Treasury and Markets Prepare for Default On US Gov’t Debt

In the face of escalating debates over raising the United States’ $31.4 trillion debt ceiling, the financial world, including Wall Street banks and asset management firms, is preparing for the potential of default.

This isn’t the first time the financial industry has needed to gear up for such a situation, with the last instance happening in September 2021. However, the limited timeframe to reach an agreement this time around has key industry figures worried. However, most financial and political commentators maintain that the likelihood of default remains relatively low.

Market Concerns and Readiness Measures

Citigroup’s head, Jane Fraser, has voiced concerns that the current debt ceiling predicament is more worrisome than previous instances. Similarly, Jamie Dimon, the CEO of JPMorgan Chase & Co, stated that the bank has been conducting weekly meetings to review the potential implications.

Potential Impact of a US Default

Given the significant dependence of the global financial system on US government bonds, the potential fallout from default is challenging to fully anticipate. Nonetheless, executives forecast extreme equity, debt, and other market fluctuations should a default occur.

The ability to trade Treasury positions in secondary markets could be significantly impaired. With insights into the Treasury’s debt affairs, Wall Street leaders caution that potential Treasury market disturbances could quickly affect derivative, mortgage, and commodity markets. This stems from the possibility that investors might doubt the reliability of Treasuries, typically used as collateral for trades and loans. Analysts suggest that financial institutions might ask counterparties to substitute bonds that have defaulted.

Even a slight breach of the debt limit could lead to a surge in interest rates, a tumble in equity prices, and breaches of loan documentation and leverage agreements. Moody’s Analytics has also warned of a potential freeze in short-term funding markets.

Preparatory Actions by Financial Institutions

Banks, brokers, and trading platforms are developing contingency plans to anticipate potential disruptions in the Treasury market and heightened volatility. Typically, these involve strategizing the handling of Treasury security payments, gauging reactions of crucial funding markets, ensuring adequate technological, staffing, and cash resources to cope with high trading volumes, and assessing potential effects on client contracts.

Top bond investors emphasize the need to maintain high liquidity levels to weather possible severe asset price swings and avoid forced sales at inopportune times.

Tradeweb, a bond trading platform, has continuously discussed contingency strategies with clients, industry groups, and other market players.

Contingency Plans in Place

A leading industry group, the Securities Industry and Financial Markets Association (SIFMA), has devised a plan detailing how Treasury market stakeholders would communicate in case of possible Treasury payment defaults.

SIFMA has contemplated various scenarios. The most likely situation is the Treasury postponing bondholder repayments by declaring a one-day extension of maturing securities. Although this would maintain the market’s operation, interest on the deferred payment would probably not accrue.

In the most disruptive scenario, the Treasury fails to pay both principal and interest and does not extend maturities. In this case, the unpaid bonds would no longer be tradable or transferable via the Fedwire Securities Service, a system used to manage, transfer, and settle Treasury securities.

Any scenario would likely lead to substantial operational challenges and require manual adjustments to the daily trading and settlement processes.

Rob Toomey, SIFMA’s managing director and associate general counsel for capital markets, acknowledged the unprecedented nature of the situation but noted that the organization is striving to guide its members through any potential disturbances.

The Treasury Market Practices Group (TMPG) has a strategy for trading unpaid Treasury bills set to be reviewed at the end of 2022. The New York Fed has yet to comment further on this matter.

During previous debt-ceiling standoffs in 2011 and 2013, Federal Reserve staff and policymakers formulated a strategy that is likely to be invoked under the current circumstances. The most pivotal step in this strategy would involve removing all defaulted securities from the market.

The Depository Trust & Clearing Corporation, the parent entity of the Fixed Income Clearing Corporation (FICC), has stated that it’s keeping a close eye on the situation and has run through a series of scenarios based on SIFMA’s strategy.

The corporation stated, “We are also collaborating with our industry partners, regulators, and participants to ensure activities are harmonized.” This statement emphasizes that despite the unsettling situation, the financial sector employs extensive measures to minimize potential harm and navigate any possible disruptions. These widespread precautions taken by the industry underline the seriousness of the situation but also show a readiness to handle the potential fallout of a US default.

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