing short positions in the futures market along with the underlying commodity, hedge funds can take advantage of small price differences.

What Are Repos?

Loans of treasury bonds are called “repos” and are used to raise cash to make basis trades. “Repos” refers to repurchasers — the repurchaser sells their bonds to an investor and promises to repurchase them after a short period, usually in around 48 hours. These short-term loans allow entities that own a lot of securities to raise cash quickly.

Dangers to the U.S. Treasury Market

The Treasury Market is considered a safe market, but a few recent crashes have exposed weaknesses, which the SEC believes a central clearinghouse could solve.

• On October 15, 2014, the U.S. Treasury Bond market experienced a flash crash. The bond market crashed and recovered 1.6%. It is unclear what caused the crash.
• In 2019, the repo market crashed. Several factors drove the need for certain businesses to quickly raise cash. Experts believe this may have been due to the deadline for quarterly taxes. The sudden increase in repos caused an enormous spike in repo interest rates. As a result, investors struggled to complete transactions in the repo market and the Federal Reserve had to inject it with cash.
• In 2020, the Covid-19 pandemic resulted in massive volatility in the treasury market. Foreign banks liquidated their U.S. treasury holdings. As cash bonds declined in value, basis trades suffered significant losses.

What’s Next?

Because the root causes driving crashes in the treasury market are poorly understood, it is not certain that a central clearinghouse will address these issues. It remains to be seen whether the increased security offered by a central clearinghouse and increased regulation of dealers will benefit investors more than increased liquidity in a less-regulated financial market.