Our previous post explained the SEC’s proposal (the Proposal) to require central clearing of all “eligible secondary market transactions” with a participant in the Fixed Income Clearing Corporation (FICC). In this post we review the benefits of central clearing cited by the SEC to justify its Proposal. We also discuss “hybrid clearing” and “multilateral netting.”

Potential Benefits of Central Clearing

The Proposal identifies five benefits of clearing and settling Treasury trades through the FICC.

• The Proposal would decrease the overall amount of counterparty credit risk in the secondary market for U.S. Treasury securities.
• The Proposal would help the FICC to avoid a potential disorderly participant default.
• The Proposal would further the prompt and accurate clearance and settlement of U.S. Treasury securities by increasing the multilateral netting of transactions in these instruments, thereby reducing operational and liquidity risks, among others.
• The potential benefits associated with the multilateral netting of transactions at the FICC could help to unlock further improvements in U.S. Treasury market structure.
• Increased central clearing should enhance regulatory visibility in the U.S. Treasury market.

“Hybrid” Clearing

The risks of so-called “hybrid” clearing are of particular concern to the SEC. Hybrid clearing may result from the operation of electronic trading platforms by interdealer brokers (IDBs) for U.S. Treasury securities. As described in the Proposal:

Typically, an IDB provides a trading facility for multiple buyers and sellers for U.S. Treasury securities to enter orders at specified prices and sizes and have these orders displayed to all users on an anonymous basis. The trading facility automatically matches these orders according to priority and execution rules that are programmed in the trading facility. When a match occurs and a trade is executed, the IDB then books two trades, with the IDB functioning as the principal to each respective counterparty, thereby protecting the anonymity of each party, but taking on credit risk from each counterparty.”

Most IDBs are participants in the FICC, so, as explained in the previous post, an IDB must centrally clear with the FICC any trades with another FICC participant. If the other counterparty is not an FICC participant, then its trade is settled bilaterally through the Fed Securities Wire, commonly on a T+1 basis. In this circumstance, a failure by the non-participant may cause the IDB to fail on its centrally cleared trade, indirectly exposing the FICC to the non-participant’s counterparty risk. As the FICC is unaware of the trade with the non-participant, it cannot take steps (such as requiring margin) to protect against this risk.

Multilateral Netting

The Proposal includes the following example of “multilateral netting.”

Firm A is buying $90 million in U.S. Treasury securities from Firm B, Firm B is buying $80 million in the same U.S. Treasury securities from Firm C, and Firm C is buying $100 million in the same U.S. Treasury securities from Firm A.”

The following table shows the effects of novating these trades to the FICC and netting the dollar obligations.

	Amount due from (to) FICC (in millions)
Trade/ Counterparty	First	Second	Third	Net Amount Due
Firm A	($90)		$100	$10
Firm B	$90	($80)		$10
Firm C		$80	($100)	($20)

Without multilateral netting, if Firm C becomes insolvent, Firm A would still have to pay Firm B $90 million even though it does not receive the $100 million due from Firm C. By netting the first and third trade, however, the FICC will pay Firm A $10 million. Netting the second and third trade will result in the payment of another $10 million by the FICC to Firm B, leaving the FICC with a $20 million claim against Firm C. This is one-fifth of the $100 million loss that Firm A would incur without netting and might be recovered by the FICC from margin previously collected from Firm C.

Having described the SEC’s general objectives, our next posts will discuss in more detail the scope of “eligible secondary market transactions.”