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US Treasury Reforms: The Crystal Ball for EM Traders
The SEC voted in December to require more US Treasury bonds to be centrally cleared in order to improve market resiliency, and it continues to propose major reforms to that market. These reforms are getting significant attention in the press and sparking a debate on financial news and social media platforms. Emerging markets investors might be forgiven for paying little attention to market structure developments in US Treasuries, but ignoring these developments is a mistake.
Market structure changes in developed markets almost always have an impact on emerging markets, but with a lag. The last major structural change in execution in developed markets was the Dodd-Frank derivative reforms. These changes, at first, primarily impacted US interest rate swaps and US high yield/investment grade credit index derivatives. Debates in the press and lobbying in Washington centered around these US markets. Forward thinking emerging markets investors, however, saw one theme that would have a significant impact on how emerging markets derivatives would trade in the coming years: credit intermediation. The regulatory push to use clearinghouses for derivatives separated execution of derivatives and the counterparty credit that limited trading of derivatives to large global banks. Dynamic asset managers used central clearing to open their liquidity pools to trade EM interest rate swaps and credit derivatives with banks beyond only those with whom they have an ISDA, including local banks. In many cases, these deeper liquidity pools have led to lower transaction costs. Non-deliverable forwards (NDFs) remain the final frontier in this development and only a few asset managers use this tool to deepen their liquidity and reduce transaction costs, but that market is also rapidly evolving.
History may now be repeating itself. The SEC proposed reform in the US Treasury market will likely have similar impacts on the future of trading emerging markets bonds. Once again, the SEC is proposing splitting execution and credit, but this time in US Treasuries. Emerging markets may not be far behind. There are trading venues today in emerging markets bonds that split execution and credit, but they have not been widely adopted. Most EM investors limit their trading to banks where they have an existing relationship in order to bundle execution and credit. The standardization of clearing in US Treasuries may bring regulatory endorsement to splitting execution and credit. This endorsement may increase participation of investors in these new trading venues and potentially increase liquidity by connecting more market participants. Bank market makers and their credit capabilities will still be a critical part of this ecosystem, but the increased connection between liquidity nodes will likely benefit price discovery and reduce transaction costs, if EM managers are paying attention.
Market structure is always evolving across all asset classes even if it progresses at different rates. The edge in emerging markets trading will go to those investors who look at market structure beyond the walls of one asset class. Ignore US Treasury market reforms at your own peril.
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