US securities regulators are rolling out big changes to the market plumbing for US Treasuries. They aim to aid transparency and resiliency to a more than $26 trillion market that helps guide the price of all kinds of securities and loans but whose trading activity is opaque and has suffered from big disruptions. Rules being phased in over the next couple of years will alter the trading infrastructure, operating rules and disclosure requirements for the large private funds operating in the market.

Under the rules, many of these high-frequency trading firms and hedge funds that are responsible for a large chunk of trading volume in Treasuries would have to register as dealers, requiring them to hold more capital as a cushion against losses and subjecting them to greater regulatory scrutiny. Industry groups have had a mixed reaction to the proposals, with some groups considering court challenges and others showing a willingness to adapt to the evolving rules of Treasuries trading.

What’s happening
A lot:

• The Securities and Exchange Commission in early February pushed through the rule that will require big players in the Treasuries market to register as dealers. SEC Chair Gary Gensler, who has made overhauling the Treasuries market a central pillar of his tenure at the agency, has said it’s inappropriate for these major Treasuries market players to be subjected to lighter regulation than dealers are, considering that both groups are “market makers” that quote buy and sell prices and provide vital market liquidity.
• The commission adopted measures that will significantly enhance transparency of Treasuries trading by requiring private funds and others to provide daily, individual (rather than aggregate) trading reports related to the most recently issued Treasuries. This so-called on-the-run debt constitutes the majority of daily trading activity.
• The SEC, in conjunction with the Commodity Futures Trading Commission, is overhauling the so-called Form PF, a confidential filing by private fund advisers with details of their trading positions. The form will require large hedge funds — those with a net asset value of at least $500 million — to provide additional information about their investment strategies, counter-party exposure and trading and clearing mechanisms, among many other new details.
• Those quarterly Form PF filings will be supplemented by a recently enacted provision requiring private funds to report to regulators within 72 hours any significant adverse event. These could include a loss of 20% or more of a fund’s aggregate value, the termination of a prime brokerage relationship, significant margin increases or margin defaults or a counter-party default.
• The SEC approved a rule in December that will push far more Treasury repurchase agreements, which are short-term funding deals that are collateralized with Treasuries, into central clearing. Some additional cash Treasuries trades will also have to be centrally cleared.
• The commission is forcing more proprietary trading firms — which typically trade with their own money — to join the Financial Industry Regulatory Authority, the industry’s self-regulator for broker-dealers. That change will result in more trade reporting on prop traders’ Treasuries transactions.

Why it’s happening
Several severe breakdowns in market liquidity have occurred over the last decade. They had many causes, but a big one was the ballooning US debt — $26 trillion now, compared with $12 trillion a decade ago — and dealers’ inability to keep pace. In response, regulatory agencies have undertaken a multipronged effort to shore up the Treasuries market and make it more resilient:

• After Treasuries convulsed on Oct. 15, 2014, for no clear reason — it was dubbed a flash rally — the SEC, CFTC, Treasury Department, Federal Reserve Board and New York Fed conducted a review. One result was a mandate to collect and disclose more Treasury trading data.
• In the course of just a few days in September 2019, interest rates for shot-term repurchase agreement loans shot up to almost 10% from under 3%, affecting rates across the maturity spectrum. Regulators posited that the spike was caused by the combination of dealers draining their reserves to pay corporate taxes due just as $54 billion of short-term Treasury debt hit the market, creating an imbalance of supply and demand. The Fed had to inject billions of dollars of liquidity in the system to stabilize it.
• A panic in the Treasuries market prompted by the start of the Covid-19 pandemic in March 2020 nearly froze trading and required the Fed to provide a backstop by buying billions of dollars in Treasuries per day.

The industry’s take
Many market participants say that “liquidity,” or the ability to easily trade, in the world’s biggest bond market has suffered as the amount of outstanding US debt has surged. Some investors assert that post-2008 financial crisis regulations on banks have reduced dealers’ ability to make markets by subjecting them to higher capital requirements, among other measures. Large dips in daily liquidity have become more frequent, in line with the heightened volatility in rates caused by uncertainty over Federal Reserve policy and geopolitical tensions, according to Josh Frost, the Treasury Department’s assistant secretary for financial markets.

Market participants’ reactions to all of these regulatory measures have been mixed. Many don’t oppose the concept of central clearing of Treasuries but say the devil’s in the details of how the new market plumbing will actually work. Daily, individualized trade reporting of Treasuries garnered the support of the hedge fund giant Citadel and the Investment Company Institute trade group.

What’s ahead
Market players in Treasuries are bracing for the changes in different ways. Industry groups are still figuring out whether they might litigate the latest dealer rule. Some trade groups, including the Managed Funds Association, are suing the SEC over other rules, finalized in August 2023, that would require more fee disclosures and retool contractual arrangements between hedge funds or private equity firms and their investors, often pension funds and endowments. The retooling would prohibit preferential treatment of some investors unless that’s disclosed to all investors in a fund. The group also came out swinging against the latest overhaul to the Form PF requirements, saying the required information would create a “warped perception of fund activity.” The critique may be an indication that the group might seek to litigate those changes as well.

The final rules to mandate more central clearing of Treasuries will take more than a year to flesh out. That’s because the only clearinghouse that handles Treasuries, the Fixed Income Clearing Corp., has to revamp how hedge funds and prop trading firms can gain access to its system to process trades. Many firms affected by that clearinghouse mandate say they’ll be keeping a close eye on what FICC proposes and how their ability to centrally clear Treasuries is affected as the industry, as a whole, works out the details to comply with the mandate.

What it all means
Regulators say they hope the changes, taken together, will result in a far more stable and transparent market, where regulators can get a grasp faster on leverage building up within the financial system, catch developing systemic risk earlier, and better understand the actions of private funds, whose size dwarfs that of the US banking system. More data means the Financial Stability Oversight Council, comprised of the heads of Treasury, the Fed and other financial regulators, could theoretically step in earlier with government programs during an emerging crisis to shore up whatever part of the financial system might be foundering and to avoid broader systemic risk. The private funds industry is reeling as it prepares to absorb more than a dozen overlapping compliance deadlines. Many are still digesting how exactly some of the rules might affect their trading strategies.

This article was provided by Bloomberg News.