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BNY Mellon flags Treasury market functioning risks as key reform looms

A key reform proposed by the U.S. Securities and Exchange Commission to boost the use of central clearing in the Treasury market would need to be implemented over an extended period to avoid disruptions at a time of already turbulent market dynamics, BNY Mellon said on Wednesday.

The SEC central clearing rule, first proposed in September last year, would apply to the cash Treasury and repurchase agreements (repo) markets, where banks and other players such as hedge funds borrow short-term loans backed by Treasuries and other securities.

Under the rule, more trades would be sent to a clearing house, requiring counterparties to put up cash to guarantee execution in the event of defaults.

The regulator is expected to finalize the rule soon, but it is unclear how much time the industry would have to implement it. Some market participants worry that the higher trading costs linked to central clearing could discourage certain investors from trading, undermining the rule’s objective to improve liquidity and resilience in the world’s biggest bond market.

“We’re in a period when the Treasury market needs to be relied upon for its safety and liquidity,” Nate Wuerffel, head of market structure at BNY Mellon, said in an interview.

“And if on top of that you’re trying to implement very rapidly a fundamental reassembly of the Treasury market, that’s when you run the risk of having market functioning deteriorate.”

Liquidity crunches in recent years have raised regulatory concerns about the Treasury market’s ability to function during times of stress. Notably, in March 2020 the market seized up as pandemic fears gripped investors, prompting the Federal Reserve to buy Treasuries to support the market.

The rule would likely be implemented at a crucial time for bond investors. The Federal Reserve is reducing its Treasury security holdings as part of quantitative tightening, the Treasury plans to issue more debt to fund rising fiscal deficits, and investors are adjusting to the fastest increase in interest rates in at least 40 years.

“Central clearing will strengthen the market’s core attributes of safety and liquidity in times of stress. But implementation will be difficult,” Wuerffel said in a note on Wednesday.

“An extended implementation timeline in the final rule could substantially lower the risk that the transition itself could worsen market functioning,” he said.

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