Thursday, September 15, 2022

SEC proposes improvements to membership requirements and risk management for clearing Treasury securities

By Rodney F. Tonkovic, J.D.

The SEC has proposed rule amendments intended to enhance risk management in clearance and settlement for the U.S. Treasury market. According to the Commission, the increasing volume of non-centrally cleared transactions in U.S. Treasury securities may render central clearing agencies susceptible to member defaults from risks outside the transactions cleared by the agencies. To address this, the "Membership Proposal" would amend Exchange Act Rule 17aD-22 to amend the standards applicable to covered clearing agencies for Treasury securities to require written policies and procedures requiring that all direct participants submit all eligible secondary market transactions for clearance. Additional amendments address risk management and amend the broker-dealer customer protection rule. Comments will be due 60 days after publication in the Federal Register (Standards for Covered Clearing Agencies for U.S. Treasury Securities and Application of the Broker-Dealer Customer Protection Rule With Respect to U.S. Treasury Securities, Release No. 34-95763, September 14, 2022).

The SEC has been authorized to regulate clearing agencies engaged in the clearance and settlement of government securities, including Treasury securities, since 1986. As Chair Gensler noted, the Treasury market is the deepest and most liquid market in the world and is the base under which other markets are built, including mortgage and bank lending markets. The SEC plays a critical role in the function of the Treasury market, and a key aspect is oversight of clearinghouses for Treasury securities, and Rule 17aD-22 sets out the standards for Commission-registered clearing agencies. There is currently one Treasury clearing agency, the fixed Income Clearing Corporation.

While the Treasury market is generally safe, it has seen tremors such as the COVID shock in March 2020 and the October 2014 flash rally. Central clearing serves to lower risk by sitting in the middle "as the buyer to every seller and the seller to every buyer. Gensler said: "While central clearing does not eliminate all risk, it certainly does lower it. In 2017, however, only 13 percent of Treasury cash transactions were centrally cleared. Thus, I think there is more work to be done with respect to the amount of Treasury activity that is centrally cleared. I think that these rules would reduce risk across a vital part of our capital markets in both normal and stress times. This advances our three-part mission."

Rule 17Ad-22. There are three aspects to the proposed amendments to Rule 17Ad-22. First and foremost, the rule would be amended to require covered clearing agencies providing central counterparty services for Treasury securities to have policies and procedures reasonably designed to establish criteria for participation and requiring direct participants to submit for clearing eligible secondary market transactions to which they are a counterparty. Eligible secondary market transactions would be defined under Rule 17Ad-22(a) to include:
  • Repurchase agreements and reverse repurchase agreements in which one of the counterparties is a direct participant;
  • Any purchases and sales entered into by a direct participant if the direct participant (A) brings together multiple buyers and sellers using a trading facility (such as a limit order book) and (B) is a counterparty to both the buyer and seller in two separate transactions; and
  • Any purchases and sales of U.S. Treasury securities between a direct participant and a counterparty that is a registered broker-dealer, government securities dealer, or government securities broker, a hedge fund, and a levered account.
Eligible secondary market transactions would not include transactions where the counterparty is a central bank, a sovereign entity, an international financial institution, or a natural person. Clearing agencies would also be required to establish written policies and procedures to identify and monitor direct participants’ submission of transactions for clearing.

Two additional changes to the covered clearing agency standards are meant to improve risk management. Amendments to Rule 17Ad-22(e)(6)(i) would require that covered clearing agencies for U.S. Treasury securities have policies and procedures to calculate, collect, and hold margin for their direct participants' proprietary transactions separately from transactions submitted on behalf of indirect participants. Finally, the proposal would amend Rule 17Ad-22(e)(18) to require that clearing agencies have policies and procedures to ensure that they have appropriate means to facilitate access to clearance and settlement services of all eligible secondary market transactions, including those of indirect participants.

Customer protection provisions. The proposal would also amend Rule 15c3-3a, which, along with Rule 15c3-3, is part of the broker-dealer customer protection provisions. These provisions provide for safeguarding customer assets by segregating them from a broker-dealer's proprietary business activities. As the release notes, the proposed rules could cause a substantial increase in the margin broker-dealers must post to a Treasury securities central clearing agency resulting from their customers' cleared positions. Rule 15c3-3a currently does not permit broker-dealers to include a debit in the customer reserve formula equal to the amount of margin required and on deposit at a covered clearing agency for U.S. Treasury securities, meaning that brokers would need to use their case and securities to meet these requirements.

The proposal would amend rule 15c3-3a to permit margin required and on deposit at a Treasury securities central clearing agency to be included as a debit item in the customer reserve formula. This new debit item, which is subject to conditions for the protection of a broker-dealer's customers, would offset credit items in the Rule 15c3-3a formula and free up resources that could be used to meet the margin requirements of a covered clearing agency. This item would be reported on a new Item 15 of the Rule 15c3-3a reserve formula.

Commissioners' reactions. Chair Gensler was pleased to see that the proposal was approved unanimously. Commissioners Crenshaw and Lizárraga offered firm support for the proposed amendments, both stressing the size and significance of the Treasury market. Commissioners Peirce and Uyeda had some reservations, however, with Uyeda preferring a comment period of at least 90 days, given the complexities of regulating the Treasuries market. Commissioner Peirce supported addressing the problems in the Treasuries market but did not necessarily back the proposed solution. She described the proposal's approach as heavy-handed and made several suggestions to approach the issue with a lighter touch.

The release is No. 34-95763.