United States: SEC Adopts Clearing Requirement For U.S. Treasury Transactions

Overview:

On December 13, 2023, the Securities and Exchange Commission (the "SEC" or "Commission") adopted rule amendments (the "Amendments")¹ under the Securities Exchange Act of 1934 that will, in effect, require direct participants of covered securities clearing agencies (CCAs)² to submit for clearing all their repurchase and reverse repurchase transactions involving U.S. Treasury securities and other cash market transactions in U.S. Treasury securities with certain types of regulated counterparties.

The Amendments mandate that CCAs engaged in Treasury clearing have written policies and procedures reasonably designed to require that every direct participant of the CCA submit for clearance and settlement all "eligible secondary market transactions" in U.S. Treasury securities to which it is a counterparty. Currently, the Fixed Income Clearing Corporation (FICC), a subsidiary of the Depository Trust & Clearing Corporation, is the only CCA that offers clearing services for Treasury repurchase and reverse repurchase transactions (collectively, "Treasury Repos"), although the Amendments do not restrict the development of other CCAs for Treasury clearing.

The Amendments are likely to result in significant changes in the structure and operation of the U.S. Treasury markets, particularly for Treasury Repos. Although the Amendments by their terms only address Treasury Repos that are entered into with by direct participants of a CCA, most Treasury Repo transactions that are entered into by institutional investors are with direct participants of a CCA, which means that any of these Treasury Repos that qualify as eligible secondary market transactions will be subject to the Amendments and require clearing. The approach taken in the Amendments, i.e., imposing an indirect requirement for clearing through members of registered CCAs, reflects limitations on the SEC's authority to impose a more direct requirement. Full implementation of the Amendments is expected to require changes in the way CCAs and their direct participants provide access to clearing for direct participants' own customers. In addition, customers of direct participants that may be subject to indirect clearing requirements under the Amendments will likely need to put into place new documentation and arrangements in order to clear their transactions.

The scope of this clearing requirement with respect to transactions other than repurchase transactions is somewhat narrower than under the proposed rules ("Proposed Rules").³ In particular, the Amendments will generally not require clearing of cash market transactions of most fund entities. The Amendments will also require registered CCAs to take further steps to facilitate indirect access to U.S. Treasury clearing and will amend broker-dealer reserve formulas to address margin on deposit with a CCA in a manner intended to facilitate U.S. Treasury clearing.

The Amendments provide for a phased implementation. Covered cash market transactions will have to be cleared beginning December 31, 2025. Covered repo transactions will have to be cleared beginning June 30, 2026. CCAs will be required to submit to the SEC their rules implementing the clearing mandate and related procedures by specified deadlines in advance of those dates, as explained further below.

Requirement to Clear "Eligible Secondary Market Transactions"

Under the Amendments, a CCA will be required to mandate, as part of its criteria for participation, that direct participants of the CCA submit for clearance and settlement all the "eligible secondary market transactions" to which they are a party.⁴

"Eligible secondary market transaction" is defined as:

• Treasury Repo (subject to a few exclusions as discussed below), in which one of the counterparties is a direct participant;
• any purchases and sales of U.S. Treasury securities entered into by a direct participant if the direct participant:
  • brings together multiple buyers and sellers using a trading facility (such as a limit order book); and
  • is a counterparty to both the buyer and seller in two separate transactions; and
• any purchases and sales of U.S. Treasury securities between a direct participant and a counterparty that is a registered broker-dealer, government securities dealer or government securities broker.

Treasury Repo transactions that are covered by the Amendments thus include: (i) triparty repos; (ii) repo transactions by registered funds⁵ and hedge funds;⁶ (iii) repos by futures commission merchants (FCM); and (iv) repos by commercial end users, in each case, provided that they are entered into with a direct participant of the clearing agency.⁷

The scope of covered cash market transactions is significantly more limited. Only those transactions entered into between a direct participant and a broker-dealer or government securities broker-dealer would be covered. Significantly, for cash market transactions, the SEC did not adopt a requirement from the Proposed Rules that cash market transactions between hedge funds or other leveraged vehicles and direct participants be cleared (although repos involving such funds are subject to clearing under the rules). Cash market transactions are also covered, where the direct participant is operating a trading facility such as a limit order book and serves as a counterparty to both buyers and sellers matched by the facility.

The clearing requirement only applies to the types of Treasury transactions that are accepted for clearing at a covered CCA; it does not impose a requirement on a CCA to offer additional products for clearing.

Exclusions: The Amendments provide certain exclusions from the clearing requirement:

• any Treasury Repo transaction in which one counterparty is itself a CCA providing central counterparty (CCP) services, is a derivatives clearing organization registered under the Commodity Exchange Act, or is regulated as a CCP in its home jurisdiction;
• inter-affiliate repo transactions entered into between a direct participant and an affiliated counterparty that is a bank, broker-dealer or FCM, provided that the affiliated counterparty submits for clearance and settlement all other Treasury Repo agreements to which it is a party;⁸
• any Treasury Repo between a direct participant and a state or local government, other than any pension or retirement plan established or maintained by a state, any of its political sub-divisions, or any agency or instrumentality of a state, for the benefit of its employees;
• any transaction between a direct participant and a central bank, a sovereign entity,⁹ or an international financial institution;¹⁰ and
• any transaction between a direct participant and a natural person.

In the adopting release, the SEC recognized, in response to comments raised by some market participants, that there is currently only a single CCA that provides U.S. Treasury clearing, the FICC. The SEC rejected comments that a clearing requirement should only be imposed if there were more than one eligible CCA. The SEC noted in response to these concerns that the FICC is itself a highly regulated designated CCA under Title VIII of the Dodd-Frank Wall Street Reform and Consumer Protection Act that is subject to heightened supervision and examination by the Commission, in consultation with the Board of Governors of the Federal Reserve System, in addition to the SEC's rules for CCAs. The SEC also noted that other CCAs could engage in Treasury clearing in the future.

Amendments to Covered Clearing Agency Standards

The Amendments also include a number of additional requirements for CCAs engaging in Treasury clearing, including the following:

• The CCA must calculate, collect and hold margin amounts from a direct participant for its proprietary U.S. Treasury positions separately from margin of indirect participants (i.e., customers) that clear through the direct participant. As a result, a U.S. Treasury securities CCA will not be able to net customer and proprietary positions and margin.¹¹
• The CCA must have appropriate means to facilitate direct and indirect access. The CCA's board must review the policies and procedures relating to such access annually. The SEC did not impose any particular models for indirect access, but stated that a CCA, in consultation with stakeholders, must develop access models that meet the needs of different market participants. The SEC noted a concern with access models that treat transactions differently based on the identity of the participant submitting the transaction, the fact that a customer is a party to the transaction, or the method of execution, among other factors.
• The CCA is required to monitor whether direct participants are submitting transactions for clearing as required. A CCA must have policies and procedures to address a participant's failure to do so, including to provide that direct participants will be appropriately disciplined for violation of these requirements. The SEC left CCAs with flexibility as to how to assess compliance by direct participants.¹²

Amendments to Broker-Dealer Customer Protection Rule

To facilitate clearing of Treasury transactions of indirect participants and recognizing the need for broker-dealers to post margin to a U.S. Treasury securities CCA resulting from their customers' cleared U.S. Treasury positions, the Amendments modify the broker-dealer reserve requirements under SEC Rule 15c3-3a. In general, a broker-dealer will have to credit to the reserve formula the amount of customer margin received by the broker-dealer with respect to cleared Treasury transactions. Under the Amendments, subject to certain conditions mentioned below, a broker-dealer may include customer margin required and on deposit at the CCA for customer Treasury positions as a debit item in the customer reserve formula, thus offsetting the credit from the customer margin.¹³ There are certain conditions to the broker-dealer's ability to debit these amounts:

• Permitted Collateral: The customer position margin must be in the form of cash, U.S. Treasury securities or other qualified customer securities¹⁴ and must be used by the broker-dealer to margin U.S. Treasury securities positions of its customers that are cleared, settled and novated at the CCA.
• Use of Customer Margin: The customer position margin must be delivered by the broker-dealer to meet a margin requirement resulting from that customer's U.S. Treasury securities positions cleared, at the CCA and not for any other customer's or the broker-dealer's own positions. Broker-dealers may elect to deliver proprietary U.S. Treasury securities to meet a margin requirement of a customer resulting from that customer's cleared positions, subject to certain limitations.
• Rules of U.S. Treasury Securities CCA: The CCA must implement a set of rules relating to the manner in which margin is held:
  • The CCA must have rules providing for calculation of a separate margin amount for each customer of the broker-dealer and the broker-dealer must deliver that amount of margin for each customer on a gross basis;
  • The CCA must be limited to investing customer position margin in U.S. Treasury securities with a maturity of one year or less;
  • The CCA rules must provide for segregation of the broker-dealer's account at the CCA and set certain limitations on the CCA's ability to use the margin; and
  • The CCA rules must address how the CCA holds the customer position margin (i.e., whether the CCA holds the customer position margin itself or at either a U.S. Federal Reserve Bank or a qualifying bank).
• If the Commission approves CCA rules that meet the conditions, the Commission will publish a notice that brokers-dealers may include as a debit in the customer reserve formula the amount of customer position margin deposited with that CCA for cleared customer positions.

Compliance Dates

The Commission adopted a phased approach to the implementation and compliance with the Amendments.

FICC will be required to file with the Commission any proposed rule changes relating to the clearing mandate required by the Amendments no later than one hundred and fifty (150) days following January 16, 2024.

The proposed rule changes must be effective:

• For cash market transactions by December 31, 2025;
• For repo market transactions by June 30, 2026; and
• Compliance by the direct participants of a U.S. Treasury securities CCA with the requirement to clear eligible secondary market transactions would not be required until December 31, 2025, and June 30, 2026, for cash and repo transactions, respectively.

In respect of other rule Amendments such as separation of house and customer margin, facilitating access to clearance services and the broker-dealer customer protection rule:

• FICC will be required to file with the Commission any proposed rule changes regarding those amendments no later than sixty (60) days following January 16, 2024; and
• the proposed rule changes must be effective by March 31, 2025.

Conclusion:

The Amendments to the Final Rules are intended to result in a far-reaching set of changes to the operation of the U.S. Treasury securities markets. Although the Final Rules do not go quite as far as the Proposed Rules in some respects, particularly around cash market transactions, these Amendments will have a significant effect on the Treasury Repo market at a minimum. Although the compliance dates for mandated clearing are not until the end of 2025 at the earliest, there will be a significant amount of work for market participants before implementation. CCAs in particular will be required to adopt significant rule changes requiring additional segregation and similar requirements, and generally expanding access models for indirect participation. Market participants themselves will in many cases need new relationships and documentation in order to submit transactions for clearing. The effect of the Amendments on the markets, and the timing of that effect, will likely depend on the scope of these changes as well as the speed of implementation.

Footnotes

1 STANDARDS FOR COVERED CLEARING AGENCIES FOR U.S. TREASURY SECURITIES AND APPLICATION OF THE BROKER-DEALER CUSTOMER PROTECTION RULE WITH RESPECT TO U.S. TREASURY SECURITIES, Vol. 89, No. 10 (2024) https://www.govinfo.gov/content/pkg/FR-2024-01-16/pdf/2023-27860.pdf ("Final Rules").

2 Covered clearing agency means a registered clearing agency that provides the services of a central counterparty or central securities depository. 17 CFR § 240.17Ad-22.

3 Proposed Rule: Standards for Covered Clearing Agencies for U.S. Treasury Securities and Application of the Broker-Dealer Customer Protection Rule With Respect to U.S. Treasury Securities, SECURITIES AND EXCHANGE COMMISSION (2022), https://www.sec.gov/files/rules/proposed/2022/34-95763.pdf.

4 "Direct participant

DS1 "is defined as the entity that has direct access to a U.S. Treasury securities CCA.The Commission distinguished a direct participant from an "indirect participant," which is defined as an entity that relies on a direct participant to clear and settle its U.S. Treasury securities transaction with the CCA, such as customers or clients including money market funds, hedge funds, and other asset managers. See Final Rule, supra note1, at 2717.

5 Registered investment companies, or registered funds, are those entities that are registered under the Investment Company Act of 1940, including money market funds and exchange-traded funds. See Final Rule, supra note1, at 2726.

6 With respect to registered funds, the Commission noted the unique circumstances facing registered funds in the context of entering into eligible secondary market transactions using FICC's sponsored membership program and provided limited no-action relief for a period of five years under Section 17(f) of the Investment Company Act of 1940 to permit a registered fund's cash and/or securities to be placed and maintained in the custody of FICC for purposes of meeting FICC's margin deposit requirements for eligible secondary market transactions in connection with the fund's participation in FICC sponsored membership program. The relief is subject to the conditions that:(i) FICC withdraws the margin provided by a sponsored member registered fund only upon that registered fund's default; (ii) the margin provided by a registered fund is not commingled with, and is kept separate from FICC's assets; (iii) FICC segregates on its books and records the margin provided by the registered fund, and identifies a value of margin in its books and records as being attributable to the registered fund; (iv) the entity that FICC uses to custody such margin is an eligible fund custodian under the Investment Company Act of 1940 Act and the applicable rules thereunder; (v) the margin provided by a registered fund is not subject to loss mutualization or allocation; (vi) the margin provided by a registered fund is not used by FICC for any purpose other than in connection with that registered fund's default as a sponsored member; (vii) registered funds receive quarterly statements of accounts concerning the margin provided in connection with eligible secondary market transactions showing, at a minimum, the name of the account, asset movements during the quarter, and quarter-end positions; and (viii) the account into which a registered fund's margin is deposited is governed by a contract by and among the registered fund, its sponsoring member, and FICC providing for an arrangement consistent with this Commission position. SeeFinal Rule, supra note1, at 2728.

7 This includes commercial entities participating in the Treasury Repo market solely for investing their extra cash balances.

8 An affiliated counterparty is defined as a bank, broker-dealer or futures commission merchant, or any entity regulated as a bank, broker, dealer, or futures commission merchant in its home jurisdiction, that is a majority-owned affiliate of the direct participant and that is consolidated with the direct participant for accounting purposes. SeeFinal Rule, supra note1, at 2738.

9 A sovereign entity is defined as a central government (including the U.S. Government), or an agency, department, or ministry of a central government. SeeFinal Rule, supra note1, at 2748.

10 An international financial institution is defined as: (1) African Development Bank; (2) African Development Fund; (3) Asian Development Bank; (4) Banco Centroamericano de Integración Económica; (5) Bank for Economic Cooperation and Development in the Middle East and North Africa; (6) Caribbean Development Bank; (7) Corporación Andina de Fomento; (8) Council of Europe Development Bank; (9) European Bank for Reconstruction and Development; (10) European Investment Bank; (11) European Investment Fund; (12) European Stability Mechanism; (13) Inter- American Development Bank; (14) Inter-American Investment Corporation; (15) International Bank for Reconstruction and Development; (16) International Development Association; (17) International Finance Corporation; (18) International Monetary Fund; (19) Islamic Development Bank; (20) Multilateral Investment Guarantee Agency; (21) Nordic Investment Bank; (22) North American Development Bank, and providing that the term would also include any other entity that provides financing for national or regional development in which the United States government is a shareholder or contributing member. SeeFinal Rule, supra note1, at 2748.

11 The SEC did not require that the direct participant collect a specified amount of margin from its customers or determine customer margin in a particular manner, such as on a gross basis. SeeFinalRule, supra note1, at 2753.

12 For instance, the SEC noted that a CCA could require direct participants to submit to the CCA information regarding their U.S. Treasury securities transactions or require attestations from senior officials of the CCA's direct participants as to their submission of the required transactions. A CCA could also review publicly available information and information made available to it by regulatory and self-regulatory organizations as part of its assessment of its direct participants' compliance. SeeFinal Rule, supra note1, at 2749.

13 Certain corresponding changes are also made to the broker-dealer reserve calculation for its proprietary accounts (the "PAB" reserve requirement).

14 The term "qualified customer securities" is defined to mean securities of a customer of the broker-dealer (other than U.S. Treasury securities) that are held in custody by the broker-dealer for the customer and that under the rules of the U.S. Treasury securities CCA are eligible to be used to margin U.S. Treasury securities positions of the customer at the CCA. SeeFinal Rule, supra note1, at 2762.