On Tuesday, May 25, 2021, the U. S. Securities and Exchange Commission (“SEC”) issued a notice (the “Notice”) that the Fixed Income Clearing Corporation (“FICC”) had filed proposed rule changes intended to enhance the ability to clear certain trades, particularly those involving repurchase agreements (“Repos”) on FICC. The FICC, created in 2003 by the merger of the Government Securities Clearing Corporation and the Mortgage Backed Securities Corporation, is a wholly-owned subsidiary of the Depository Trust and Clearing Corporation (“DTCC”).

The SEC and Repo Clearing

I have previously written about the crucial importance of clearing agencies to the functioning of the American capital markets and recent regulatory efforts to increase their efficiency while reducing some of the risks involved in their operations. See most recently my May 27, 2021, blog post, “‘Margin, I Have to Have More Margin:’ The National Securities Clearing Corporation Proposes to Increase the Minimum Required Fund Deposit.” And before that, see my April 29, 2021, blog post, “Tightening the Reins: SEC Approves Proposed Rule Change to Clearing Agency Investment Policy.” The SEC, the clearing agencies involved, and the capital markets generally have come to see both the key role fulfilled in handling the clearing of securities transactions, AND in the aftermath of 2008 (the Great Recession) and 2020 (the COVID-19 pandemic), the potential fragility of these agencies when they no longer function well.

Some of the most significant areas of concern (with the benefit of hindsight) involve money market mutual funds (“MMF”) and Repos. As I have written at length in my February 23, 2021, blog post, “‘Bucking the Break’: SEC Requests Comments on MMF Reforms,” the SEC desires acceptable structural adjustments to MMF’s to impede, if not forestall, runs on MMF’s in times of market duress. This is the Board of Governors of the Federal Reserve System (the “Fed”) does not have to take emergent steps (as it did in 2008 and again in 2020) to prevent runs on MMFs.

Closely related to these worries is the risk of the “freezing up” of the Repo market as almost occurred in September 2019, when the average overnight Repo rate surged from 1.75% to 5.25% between September 13 and September 17. See both my December 9, 2019, blog post, “SOFR and the Shutdown of Overnight Repos: What Happens If There Is Nothing to Measure?,” AND Gara Afonso et al., Federal Reserve Bank of New York, Staff Report No. 918, “The Market Event of Mid-September 2019” (March 2020) cited in footnote 12 of the Notice.

More Repo Clearing Encouraged

The FICC dominates the clearing of fixed income securities but does not serve to clear private one-on-one transactions. The Notice reports that the FICC’s Sponsoring Member/Sponsored Member Service (the “Service”), which handles the clearing functions, began in 2005 and “has seen a steady increase in the number of Sponsoring Members, in the number of Sponsored and in the volume of Sponsored Member Trades over the past three years.” Footnote 9 adds that in 2017 there was one Sponsoring Member and there were 1422 Sponsored Members; and as of the end of 2020, there were 27 Sponsoring Members and some 1894 Sponsored Members.

As of March 31, 2017, the aggregate price of Sponsored Member Trades was approximately $32.2 billion, compared with $286 billion as of 31 March 2021. To be a Member, an entity must be a “qualified institutional buyer” as defined in SEC Rule 144A under the Securities Act of 1933, as amended, or a legal entity that “satisfies the financial requirements necessary to be a ‘qualified institutional buyer.’”

The FICC asserts, and the Notice indicates that the SEC concurs, that causing more fixed income securities transactions to close through a clearing agency provides many benefits to the capital markets and its several participants by:

1. Ensuring that the markets and their regulators (including the SEC and the Fed) are better informed as to the volume, timing, and performance of participants

2. Allowing the clearing agency, here the FICC, to manage risk and impose interim requirements to restrict market breaks

3. Imposing consistent participation requirements so that all market actors have to meet consistent performance standards

4. Insisting on diligence and risk management substantially reduces the possibility of transaction failure or other default

Agency’s Proposed Rule Changes

The 56-page Notice lays out FICC’s proposed rule changes in excruciating (and sometimes opaque) detail but this blog post focuses on adjustments in those significant areas of concern. Under FICC’s Service, as it now exists, the settlement process requires putting up cash as collateral for the risk exposures inherent in clearing activity. As the Notice says:

…certain cash provider Sponsored Member clients, particularly money market funds and other mutual funds [find the cash-margin settlement process] …not conducive. …Specifically, money market funds and other mutual funds are not operationally equipped to provide or receive cash margin in connection with their term repo activity…. These funds depend on transfers of securities to maintain required margin…

The proposed rule changes would permit the posting of eligible securities as margin, instead of cash. This can be done using a basket of eligible securities, and would not require a specific margin posting for specific transactions.

Fixing FICC

In parallel parts of the proposed rule changes, FICC Members would be able to “offset on their balance sheets their obligations to FICC…” with other FICC transactions, as opposed to having to post collateral for each specific transaction. As stated in the Notice, this allows Members “to take lesser capital charges for Repo Transactions … than would be required were such transactions uncleared.” The Notice emphasizes that this is consistent with FICC’s efforts to encourage Members “to submit term (rather than overnight) repo transactions for clearing.” The Notice goes on to say that FICC “believes that enabling more term (rather than overnight) repo activity…can serve to help reduce repo rate volatility in the market,” including the September 2019 rate surge described above.

The Notice provides that the proposed changes will become subject to SEC approval or rejection 45 days after publication in the Federal Register unless the SEC or the FICC determines that additional time up to 90 days from publication is required. Comments from market participants are requested by the SEC.

The proposed rule changes are meant to bring more fixed income securities, and especially Repo (both term and overnight) transactions “inside the clearing agency tent” to make those transactions and their pricing more transparent, and, hence, the capital markets stronger and fairer.