NEW YORK/WASHINGTON, May 15 (Reuters) – As talks intensify over raising the US government’s $31.4 trillion debt ceiling, Wall Street banks and asset managers are beginning to prepare for the fallout from a possible default.
The financial sector has prepared for such a crisis before, most recently in September 2021. But this time, the relatively short time frame for reaching a compromise has left bankers on edge, a senior industry official said.
Jane Fraser, CEO of Citigroup (CN), said this debt ceiling debate is “more worrying” than previous ones. Jamie Dimon, CEO of JPMorgan Chase & CO (JPM.N), said the bank is holding weekly meetings to discuss the implications.
WHAT WOULD HAPPEN IF THE US WERE IN DEFAULT?
U.S. Treasury bonds underpin the global financial system, so it’s hard to fully assess the damage a bankruptcy would do, but executives expect massive volatility in stocks, debt and other markets.
The ability to trade in and out of Treasury positions in the secondary market would be severely compromised.
Wall Street executives who have advised Treasury debt operations warned that the dysfunction of the Treasury market would quickly spread to the derivatives, mortgage and commodities markets as investors test the validity of Treasury bills widely used as collateral for the Treasury. securing transactions and loans. Financial institutions could ask counterparties to replace bonds hit by missed payments, analysts said.
Even a brief breach of the debt limit can lead to a spike in interest rates, a plunge in stock prices, and breaches of covenants in loan documentation and leverage agreements.
Short-term finance markets would also likely freeze, Moody’s Analytics said.
HOW DO INSTITUTIONS PREPARE?
Banks, brokers and trading venues are preparing for Treasury market disruption and wider volatility.
This generally includes game planning how Treasury bill payments would be handled; how critical funding markets would respond; ensure sufficient technology, staffing capacity and cash to handle high volumes of trade; and monitoring the potential impact on customer contracts.
Major bond investors have warned that maintaining high levels of liquidity was important to withstand potentially violent price movements and avoid having to sell at the worst possible time.
Bond trading platform Tradeweb said it was in talks with clients, industry groups and other market participants about contingency plans.
WHAT SCENARIOS ARE CONSIDERED?
The Securities Industry and Financial Markets Association (SIFMA), a leading industry group, has a Playbook detailed how Treasury market stakeholders – the Federal Reserve Bank of New York, the Fixed Income Clearing Corporation (FICC), clearing banks and Treasury dealers – would communicate prior to and during the days of potentially missed Treasury payments.
SIFMA considered several scenarios. It would be all the more likely that the Treasury would buy time to repay bondholders by announcing ahead of a payment that it would roll over those maturing securities and extend them one day at a time. That would allow the market to continue to function, but interest would probably not accrue for the delayed payment.
In the most disruptive scenario, the Treasury fails to pay both principal and coupon and does not extend the maturity. The unpaid bonds could no longer be traded and would no longer be transferable on the Fedwire Securities Service, which is used to hold, transfer and settle Treasuries.
Any scenario would likely lead to significant operational difficulties and require manual day-to-day adjustments to trading and settlement processes.
“It’s hard because this is unprecedented, but all we’re trying to do is make sure we develop a plan with our members to help them navigate what could be a disruptive situation,” said Rob Toomey, general director of SIFMA and associate general counsel for capital markets.
The Treasury Market Practices Group (TMPG) — an industry group sponsored by the New York Federal Reserve — also has a plan for trading unpaid Treasuries, which it will review at the end of 2022, according to meeting minutes on its website dated 29 November. The New York Fed declined to comment further.
Moreover, in past debt-ceiling deadlocks—in 2011 and 2013—Fed officials and policymakers developed a roadmap that would likely provide a starting point, with the final and most sensitive step being the complete removal of defaulted securities from the market.
The Depository Trust & Clearing Corporation, which owns FICC, said it is monitoring the situation and has modeled several scenarios based on SIFMA’s playbook.
“We are also working with our industry partners, regulators and participants to ensure that activities are coordinated,” it said.
Reporting by Davide Barbuscia; adaptation by Megan Davies, Michelle Price and David Gregorio