U.S. SEC Adopts Rules Requiring Central Clearing in the U.S. Treasury Market

On December 13, 2023, the U.S. Securities and Exchange Commission (SEC) adopted a Final Rule under the Securities Exchange Act of 1934 (the Exchange Act) to require central clearing of certain secondary market transactions involving U.S. Treasury securities (USTs).¹ The Final Rule was approved by a 4-1 vote, with a dissent by Commissioner Hester M. Peirce.² Currently, the Government Securities Division of Fixed Income Clearing Corporation (FICC GSD) is the only clearing agency that centrally clears UST transactions. 

Explanation of the Final Rule

The Final Rule requires central clearing of certain secondary market repurchase and reverse repurchase transactions (collectively, repos) and secondary market purchase and sale transactions involving USTs. It implements these requirements by amending current standards in Exchange Act Rule 17Ad-22(e)(18) for a so-called covered clearing agency³ where such clearing agency provides central counterparty (CCP)⁴ services for transactions involving USTs. Because FICC GSD is the only such clearing agency operating today, the Final Rule requires FICC GSD to adopt written policies and procedures reasonably designed to require direct participants⁵ to submit all “eligible secondary market transactions” (ESMTs) in USTs.  

In addition, the Final Rule amends certain margining requirements that apply to FICC GSD under Exchange Act Rule 17Ad-22(e)(6). These aspects will require FICC GSD to calculate, collect, and hold margin separately for proprietary UST positions of a direct participant from customer positions of a direct participant. 

The Final Rule also amends the broker-dealer customer protection rule, Exchange Act Rule 15c3-3, to permit margin required and on deposit with FICC GSD to be included under certain conditions as a debit in the broker-dealer reserve formulas.

Implementation Phases

As urged by commenters, the SEC will use a staged approach to implement the new requirements. Because the structure of the Final Rule focuses on requiring FICC GSD to have written policies and procedures reasonably designed to implement many of its requirements (including the requirement for direct participants to submit ESMTs for central clearing), the implementation process must afford time for FICC GSD to make certain rule filings with the SEC. Accordingly, the SEC adopted the following implementation schedule.

• Compliance Date Package 1 – Applies to the amendments to Rule 17Ad-22(e)(6)(i) (regarding separation of margin for proprietary and customer positions);17Ad-22(e)(18)(iv)(C) (regarding FICC GSD access), and 15c3-3 (regarding the broker-dealer customer reserve formula):
  
  • FICC GSD must file necessary rule filings with the SEC no later than 60 calendar days following publication of the Final Rule in the Federal Register;⁶ and
  • The proposed rule filings by FICC GSD must be effective by March 31, 2025.

• Compliance Date Package 2 – Applies to the amendments to Rules 17Ad-22(e)(18)(iv)(A) and (B) (regarding the requirements for central clearing of ESMTs and for FICC GSD to monitor the submission of such transactions by its direct participants):
  
  • FICC GSD must file necessary rule filings with the SEC no later than 150 calendar days following publication of the Final Rules in the Federal Register; and
  • The proposed rule filings must become effective by December 31, 2025, for purchases and sales and June 30, 2026, for repo transactions.

Submit Comments to FICC GSD Now and to the SEC Later

The public will have the opportunity to comment on the FICC GSD rule filings when they are published in the Federal Register.  

Importantly, however, market participants need not wait to engage with FICC GSD to provide comments on the forthcoming rule filings. This is because FICC GSD must use SEC Form 19b-4 to make its rule filings with the SEC, and the instructions to the form require FICC GSD to summarize the substance of all written comments received and to respond in detail to any significant issues raised. So market participants should consider providing written comments as soon as possible.

What UST Repo and UST Purchase and Sale Transactions Are Covered 

The ESMT definition is the linchpin to understanding whether a particular UST transaction will be required to be centrally cleared. This is because Rule 17Ad-22(e)(18)(iv) requires FICC GSD to require its direct participants to submit any ESMT to which they are a counterparty to FICC GSD for central clearing.  

A breakdown of the ESMT definition is below. Market participants should prioritize working through the logic and exclusions embedded in the definition to understand whether aspects of their participation in the UST market are covered. Terms in quotes below are defined in Rule 17Ad-22(a).

The ESMT Definition Is the Key to Applicability

An ESMT means

• a secondary market transaction in USTs
• of a type accepted for clearing by a registered covered clearing agency (i.e., FICC GSD) that is one of the following:

1. Repurchase or Reverse Repurchase Agreement

• collateralized by USTs
• in which one of the counterparties is a FICC GSD direct participant

However, the definition excludes any repurchase or reverse repurchase agreement that meets these conditions but for which

• one counterparty is a “central bank,” a “sovereign entity,” an “international financial institution,” or a natural person;
• one counterparty is a covered clearing agency providing CCP services or a derivatives clearing organization or is regulated as a CCP in its home jurisdiction;
• one counterparty is a “state or local government”; or
• the counterparty of the direct participant is
  • an “affiliated counterparty” (i.e., certain specified banks, brokers, dealers, or futures commission merchants) and has a relationship with the direct participant that meets certain control test (i.e., majority ownership) and financial statement conditions (i.e., U.S. Generally Accepted Accounting Principles or International Financial Reporting Standards)
  • the “affiliated counterparty” submits for clearance and settlement all other repurchase or reverse repurchase agreements to which it is a party that are collateralized by U.S. Treasury securities

2. Purchase or Sale

• between a direct participant and any counterparty, 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
• a registered broker-dealer, government securities broker, or government securities dealer

However, the definition excludes any purchase or sale that meets these conditions but for which one counterparty is a “central bank,” a “sovereign entity,” an “international financial institution,” or a natural person. 

Practical Consequences for Buy-Side Firms 

The SEC guidance in the Final Rule is explicit that ESMTs by investment funds and end users are not excluded from the central clearing requirement. As a practical consequence, to the extent an investment fund that is not a direct FICC GSD participant transacts in an ESMT with a direct participant, then it would need to enter such ESMTs through the sponsored member program of FICC GSD. That requires forming a relationship with a sponsoring member, which in turn requires the negotiation and execution of additional legal agreements.  

Other Notable Points on the Scope of the Final Rule

Securities lending transactions involving USTs are entirely excluded.  

Bilateral and triparty repos/reverse repos are all included to the extent they meet the ESMT definition.  

If a repo does not involve any USTs as collateral, then it does not meet the ESMT definition and therefore is not covered (e.g., if the collateral instead is U.S. government agency securities).  

If the transaction involving USTs is with a counterparty that is not a direct FICC GSD participant, then the transaction is not covered.  

Changes to FICC GSD’s Margining Process

The changes to Rule 17ad-22(e)(6)(i) require FICC GSD to have written policies and procedures reasonably designed to calculate, collect, and hold margin from a direct participant for its proprietary UST positions separately from margin calculated and collected from for UST positions of an indirect participant that relies on the direct participant to access FICC GSD. Customer segregation can be achieved through an omnibus account structure in which all collateral belonging to customers of a particular direct participant is commingled and held in a single account segregated from that of the direct participant. The structure also prohibits netting of customer and proprietary positions. These amendments closely resemble how the calculation, collection, and holding of margin occur today for listed options.  

The amendment to Rule 17ad-22(e)(6)(i) does not require that a direct participant in FICC GSD collect a specified amount of margin from customers or determine customer margin in a particular manner (e.g., gross basis). The calculation and collection of margin between a direct participant and customers will be left to other applicable regulations and bilateral negotiation.  

Changes to the Customer Reserve Formula

Currently, the customer and PAB⁷ reserve formulas in Exhibit A to Exchange Act Rule 15c3-3 allow a broker-dealer to include a debit in the applicable formula with respect to either (i) margin required and on deposit with The Options Clearing Corporation (for all option contracts written or purchased in customer accounts)⁸ or (ii) margin required and on deposit with certain clearing agencies related to security futures products and certain futures contracts (and options thereon) with respect to positions written, purchased or sold in customer accounts,⁹ but not with respect to margin required and on deposit at other clearing agencies. A debit in the applicable reserve formula nets against credits (such as item 1 customer free credit balances) and, thus, reduces the broker-dealer’s reserve deposit. The debits potentially allow the broker-dealer to use customers’ free credit balances to fund the broker-dealer’s margin deposit with the applicable clearing agency in connection with customer activity. 

The Final Rule will expand this treatment to allow a broker-dealer to also include a new item 15 debit for margin required and on deposit with FICC GSD. Until now, FICC GSD has not had rules to segregate broker-dealer customer margin and use it solely to cover customer obligations. But in light of the new margin segregation structure that will be implemented, the Final Rule amends the customer and PAB reserve formulas to permit that under certain conditions margin that is required and on deposit at FICC GSD can be included as a debit item. Thus, as noted above, the debit item will offset credits and thereby potentially provide a new funding source (customers’ free credit balances) for the broker-dealer’s required FICC GSD margin deposit.

Going Forward

As described above, the Final Rule requires significant rule filings by FICC GSD to accomplish implementation. Market participants should consider submitting comments directly to FICC GSD even before the SEC publishes the rule filings for notice and comment. In addition, firms should closely analyze the ESMT definition to understand its application to their business.    

¹ Standard 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, Release No. 34-99149 (Dec. 13, 2023), available at https://www.sec.gov/files/rules/final/2023/34-99149.pdf. 

² Careening Toward Clearing: Statement on Rules to Improve Risk Management in Clearance and Settlement and to Facilitate Additional Central Clearing to the U.S. Treasury Market, Dissenting Statement by Commissioner Hester M. Peirce (Dec. 13, 2023), available at https://www.sec.gov/news/statement/peirce-statement-rules-improve-risk-management-12-13-23. 

³ A “covered clearing agency” is defined in Exchange Act Rule 17Ad-22(a)(5) to mean “a registered clearing agency that provides the services of a central counterparty or central securities depository.”

⁴ The term CCP is defined in Exchange Act Rule 17Ad-22(a)(2) to mean “a clearing agency that interposes itself between the counterparties to a securities transaction, acting functionally as the buyer to every seller and the seller to every buyer.”

⁵ The Final Rule release clarifies that a “sponsored member” that participates in FICC GSD through a sponsoring member is not a direct participant.

⁶ At the time of this Sidley Update, the Final Rule has not yet published in the Federal Register.  That publication is expected in the coming weeks, at which time the rule filing deadlines will be determinable.

⁷ Rule 15c3-3(a)(16) defines the term “PAB account” to mean a proprietary securities account of a broker-dealer.

⁸ See item 13 to the customer or PAB reserve formula.

⁹ See item 14 to the customer or PAB reserve formula.