Revolutionizing the $26.5 Trillion Treasury Market: Will New Rules Boost or Bust the World's Financial Epicenter?

In recent years, the $26.5 trillion US Treasury market, the world's largest and most liquid, has faced challenges that have raised concerns among regulators. The market plays a crucial role in executing monetary policy, facilitating government borrowing, and serving as a benchmark for global asset pricing.

Despite its importance, the Treasury market experienced dysfunction during crises such as the 2019 repo crisis and the market meltdown in March 2020, leading regulators to consider significant changes. The Securities and Exchange Commission (SEC), led by Chair Gary Gensler, has recently finalized two rules aiming to reshape the market.

The most impactful of these rules, passed in December, will reshape the market's infrastructure by mandating more trades through a clearinghouse. This move is expected to enhance oversight, protect investors, and prevent cascading defaults during crises. Kevin McPartland, head of market structure at Coalition Greenwich, describes this as a "monumental change" that will enhance market resilience.

In February, the SEC also approved the dealer rule, subjecting high-speed traders and potentially some hedge funds to regulatory scrutiny. These reforms, according to Josh Frost, assistant secretary for financial markets at the Treasury department, are significant steps toward making the Treasury market more resilient and maintaining its status as the world's deepest and most liquid market.

However, critics argue that these changes might impose additional costs, reduce trading volume, and concentrate risk within clearinghouses. The central clearing mandate, effective from December 2025, will require all Treasury trades with broker-dealers or interdealer brokers to pass through a clearinghouse, with most repo trades following suit from June 2026.

While central clearing is designed to protect investors during crises and improve market safety, there are concerns about potential negative impacts on liquidity and operational security. Market participants will need to navigate operational, technological, and legal challenges to implement these changes successfully.

The move to central clearing will likely increase costs for many traders, as they'll need to post cash as collateral and pay fees to clearinghouses. This collateral requirement can be seen as a cap on leverage, impacting strategies like the basis trade used by hedge funds. The SEC aims to balance risk management and liquidity to ensure a more efficient and liquid Treasury market in the long run.

Despite potential challenges, regulators believe that making the market safer will instill confidence among traders, generating greater interest and improving liquidity. The shift toward cleared trades backed by collateral could also lighten the burden on banks' balance sheets, theoretically reducing costs for facilitating this business.

While the Fixed Income Clearing Corporation (FICC) is currently the main clearing entity for Treasury trades, concerns arise regarding its potential single point of failure. The SEC has given the FICC until mid-March to outline its plans for handling the increased trade flow resulting from the overhaul.

Competition in the clearing space may emerge, with exchanges like CME Group and Intercontinental Exchange considering entry. The hope is that competition will drive down costs and mitigate the risks associated with relying solely on one clearinghouse.

Despite potential opposition and legal challenges, the SEC remains confident in the necessity and effectiveness of these reforms. Gensler emphasizes the importance of adapting to legal challenges and ensuring the Treasury market's continued resilience. The long-term goal is to create a more efficient and liquid market that can withstand future challenges.