Remember the Repo Crisis of Sep 2019?
Overnight money market rates had spiked and showed significant volatility, with the SOFR spiking up from 2.43% on Sep 16 to 5.25% on Sep 17. (Refer image; Source: www.federalreserve.gov)
The largest money market in the world had just experienced an unsettling liquidity squeeze! (.. a situation that was then only alleviated after the Fed announced an overnight repo operation, to be conducted on the morning of 17th, offering up to $75 billion against USTs and other govt. bonds as collateral).
The events of Sep 2019 would ultimately only serve as a precursor to the biggest liquidity shock ever experienced in the US treasury market ─ the dash-for-cash in March 2020.
Which might prompt you to think: Why would the biggest fixed-income market experience liquidity outages?
Consider this: The Fixed Income Clearing Corporation (FICC) is the sole clearer of Treasuries and at present just 13% of cash treasury trades go through it!
That’s a staggeringly low percentage; and does make the UST market vulnerable during periods of heightened stress.
Here’s how:
Presently, a large volume of cash treasury trades is bilaterally cleared: which means each party assumes a counterparty risk of the other and the settlement is directly between the two parties.
You can see straightaway the risk this form of clearing poses during a period of market stress.
What if one of the counterparty defaults?
And imagine the subsequent domino effect it could create on the world order.
The SEC has identified this [bilateral clearing] as a clear-and-present danger for liquidity seizing up in the UST markets and have rung in changes that would force larger volumes of trades through a Clearing House.
And how does a Clearing House reduce counterparty default risk?
Think of a Clearing House as an entity that sits between a buyer and seller in a trade and takes collateral from both to safeguard each party’s interests.
It’s not all hunky-dory though for all market participants: forcing a larger volume of trades through a Central Clearing House means the SEC has taken the axe to Hedge Funds running strategies related to basis trades ─ usually 100x levered trades that bet on a convergence in the prices of Treasury Cash-Futures.
Hedge Funds may not really have the same appetite for Basis Trades, since they will now be required to post cash as collateral.
