The Treasury Report: Implications for the U.S. Treasury Market
The U.S. Department of the Treasury published its eagerly anticipated second report on the Trump administration’s “Core Principles” on financial regulation. As a reminder, those Core Principles were defined in the original executive order signed two weeks after Trump’s inauguration and are a conservative grab bag of “preventing bailouts” and “moral hazards,” “advancing American interests,” enabling America companies to be more “competitive,” and making regulation “efficient” and “accountable.” Typically, these types of directives are done at the beginning of a Presidential term to lay the theoretical groundwork for the administration’s thinking about the current regulatory regime.
To be honest, I was a bit worried before the release of the report. Trump had gems on the campaign trail like, “Dodd-Frank has made it impossible for bankers to function.” I worked at a bank, and while it was dysfunctional, it was definitely possible to function. Trump also promised the changes he would make would be “close to dismantling of Dodd-Frank.” Now, we all know, Trump does not understand what Dodd-Frank is, much less how to dismantle it, so it is hard to take things like this seriously (or is it literally?).
The report is forward-looking for the U.S. Equities markets and echoes many of the ideas that the SEC under Mary Jo White advocated for in recent years. The OTC derivatives reforms are also pretty nuanced, and there are some good ideas to fix a few of the areas that Dodd-Frank got wrong. The recommendations are consistent with CFTC Commissioner Giancarlo’s prior public pronouncements. The U.S. Treasury market section, however, is rather disappointing and a giant break from the last administration.
Trade Reporting
As of July 2017, broker-dealers are required to report all transactions in U.S. Treasuries to TRACE, FINRA’s trade reporting facility for bonds. Unlike other fixed income asset classes, U.S. Treasury transaction data is only available to regulators. Last October, Antonio Weiss, counselor to the last Secretary of the Treasury, advocated to swiftly make the data available to the public:
But we believe the debate should shift from whether to seek increased transparency to how, when, and on what basis. … Properly implemented, greater transparency in the Treasury market can offer substantial benefits, while protecting market functioning and liquidity.
The Treasury report walks back Weiss’ definitive statement to an “under review”:
The data on Treasury transactions is not being publically disseminated and is available to regulators and Treasury only, with the policy concerning public dissemination of the data currently under review by Treasury.
From what I have heard, we will likely never see the public dissemination of TRACE under the current regime. A I wrote in July, the Treasury Department is understaffed, and its leaders seem largely uninterested in reforms of our most important market.
Regulatory Regime
Large parts of the secondary U.S. Treasury market are lightly regulated. Proprietary trading firms (“PTFs” a/k/a “HFT firms”) can only trade on a U.S. equity exchange (e.g., NASDAQ) with a broker-dealer. There is no such regulatory requirement for PTFs to trade on a U.S. Treasury interdealer broker (“IDB”) (e.g., BrokerTec). As a result, some firms trade through broker-dealers while others do so through unregulated entities.
Weiss was an advocate of putting the interdealer market under a firmer regulatory regime by requiring all PTFs to trade through broker-dealers. Furthermore, IDBs would have to register with the SEC as an alternative trading system (“ATS”). These are common sense reforms and would not actually be a huge burden for market participants to bear.
The report has no mention of registration. In fact, there is an explicit acknowledgement that PTFs are not dealers in the document: “Most PTFs are not regulated because they do not meet the definition of dealer, as set forth in the Exchange Act and interpreted by the SEC.” Instead of requiring PTFs to register as dealers to facilitate TRACE reporting, the Treasury has come up with a scheme to modify TRACE so that the IDB will identify the PTF on the trade ticket:
Treasury recommends closing the gap in the granularity of PTF data. To close this gap, trading platforms operated by FINRA member broker-dealers that facilitate transactions in Treasury securities would be required to identify customers in their reports of Treasury security transactions to TRACE.
Central Clearing
Central clearing is near and dear to my heart, so it is always nice to see the problem articulated accurately:
The advent of electronic platforms enabled new types of participants — namely PTFs — to enter the IDB market in the early 2000s and grow rapidly. While the registered broker-dealers that are members of FICC clear their transactions through FICC, transactions between PTFs that are not FICC members must be settled bilaterally.
The ultimate consequence of these changes in clearing practices is twofold. First, there is less netting down of settlements than there would be if all interdealer market participants were FICC members. Second, if a large PTF with unsettled trading volumes were to fail, the failure could introduce risk to the market and market participants.
And the Treasury points the blame squarely at the capital requirements and fee structure of the central clearing counterparty, FICC, as I have written about in the past:
Despite the disadvantages that result from the bifurcation of clearing and settlement in the Treasury IDB market, any effort to include PTFs in FICC’s membership is complicated by the current fee structure and capital requirements imposed by FICC on its members, which could pose an economic barrier to entry for these firms.
FICC’s fee structure was designed for the 1980s to process large tickets (wholesale trades through voice brokers) and to account for its member firms holding large overnight positions. PTFs do not trade that way. They trade in small clips, turn over inventory many times a day, and aim to end the day with no position.
In the report, the Treasury punts on the idea as needing more study. It does not say it explicitly, but the Treasury is actually just deferring to the Treasury Market Practices Group (“TMPG”), which is working on a project to map out the entire clearing and settlement landscape. This group includes primary dealers, PTFs, IDBs, and the FICC. Ultimately, the report they produce will lay the theoretical groundwork for any central clearing mandate and ultimate changes to FICC’s fee schedule and membership requirements.
