The $13.4 trillion Treasury market is the deepest, most active debt market in the world. Yet it has some surprisingly dysfunctional corners, especially when it comes to the most pedestrian part of trading: processing paperwork in back offices.
According to estimates from various market participants, about half of Treasury trades are cleared centrally through the Fixed Income Clearing Corporation, whose members --- about 150 banks and brokers -- post collateral to compensate for losses if a party fails to live up to its end of the deal. The other half is cleared bilaterally, meaning that the parties come up with their own ways of assessing and protecting against such risk.
This hodgepodge approach to clearing presents a bigger challenge for firms when managing their trading risk than it does for, say, stocks, which are all cleared centrally.
Jim Greco, who conceived of an electronic Treasury trading platform called Direct Match in 2014, expressed his frustration over the Treasury market’s idiosyncratic quirks in a note published last week in Business Insider. In it, he explained why he shelved the planned launch of the electronic system, which aimed to provide a central location for different types of traders to come together, and why its future is in jeopardy.
"My greatest error was that I was so committed to altering the competitive landscape in the front-office that I did not adequately structure the firm to simultaneously attack the uncompetitive landscape in the back-office," he wrote.
Basically, Direct Match relied on one big firm, State Street, to serve as its clearing agent, but the firm withdrew from the arrangement at the last minute. Direct Match couldn't get off the ground without a big well-capitalized partner to make sure the back-office work was performed smoothly and with minimal counterparty risk.
In his post last week and a Bloomberg News article on Monday, Greco implied that he was frozen out of the market by self-interested dealers that are bullying smaller upstarts from joining the market. That seems to be a bit of an overreach. To join FICC, a firm must have a significant amount of capital and six months' experience running a profitable business. Big Wall Street banks are certainly competitive, but they are also concerned with managing risk. It's understandable for them to be wary of firms without a track record or much capital because they don't want to be on the hook for any potential trade failures.
But Greco makes a more salient point about the disjointed structure of the market, and the failure of his electronic marketplace to take off highlights how Treasuries may never trade like stocks, with central clearing and greater transparency. And it also highlights how the Treasury market's antiquated aspects make it more vulnerable to the risk of an individual firm running into trouble if it fails to manage its risk sufficiently.
The complexity of the back-office requirements has already had real consequences in markets, such as pushing an increasing number of the fastest bond traders to centrally cleared derivatives rather than cash bonds. Also, high-frequency traders often prefer to trade bilaterally because it's cheaper. But that means that it's harder to ensure these firms are accounting for the true risk of their counterparties failing to make good on the other end of a trade.
In contrast, if everyone were to clear their trades centrally, it would most likely become cheaper to do so because more firms would be contributing capital to protect against failures, and it would better quantify counterparty risks.
While Direct Match may not have been the answer, a push toward centrally clearing a greater proportion of Treasury trades would be a welcome development.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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