Central clearing and the functioning of government bond markets

Yuliya Baranova, Eleanor Holbrook, David MacDonald, William Rawstorne, Nicholas Vause and Georgia Waddington

The functioning of major government bond and related repo markets has deteriorated on several occasions in recent years as trading demand has overwhelmed dealers’ intermediation capacity. Seeking a remedy, Duffie (2020) proposes a study of the costs and benefits of a clearing mandate in these markets. Such a policy could boost dealers’ intermediation capacity by allowing more of their trades to be netted, thereby reducing their balance sheet exposures and capital requirements. In a recent staff working paper, we estimate the effects of comprehensive central clearing of cash gilt and gilt repo trades on UK dealer balance sheets during one particular stress episode. This post summarises those quantitative results and discusses qualitatively other costs and benefits of broader central clearing.

Background

Trading demand has overwhelmed dealer intermediation capacity in recent episodes such as the September 2019 strains in the US Treasury repo market, the March 2020 global ‘dash for cash’ (DFC) and the September-October 2022 stress in the UK gilt market. On each occasion, markets became highly illiquid. For example, Table A shows the extent to which liquidity deteriorated in UK and US government bond markets during the DFC episode.

Table A: Measures of deterioration in government bond market liquidity in March 2020

Moreover, with government bond markets growing faster than dealer balance sheets, there is a risk that such episodes could recur or even become more frequent in the future. Hence, policymakers are responding on three fronts. First, they are developing measures to dampen surges in demand for market liquidity. Second, they are considering policies to enhance market intermediation capacity. Third, they are evaluating the most effective ways for central banks to provide backstop support to core markets in extreme stresses.

Central clearing

Consideration of broader central clearing falls into the second set of policy responses. When a contract is centrally cleared, a central counterparty (CCP) becomes both the seller to the buyer and the buyer to the seller. As a result, the original buyer and seller no longer face each other as counterparties, but rather face a CCP, which is by design an extremely robust counterparty. Moreover, as illustrated in Chart 1, comprehensive central clearing would mean that instead of having exposures to multiple trading counterparties, dealers would only have exposure to a single counterparty: the CCP. Hence, buy and sell trades pending settlement or lending and borrowing via repo could be netted, reducing balance sheet exposures and capital requirements.

Chart 1: Effect of clearing arrangements on counterparty exposures

As shown in Table B, rates of central clearing vary among major government bond and related repo markets at present. In the United Kingdom, there is essentially no central clearing of cash gilts, while around one third of gilt repo trades are centrally cleared. Clearing rates are somewhat similar in the United States and Germany, while Japan sets a precedent for very high rates of central clearing in a major advanced economy.

Table B: Estimated share of centrally cleared trades in government bond markets

Netting benefits for gilt repo trades

Repo intermediation involves dealers borrowing cash against collateral from one counterparty and lending it against other collateral to other counterparties. Unless these trades can be netted, however, they increase dealers’ total exposures and hence capital requirements, as measured by the Basel III Leverage Exposure Measure (LEM) and Leverage Ratio (LR) respectively. Potentially, these capital requirements could constrain the volume of repo intermediation that dealers are able to provide.

The Leverage Ratio framework allows dealers to net exposures arising from repo and reverse repo trades if they: (i) have the same counterparty, (ii) have the same maturity date and (iii) are governed by a common legally enforceable netting agreement. Trades meeting these conditions would not increase LEMs (and hence LR capital requirements). Thus, to estimate the contribution of gilt repo and reverse repo trades to UK dealers’ exposures, we gather data on these trades from the Bank of England’s Sterling Money Markets Daily (SMMD) data set and net outstanding trades if conditions (i) and (ii) are satisfied, assuming condition (iii) is always satisfied. This gives us estimates of exposures under the status quo.

Then, to estimate counterfactual exposures under comprehensive central clearing, we substitute the recorded counterparties in the data set for a single CCP and repeat our netting calculations. We also estimate exposures in a second counterfactual in which repo maturity dates (apart from overnight repos) are additionally standardised to a common day of the week, making condition (ii) more likely to apply. We construct these estimates around the DFC period. The results are shown in Chart 2.

Chart 2: Contribution of gilt repo trades to total exposures of UK dealers during the DFC period

As shown by the total size of the orange bars, gilt repo activity accounted for about 200 basis points of UK dealers’ LEM in aggregate. Comprehensive central clearing would have reduced those exposures by around 40% (top parts of orange bars). If, in addition, repo maturity dates had been standardised, this reduction would have increased to around 55% (sum of top two parts of orange bars). Within the aggregate, however, there is significant variation: for some dealers, comprehensive central clearing and maturity standardisation would have eliminated the majority of exposures, while for others it would have eliminated only a small minority (sum of top two parts of aqua bars).

While the proportionate reduction in aggregate gilt-repo exposures from comprehensive central clearing and maturity standardisation is significant, it would only have boosted the leverage ratios (Tier 1 capital divided by LEMs) of UK dealers by 6 basis points on average. For comparison, the same dealers had an average of around 190 basis points of leverage-ratio headroom over regulatory requirements before the DFC. That suggests that clearing and maturity standardisation policies may not have alleviated any firm-wide leverage-ratio constraints during the DFC. However, they may have eased internal constraints on repo desks, especially on the assumption that dealers maintained their internal capital allocations during our counterfactual experiment.

Netting benefits for cash gilt trades

For cash trades, the Basel III leverage ratio has been harmonised since the beginning of 2023 to allow exposures relating to sales and purchases of financial assets to be netted across counterparties for all dealers regardless of their accounting practice. As exposures can now always be netted regardless of counterparty, this means the leverage ratio already allows for netting equivalent to that under comprehensive central clearing. So expanding central clearing would not bring any further netting benefits in cash markets.

At the time of the DFC, however, dealers using trade-date accounting under International Financial Reporting Standards (IFRS) could only net the payables and receivables arising from their purchases and sales with common counterparties. Hence, our counterfactual analysis of replacing trading counterparties with a single counterparty, which we apply to cash trades from the period reported under MiFID II regulations, illustrates the benefits that the Basel III modification could bring. These are shown in Chart 3.

Chart 3: Contribution of cash gilt trades to total exposures of UK dealers using trade-date accounting under IFRS during the DFC period

Netting across all counterparties would have eliminated four fifths of UK dealers’ exposures arising from cash gilt trades in the approach to the DFC and two thirds at the peak of it for dealers that were using accounting practices that did not allow for such netting. Although larger in proportionate terms, these exposure reductions due to comprehensive central clearing are smaller in absolute terms than for gilt repo trades. Hence, as previously, this suggests that the balance sheet effects of a central clearing mandate may not have been large enough to have alleviated leverage-ratio constraints at firm level, though they may still have been material to government bond trading desks.

Policy implications

Our analysis suggests that in the gilt-repo market broader central clearing could materially enhance dealer intermediation capacity. In the cash-gilt market, in contrast, recent changes to Basel III have already brought about a boost to the intermediation capacity of certain dealers that broader central clearing might otherwise have delivered. Besides dealer intermediation capacity, however, there are additional potential benefits and costs to broader central clearing to consider.

In terms of potential benefits, central clearing could facilitate more all-to-all trading – where market participants can trade directly with each other, rather than through a dealer – since the buyers and sellers would then hardly need to concern themselves with the credit risk of their counterparty. Of course, such trading does not require any dealer intermediation capacity at all. In addition, reducing the volume of exposures to be settled would reduce the risk of settlement fails, which could have a positive impact on market functioning and market efficiency.

In terms of potential costs, the main item is the additional counterparty risk that CCPs would have to manage. This would arise if market participants were to access CCPs directly or indirectly through a sponsor but while maintaining ultimate responsibility for settlement of their trades. Moreover, these market participants could include different types of non-bank institutions, which CCPs often have not dealt with to date. In addition, more-widespread central clearing could increase liquidity strains on market participants at times of stress to the extent that CCP initial margin requirements react more to volatility than non-CCP requirements and because CCPs require variation margin calls to be settled in cash.

These other benefits and costs of broader central clearing need to be balanced against the potential quantitative effects on dealer intermediation capacity that we have documented in this post.

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Yuliya Baranova, Nicholas Vause and Georgia Waddington work in the Bank’s Capital Markets Division, Eleanor Holbrook and William Rawstorne work in the Bank’s Market Intelligence and Analysis Division and David MacDonald works in the Bank’s Post-Trade Policy Division.

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