Treasury Secondary Transaction Rule Finalized by SEC

The Securities and Exchange Commission finalized a rule Wednesday that requires central clearance of a wider range of Treasury security secondary transactions, a market of approximately $26 trillion. The commissioners voted 4 to 1 in favor of the rule change.

The rule would require clearing agencies that provide counterparty services for Treasurys to require certain secondary market transactions to be cleared. Clearing agencies also will need to update their policies to “calculate, collect, and hold margin for their direct participants’ proprietary transactions separately from transactions submitted on behalf of indirect participants.”

Secondary transactions in Treasury securities do not need to be submitted for clearing when a counterparty is a central bank, sovereign entity, international financial institution or natural person.

According to the SEC, the rule will “enhance risk management for central counterparties” because of the relative transparency of the clearing process, compared with private trades. The rule would require secondary market participants to post collateral to back their positions or cap their use of repo trades.

The SEC’s fact sheet on the amendments stated that the regulator views the changes as necessary, in part because the “U.S. Treasury market plays a unique role in the U.S. and global economy.” Central clearing for the Treasury market “can help increase the safety and efficiency of securities trading, reduce costs, and mitigate the potential for a single market participant’s failure to destabilize other market participants or the financial system.”

SEC Commissioner Caroline Crenshaw, who voted in favor of the rule, said in her statement Wednesday that the need for more clearing is in part motivated by past instances of market stress, including the “flash rally” in October 2014, a spike in repo rates in September 2019 and during the COVID-19 pandemic. She noted that, currently, about 13% of Treasury secondary transactions are centrally cleared.

Jay Gould, a special counsel with Baker Botts LLP, explains that the SEC and other regulators “are trying to address systemic risk” in this space. He says many investment banks and hedge funds are trading Treasurys “in dark pools,” where “nobody knows what’s happening.” This makes it difficult for regulators to assess and mitigate systemic risk in the economy, he says.

Gould expects the new rule to cover a “substantial majority” of secondary trades and to bring more transparency on “how leveraged the markets are,” which will help the Federal Reserve better understand the impact of interest rate changes, because they will have more data on leverage in the Treasury market.

Trading outside of clearing agencies can permit some hedge funds to trade using unreported leverage, making it harder for others to trade against them, Gould explains. He expects the rule to have the largest impact on hedge funds and other large institutional traders.

The SEC’s rule has a staggered implementation stage. Starting on March 31, 2025, requirements for clearing agencies to change management and access policies will come into effect. After that, direct participants of a clearing agency must clear secondary cash transactions by December 31, 2025, and repo transactions by June 30, 2026.