The Securities and Exchange Commission (SEC) has taken two important steps recently as part of a long-running U.S. government-wide push to reform the U.S. Treasury market. On December 13, 2023, the SEC published a final rule (the Treasury Clearing Requirement) under the Securities Exchange Act of 1934 (the ’34 Act) that significantly expands the types of transactions in U.S. Treasuries that must be cleared through a covered clearing agency. This important overhaul of the U.S. Treasury market is expected to dramatically increase the amount of daily U.S. Treasury clearing activity that will be processed through the Fixed Income Clearing Corporation (FICC).1 Then, on February 6, 2024, the SEC published a final rule (the Dealer Redefinition) establishing new standards for when a dealer is required to register under the ’34 Act. Under the final rule, entities will be required to register as dealers, under certain conditions, if such entities (1) regularly express trading interest that is at or near the best available price on both sides of the market for the same security and that is communicated and represented in a way that makes it accessible to other market participants or (2) earn revenue primarily from capturing bid-ask spreads, by buying at the bid and selling at the offer, or from capturing any incentives offered by trading venues to liquidity-supplying trading interests.
These new rules come against a background of increased regulatory activity in the U.S. Treasury market, including increased Trade Reporting and Compliance Engine (TRACE) reporting, proposed amendments to Regulation ATS, increased Federal Reserve liquidity provision against Treasuries, and other initiatives designed to shore up this important market.
Problems in the Treasury Market and the Official Sector’s Reform Agenda
The Treasury Clearing Requirement and the Dealer Redefinition both emerged from a long-running project by the U.S. agency members of the Inter-Agency Working Group for Treasury Market Surveillance to reform the U.S. Treasury market.2 These changes come in the face of increasing concern about risks in the critically important US$26 trillion U.S. Treasury market, which remains the deepest, most liquid financial market in the world. Market observers have noted cracks in the U.S. Treasury market, citing rapid growth coupled with an increasingly concentrated set of dealers and reduced capacity by broker-dealers to provide market liquidity.3
The SEC’s stated goals for the expansion of mandated central clearing include reducing counterparty, operational, and liquidity risks; bringing efficiencies to the U.S. Treasury market; and increasing regulatory visibility into the market. The Treasury Clearing Requirement is expected to result in approximately US$1.63 billion of additional daily U.S. Treasury clearing activity at FICC.4 While many market participants have welcomed the expansion of central clearing, there remains some uncertainty regarding the potential impact on market functioning.5
The Dealer Redefinition is an attempt to increase the regulation of proprietary trading firms that are playing an increasingly important role in liquidity provision in this market. Some firms have argued, however, that dealer registration would impose higher costs on operations, thereby reducing overall liquidity in the market.6
The Clearing Requirement: Eligible Secondary Market Transactions
The SEC adopted new Rule 17ad-22(e)(18)(iv) mandating that covered clearing agencies authorized to clear U.S. Treasury securities, such as FICC, establish, implement, maintain, and enforce written policies and procedures reasonably designed to facilitate the clearance and settlement of all eligible “secondary market transactions” to which a direct participant is a counterparty. This Treasury Clearing Requirement thus mandates the central clearing of the following types of eligible secondary market transactions in U.S. Treasury securities through the facilities of FICC:
- Repos and Reverse Repos: Repurchase agreements and reverse repurchase agreements collateralized by U.S. Treasury securities, in which one of the counterparties is a direct participant of FICC. Notably, this includes, among other things, both bilateral and triparty repos.
- Inter-Dealer Broker Transactions: Purchases and sales, entered into by a direct participant of FICC 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.
- Other Cash Transactions: Purchases and sales between a direct participant of FICC and a registered broker-dealer, government securities broker, or government securities dealer.
The Treasury Clearing Requirement does not apply to transactions that do not involve a direct participant of FICC. Transactions involving only indirect participants (i.e., customers of direct participants that access FICC’s services indirectly through such direct participants) are not covered.
The proposed rule would have also required the central clearing of cash transactions in U.S. Treasuries between direct FICC participants and hedge funds or leveraged accounts; however, in light of concerns regarding the cost and impact of such a requirement, the SEC removed it from the final rule.7 In addition, the SEC excluded the following types of transactions from the central clearing mandate:8
- Excluded Cash Transactions: Purchase or sale transactions in U.S. Treasury securities or repurchase or reverse repurchase agreements collateralized by U.S. Treasury securities in which one counterparty is a central bank, a sovereign entity, an international financial institution,9 or a natural person.
- Repos by Other Clearing Organizations: In recognition of the fact that central counterparties may rely heavily on repos and reverse repos as a means of creating liquidity within compressed timeframes in the case of a default, the SEC excluded repurchase or reverse repurchase agreements collateralized by U.S. Treasury securities in which one counterparty is a covered clearing agency providing central counterparty services or a derivatives clearing organization,10 or is regulated as a central counterparty in its home jurisdiction, from the central clearing mandate.
- Repos by State and Local Governments: In light of special legal, regulatory, and practical constraints (including relating to counterparty and margin requirements), the SEC excluded repurchase or reverse repurchase agreements collateralized by U.S. Treasury securities in which one counterparty is a state or local government. This exclusion does not extend to pension or retirement plans established by state or local governments for the benefit of their employees (or any of their beneficiaries).
- Interaffiliate Repos: The SEC provided a limited exclusion from central clearing for repurchase or reverse repurchase agreements collateralized by U.S. Treasury securities entered into between a direct participant of FICC and an affiliated counterparty.11 Any affiliated counterparty that takes advantage of this exclusion must clear all of its other repo and reverse repo transactions through FICC as required of direct participants under the rule (i.e., even if neither the affiliate nor its proposed counterparty were direct participants of FICC).12
In addition to the above, FICC is required to establish a framework for ensuring that its direct participants are complying with the central clearing mandate imposed under the new Treasury Clearing Rule, including by adopting policies and procedures that, at a minimum, address a direct participant’s failure to submit eligible secondary market transactions for clearing.
The Clearing Requirement: Netting and Margin Practices
In addition to the central clearing mandate described above, the Treasury Clearing Requirement also requires FICC to calculate, collect, and hold margin amounts for a direct participant's proprietary U.S. Treasury positions separately from the margin amounts for the direct participant’s customer’s U.S. Treasury positions. This would also prohibit FICC from netting customer and proprietary positions. FICC would continue to be permitted to hold all customer margin from a particular participant in a single comingled account (so long as the participant’s house margin is not also mixed in). This new rule does not require a direct participant to collect a specific amount of margin from its customers or determine customer margin in a particular manner, which will be determined based on other rules and regulations and negotiations between the direct participant and its customers. In addition, the SEC declined to prohibit FICC from using customer margin for other purposes such as loss mutualization (i.e., when a clearing agency uses non-defaulting participants’ funds to cover a default by another participant).
The segregation of house and customer margin at FICC makes it possible for the SEC to amend Rule 15c3-3a to permit broker-dealers to include customer margin required13 and on deposit with FICC in connection with U.S. Treasury purchase, sale, repo, and reverse repo transactions as a debit item in their customer reserve formula, subject to a number of conditions relating to the (1) type of margin on deposit with FICC, (2) segregation of individual customer assets being used to meet the customer position margin requirements, and (3) adoption by FICC (and the approval by the SEC) of rules relating to the calculation of margin, the investment of customer position margin by FICC, the segregation and protection of customer margin, and the return of unneeded customer margin. Including customer margin on deposit at FICC as a debit item in a broker-dealer’s customer reserve formula is expected to increase the amount of assets that a broker-dealer has available to meet the significant increases in margin requirements that are expected to result from the adoption of the Treasury Clearing Requirement.
The Dealer Redefinition
In the Dealer Redefinition, the SEC took aim at so-called proprietary trading firms (PTFs) that have become so large as to affect the liquidity and structure of the Treasury market. At the same time, the new definition applies beyond the Treasury market. In the release, the SEC noted that PTFs account for half of all daily volumes in the interdealer market, asserting that some act as “de facto market-makers.” Under the new standards, market participants that meet expanded statutory definitions are required to register with the SEC, become a member of a self-regulatory organization (SRO), and comply with other federal securities laws and regulations applicable to dealers, in addition to applicable SRO and Treasury rules and requirements. The Dealer Redefinition excludes market participants who have or control assets of less than US$50 million.
Section 3(a)(5) of the ’34 Act defines the term “dealer” to mean “any person engaged in the business of buying and selling securities … for such person’s own account through a broker or otherwise.”14 Similarly, Section 3(a)(44) of the ’34 Act provides that the term “government securities dealer” means “any person engaged in the business of buying and selling government securities for his own account, through a broker or otherwise.”15 Both the definition of “dealer” and “government securities dealer” exclude a person who buys or sells securities “not as part of a regular business.”
The SEC adopted new Rules 3a5-4 and 3a44-2 under the ’34 Act to further define “as a part of a regular business” within the definitions of “dealer” and “government securities dealer.” Under the Dealer Redefinition, any person that engages in the following activities as part of a regular business would constitute a dealer or government securities dealer:
- Regularly expressing trading interest that is at or near the best available prices on both sides of the market for the same security and that is communicated and represented in a way that makes it accessible to other market participants
- Earning revenue primarily from capturing bid-ask spreads, by buying at the bid and selling at the offer, or from capturing any incentives offered by trading venues to liquidity-supplying trading interest
In finalizing the Dealer Redefinition, the SEC made several modifications. Initially, the SEC had proposed a bright line quantitative test that would have automatically captured persons engaged in certain levels of Treasury trading within the definition of the buying and selling of securities “as part of a regular business.” Following industry comment, the SEC eliminated the quantitative standard from the final rules. Moreover, the SEC eliminated another proposed qualitative test, which would have captured persons engaging in liquidity provision by routinely making roughly comparable purchases and sales of the same or substantially similar securities in a day.
The SEC believes that the Dealer Redefinition will promote the stability and transparency of the U.S. Treasury market by subjecting all market participants that perform similar dealer functions to a common regulatory regime. Nonetheless, the SEC recognizes that the Dealer Redefinition will impose compliance costs on affected parties. The SEC estimates that 13 to 22 PTFs and up to four hedge funds will be required to register due to the Dealer Redefinition. SEC Commissioner Mark T. Uyeda expressed concern over the Dealer Redefinition finding that a “practically limitless” expansion of the “dealer” definition may “reduce liquidity in Treasury markets,” and thereby, “make them more volatile.”16
Compliance Dates
The Treasury Clearing Requirement will go into effect in three phases. Mandated central clearing of cash transactions in U.S. Treasuries will go into effect on December 31, 2025. Mandated central clearing of repurchase and reverse repurchase transactions in U.S. Treasuries will go into effect on June 30, 2026. All other elements of the new rule (including the segregation of house and customer margin) will be effective March 31, 2025.
The Dealer Redefinition becomes effective on April 29, 2024. Compliance is required by one year after this date.
Takeaways
While the full implementation of mandated central clearing of eligible secondary market transaction in U.S. Treasuries is two and a half years away, financial institutions engaging in or planning to engage in substantial activity related to covered transactions in the U.S. Treasury securities market should pay particular attention to any new proposed rules issued by FICC during this timeframe that are related to the Treasury Clearing Requirement. Broker-dealers may also wish to familiarize themselves with the new method for debiting customer margin from their customer reserve formula set forth in the new Note H to the reserve formula under Rule 15c3-3a.
Moreover, financial institutions — whether direct or indirect participants of FICC — should prepare for cost increases relating to central clearing, including increased costs associated with initial margin requirements and clearing fees and obligations with respect to FICC’s capped contingency liquidity facility.
Regarding the Dealer Redefinition, entities that are not currently dealers, or entitled to an exemption, and that are very active in the Treasury market should evaluate if they are covered by the SEC’s new qualitative standards.
The Treasury Clearing Requirement and the Dealer Redefinition rules come on the heels of other official sector initiatives to contribute to the resilience of the U.S. Treasury market. Starting in 2017, the Financial Industry Regulatory Authority imposed an obligation on broker-dealers to report post-trade transaction data in Treasuries to the official sector.17 In 2021, the Board of Governors of the Federal Reserve System announced a new domestic standing repurchase agreement facility to serve as a backstop in money markets and limit the potential for pressure in overnight interest rates.18 Most recently, the SEC proposed amendments to Regulation ATS (Alternative Trading Systems) related to the trading of Treasuries and other government securities.19
Institutions interested in how the Treasury Clearing Requirement and the Dealer Redefinition rules may impact their business may contact any of the authors of this Advisory or their usual Arnold & Porter contact. The firm’s Financial Services and teams would be pleased to assist with any questions about the Treasury Clearing Requirement or Dealer Redefinition rules, or the U.S. Treasuries market more broadly.
© Arnold & Porter Kaye Scholer LLP 2024 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.
