Lynn Strongin Dodds looks at the next wave of products going through central clearing.
It has been a long time coming but central clearing of FX derivatives, US Treasuries and repo transactions is expected to increase this year, according Coalition Greenwich’s Top Market Structure Trends to Watch in 2024 report.
The momentum started with the uncleared margin rules, which began taking effect in 2016. They drove the cost of trading OTC derivatives higher, leading banks and investors to turn to clearinghouses. The tempo is likely to accelerate in the wake of the US Securities and Exchange Commission’s (SEC) new rules passed last December to bolster the resilience and reduce systemic risk in the $26 trn U.S. Treasury market by forcing more trades through central clearing.
The rules, which are due to land in June 2026, include all repo and reverse repo agreements centralised by US Treasury securities entered into by a member of the covered clearing agency, unless, the counterparty is a state or local government or another clearing organisation or the repurchase agreement is an inter-affiliate transaction.
Fixed Income Clearing Corporation (FICC), part of DTCC has estimated that the SEC proposal could add $1.63 trn in daily activity – $500bn in indirect participant Treasury repo activity, $520bn of indirect participant Treasury reverse and $605bn of indirect participant Treasury cash activity.
The legislation is in response to the repeated bouts of instability over the past decade, most notably the “dash for cash” that sent Treasuries into freefall at the start of Covid 19 in March 2020. Treasury trading nearly grounded to a halt, jeopardising the functioning of global financial markets. Broker dealers simply did not have enough room on their balance sheets to handle the deluge of Treasury sales from investors panicked by the unknowns of a global pandemic. As a result, the Federal Reserve had to jump in to buy hundreds of billions of dollars of Treasuries to steady the market.
The reforms in part target hedge funds and proprietary trading firms, which have become an ever-larger part of the Treasury market over the past decade but are relatively lightly regulated. The focus is on the so-called basis trades, which are typically the domain of of macro hedge funds with relative value strategies. They involve selling a futures contract, buying Treasuries deliverable into that contract with repo funding, and delivering them at contract expiry.
These trades have drawn scrutiny from regulators who worry that an abrupt unwind of leveraged positions could strain markets. In fact, last November, Moody’s Investor Services said those risks could be reduced by forcing trades through a central clearer.
As for FX derivatives, central clearing volumes are on the rise but they still remain a mere 5%, according to a mid-year report by the Bank for International Settlements. The lack of adoption can be attributed to several factors, according to a separate report from Coalition Greenwich – The Future of FX Derivatives Clearing. These include the absence of regulation, FX transactions generally have a shorter tenor, limiting counterparty risk; and certain transactions are excluded from the initial margin (IM) calculation.
However, the report noted that “FX clearing opportunities are expanding, interest rates have gone up, the market structure is evolving, and the cost of capital is rising—all tailwinds for FX clearing growth.”
Although clearing is pertinent to the derivative world, the Coalition Greenwich market structure report also highlights other trends that impact all asset classes such as the buy versus build and the never-ending search for affordable capital. However, these debates have been raging on for years. One of the more interesting questions to have emerged from the pandemic is what a normal market looks like. As the report put it, “If normal market conditions ever existed, they certainly haven’t shown themselves since at least 2019. The pandemic’s onset in 2020 left many anxiously waiting for life and financial markets to go back to the way they once were.”
It noted that this year could be a turning point, but the world will not reset the dial. “Life finding a new normal as we head into 2024,” says the Coalition Greenwich report. “Trading floors are full once more, but trains are still half empty on Monday and Friday. Seeing clients and partners in person is again important, but Zoom will often suffice in a way it didn’t in 2019. So, while pandemic restrictions are done, we live in a new world.”
The pandemic may have hit hard but markets also had to contend with a raging war in Ukraine, escalating energy prices and record high inflation and interest rates over the past two years. This is not even mentioning a mini banking crisis in the US and sluggish growth across the developed world. In many ways it could be argued that traders had become complacent in the decade long no or zero interest rater environment and forgot that volatility was often a hallmark of stock markets.
The report notes succinctly that “good news is bad news until it’s good again. Oscillations between bull and bear markets happen frequently and often defy conventional wisdom. The 60/40 portfolio died but came back to life just as quickly. And the Fed/inflation/QE/QT/rate rise/rate pause/rate cut conversation feels never-ending and increasingly tedious.”
On their own, some of these things are normal, but in combination, the current environment remains unique, and it believes that 2024 is well placed to carry the market’s abnormal nature forward.”
A separate report from Morningstar also sounds a note of optimism. It states that after four years, “2024 is lining up to be the year that the economy and individual behaviour have finally recovered and normalised. The massive disruptions caused by the pandemic and dislocations caused by those disruptions are behind us.”
Related Reading:
2024 Outlook: The Legislative Gift That Keeps On Giving
2024 Outlook: Trends to Watch Across Derivatives Post Trade
Clearing the Air – the Both Sides of the Active Account Mandate
