The Treasury Market Evolution
U.S. officials have triggered a major shift in Treasury market structure
After years of deliberation following multiple crises, America’s monetary leaders have unveiled their plan to fortify the U.S. Treasury market. The inner workings of the most systemically important debt market globally, having already undergone significant changes, will once again be transformed. The latest Treasury Market Evolution™ is about to commence.
In the mid-2000s, the complexity of the secondary Treasury market was almost nonexistent. Major dealer banks and broker-dealers dominated volumes in the interdealer segment, where they traded among themselves, while distributing most of the liquidity to clients in the dealer-to-customer region. Just as the market appeared to have peaked in sophistication, however, a new type of player emerged from the shadows: principal trading firms (PTFs), high-frequency traders seeking to profit through arbitrage while providing liquidity to dealers. Upon developing a range of high-frequency trading algorithms, PTFs began to conquer interdealer markets — the largest segment by volume, taking market share from even the most prominent players. A new age of complexity in the Treasury cash market was thus destined to emerge.
Before PTFs began to take over in the late 2000s, the interdealer market consisted largely of primary dealers and other dealers, the largest of which were all members of the FICC (Fixed Income Clearing Corporation), the sole central clearing provider (CCP) for U.S. Treasuries. The majority of secondary market transactions involved trading via the electronic platforms of interdealer brokers (IDBs), the major intermediaries of the interdealer market. As both IDBs and primary dealers held memberships with the FICC, most secondary market trades were centrally cleared. Though that was about to change. While gaining significant market share, PTFs did not meet the strict requirements needed to become FICC members, failing to obtain direct access to central clearing. Subsequently, the first “centrally cleared era” of the Treasury cash market was coming to an end.
The rise in the number of FICC non-members (PTFs, smaller dealers, and buy-side firms like hedge funds) compared to FICC members (primary dealers, larger dealers, banks, and IDBs) caused a surge in “bilateral” trading. Instead of centrally clearing through the FICC, non-member trades were cleared and settled through various separate entities, from clearing agents to the Federal Reserve and its Fedwire service. Interdealer brokers still intermediated the vast majority of trading, though, increasing the market’s complexity. The rise of “hybrid trading” emerged, in which the first leg between an FICC member (say, a dealer) and an IDB (interdealer broker) was centrally cleared while the last leg between an IDB and the FICC member’s customer (say, a hedge fund) was cleared bilaterally. FICC non-members could still access central clearing through a dealer’s prime brokerage service, yet the increased cost drove firms to trade without central clearing. These factors combined to produce a sharp decline in the share of centrally cleared trades, slowly reducing the market’s exposure to FICC protections, and thus eroding Treasury market resiliency.
Fast forward to today and countless market hiccups later, around 70 to 80% of secondary market transactions are now bilaterally cleared. According to a recent G-30 report, only “20% of commitments to settle U.S. Treasury security trades” are centrally cleared through the FICC’s platform. Meanwhile, in the interdealer segment, the largest PTFs have gained equal market share to the largest broker-dealers, accounting for half the volume on interdealer broker platforms and ~55% of the volume on “on-the-run” (the most recently issued) 10-year Treasuries.
Monetary officials, however, have responded. Vowing to end the longstanding “uncleared era” in America’s sovereign debt market, the SEC (Securities and Exchange Commission) has announced that more secondary market trades must be centrally cleared by December 31st, 2025. Market players must now adjust to comply with a new centrally cleared regime, prompting not only an extensive rewiring of the Treasury market’s plumbing but a large transfer of risk to the FICC, the lone central clearing provider. What does that mean in practice? Let’s go deeper into the mechanics.