In April, the Federal Reserve released its most recent semiannual Financial Stability Report. This report, like its predecessors, provides a wealth of information about the structure of the U.S. financial system and identifies a wide range of vulnerabilities that pose risks to financial stability in certain circumstances. This note does not attempt to provide a comprehensive review of the report. Rather, it highlights three issues that the author believes deserve further exploration and analysis: (1) Treasury market liquidity, (2) cross-margining of Treasury futures and cash market positions held by bank clients, including hedge funds, and (3) concentration of clearing of client positions in centrally cleared markets and the related vulnerabilities.
Treasury Market Liquidity
The discussion of Treasury market liquidity focuses exclusively on the markets for on-the-run Treasuries (those most recently issued). But concerns about market liquidity are most acute for other Treasury coupon securities (off-the-runs). Why? When investors sell Treasuries to raise cash, they sell what they own, and the lion’s share of what they own is off-the-runs. Also, on-the-runs are traded on electronic trading platforms managed by interdealer brokers, where principal trading firms augment the liquidity provided by bank dealers. But nearly all of the liquidity in the markets for off-the-runs comes from the broker-dealer affiliates of BHCs. So, concerns about intermediation capacity in the Treasury market are most acute for off-the-runs. While measures of market liquidity for on-the-runs are more widely available, the Fed has access to transactions data from FINRA’s TRACE reporting system, which can be used to calculate various measures of off-the-run liquidity, including yield spreads between off-the-run and on-the-run issues, within-security price dispersion in trading of the same security at the same time by different dealer clients, and root mean square errors (RMSEs) between actual yields and fitted values from estimated yield curves.[1] It would have been helpful for the Fed to include some of these measures in its report.
With respect to dealer intermediation capacity, the report states that “dealer intermediation in Treasury markets hit record highs in the first quarter of 2025.” But, unlike other metrics included in the report, it is unclear how dealer intermediation was measured. Perhaps here they are drawing on transactions data (the TRACE system operated by FINRA) to which the Fed and other regulators have access, and what they mean is that dealer purchases and sales of Treasuries reached a record high. Even then I wonder how they are defining “dealer”, and whether this reflects the SEC’s efforts to force PTFs to register as dealers. I certainly wouldn’t accept this as evidence that dealer intermediation capacity is ample, which I doubt even the Fed would assert.
Indeed, whatever recent indicators of Treasury market liquidity show, the fact is that the critical off-the-run segments remain dependent on the intermediation capacity of bank-affiliated dealers, and that capacity can’t possibly be keeping pace with the continued rapid growth of Treasury debt outstanding and the growing share held by investors that manage their portfolios more actively. In the wake of the Treasury market disruptions created by the dash for cash in 2020, a variety of proposals were made for enhancing intermediation capacity,[2] but some key measures, notably reforms of banking regulations that discourage bank intermediation, including the SLR and GSIB surcharges, have not been implemented.[3] Unless this imbalance between demand for, and supply of, intermediation is addressed, further episodes of Treasury market dysfunction seem inevitable.
Cross-Margining
In recent weeks there has been much discussion of the Treasury futures basis trade. The considerable appetite by some asset managers for long Treasury futures positions has driven up their prices and created opportunities to earn arbitrage profits by shorting Treasury futures and hedging the short position by buying Treasuries and financing them in the Treasury repo market. Hedge funds have engaged in such arbitrage on a large scale, which goes a long way toward explaining why their aggregate short futures positions have exceeded $1 trillion in notional value recently. This has given rise to concerns that large-scale unwinding of hedge fund basis trades could place significant liquidity pressure on the Treasury market. Some fear it could also pose risks to the banks that provide hedge funds with repo financing, especially because a significant share of those repos is provided without any required margin. But they may have no need to collect margin on a repo because it is part of a portfolio with a futures position, the futures margin is charged on a standalone basis and they have entered into a cross-margining agreement that allows them to cover any losses on liquidation of the repo collateral with margin collected on the futures transaction. Evidently, that is correct in principle but mostly wrong in practice.
I was surprised to read in the report that the March 2025 Senior Credit Officer Opinion Survey on Dealer Financing Terms (SCOOS) found that among dealers that have clients that transact in both Treasury repo and Treasury futures, “only a fraction reported that most, nearly all or all of their clients are under agreements that allow for cross-margining of Treasury repo and Treasury futures.” It would seem quite important to understand what the impediments are to use of cross-margining, which in other contexts is a widely used and powerful counterparty risk mitigant. Are there doubts about the legal enforceability of netting in this context? Is regulation failing to provide appropriate incentives for cross-margining? Unfortunately, neither the SCOOS nor the Financial Stability Report provides any insight into this important question.
Concentration of Client Clearing Services and Financial Stability Implications
The report provides a brief discussion of central counterparties (CCPs). CCPs have long been critical elements of financial market infrastructure. Use of central clearing has long been mandatory in the futures and options markets and in recent years large swaths of the OTC derivatives and Treasury and Treasury repo markets have become (or are becoming) subject to central clearing mandates. But discussions of the benefits and vulnerabilities associated with central clearing sometimes assume implicitly that market participants are direct members of CCPs. In reality, most market participants access central clearing indirectly through banks that intermediate between CCPs and market participants. The report correctly notes that this intermediation, which is termed client clearing, is concentrated at the largest clearing members and identifies this concentration as a vulnerability because “concentration could make transferring [often referred to as “porting”] client positions to other clearing members challenging.” [4] But it does not elaborate on the challenges or discuss options for addressing those challenges.
The significance and nature of the challenges have been made clear in recent reports prepared by regulators, CCPs and clearing banks.[5] If a clearing bank were to fail, a CCP would typically seek to transfer its clients’ positions and collateral to other clearing banks. As client clearing becomes more concentrated, the potential size of the necessary transfers grows while the number of banks to which the transfers might be made shrinks. Importantly, clearing banks are not obligated to accept such transfers, and if other clearing banks are unwilling to accept the transfers, the client positions and collateral typically would need to be closed out and liquidated, which could expose the CCP to losses and liquidity pressures.
The report observes that CCPs’ “initial margin levels remained high and stable during the second half of 2024. CCPs also maintained high levels of prefunded mutualized losses.” But those prefunded mutualized losses in most cases are predominantly resources prefunded by the clearing banks. While the failure of a CCP is a frightening prospect, a more likely but still quite scary scenario is one in which a large clearing bank fails and the CCP survives by imposing losses on the remaining clearing banks. And this prospect becomes scarier as clearing bank concentration grows. So, how concentrated is it? FSOC’s 2024 Annual Report stated: “Clearing members [as well as CCPs] are also highly concentrated. The same 10 globally systemically important banks (G-SIBs) are clearing members at the same global DFMUs (designated financial market utilities).”[6]
But what can be done about this concentration? First, do no further harm. In recent years many banks have exited the client clearing business. Notably, in the United States, the banks that have exited have predominantly been smaller foreign banks. While the reasons for the exits are not entirely clear, since 2016 the U.S. operations of many FBOs have been subject to the Fed’s IHC requirements, which impose significant fixed compliance costs that are especially burdensome for smaller players.[7] The Fed should investigate the reasons for the exits and assess whether excessive compliance costs are contributing. Second, ensure that through a combination of high initial margins and prefunded resources provided by parties other than the member clearing banks, loss mutualization does not impose losses on member banks that exacerbate the potential for contagion within the banking system. Third, adopt various practical measures advocated by CCP Global and ISDA to enhance the likelihood of successful transfer of client positions and margins to other clearing banks in the event a clearing bank fails.
Finally, when assessing the case for wider central clearing, policymakers often acknowledge that further concentration of risks in the CCP must be considered and addressed. This discussion suggests that they should also consider the risks posed by concentration of client clearing, including the potential for contagion within the banking system from excessive reliance on loss-sharing with clearing banks to protect the CCP from losses.
[1] See Duffie et al, Dealer Capacity and US Treasury Market Functioning. FRBNY Staff Report No. 1070, October 2023.
[2] See Group of Thirty, U.S. Treasury Markets: Steps Toward Increased Resilience, July 2021, https://group30.org/images/uploads/publications/G30_U.S_._Treasury_Markets-_Steps_Toward_Increased_Resilience__1.pdf; Glenn Hubbard and Donald Kohn, Report of the Task Force on Financial Stability, Brookings Institution, June 2021, https://www.brookings.edu/articles/report-of-the-task-force-on-financial-stability/.
[3] See Covas, Francisco, Sarah Flowers, and Brett Waxman. Empty Promises: Revisiting the Reasons to Fix the Supplemental Leverage Ratio. Bank Policy Institute. July 8, 2024.
[4] For information on concentration at US CCPs regulated by the Commodity Futures Trading Commission (CFTC), see Ketan B. Petal, How Concentrated is the Clearing Ecosystem and How Has It Changed Since 2007? Chicago Fed Letter, No. 497, July 2024.
[5] See Committee on Payments and Market Infrastructures and Board of the International Organization of Securities Commissions. A Discussion Paper on Client Clearing: Access and Portability. Bank for International Settlements. November 2021; CCP Global. A Primer on Portability. October 2024; and ISDA. Addressing Porting Challenges. October 2023.
[6] 2024 FSOC Annual Report, 69.
[7]See Anderson, Haelim, Francisco Covas, and Felipe Rosa. How U.S. Regulation is Reducing Foreign Bank Participation in Capital Markets. Bank Policy Institute. September 17, 2024.
