Hedge funds and other market participants could consider relocating US Treasury trading offshore or utilising alternative strategies to avoid compliance with the upcoming US Treasury clearing mandate, according to a report by Risk.net citing a new academic paper by Yesha Yadav and Joshua Younger.
The mandate, set to take effect at the end of the year for cash Treasury trades and six months later for repo transactions, will require in-scope entities to clear these trades through the Fixed Income Clearing Corporation (FICC). However, the paper highlights concerns over potential evasion tactics, particularly by hedge funds domiciled in jurisdictions like the Cayman Islands.
The paper points out that more than half of hedge funds reporting to the US Securities and Exchange Commission (SEC) are based offshore, particularly in the Cayman Islands. These offshore entities could theoretically execute repo trades with non-US entities that are not FICC members, avoiding the mandate’s requirements.
“Regulators face the risk that frequent participants in the Treasury market decide to move their activities to foreign shores and into non-US entities precisely to have the option to avoid the effect of the mandate,” Yadav and Younger wrote.
Despite this, such trades could still fall within the scope of the mandate if offshore entities engage with counterparties tied to FICC members. The SEC is expected to provide further clarification on the mandate’s scope and potential exemptions later this month.
Yadav, a professor at Vanderbilt Law School, highlights the grey area in US securities law surrounding the mandate. Historically, US law has limited the SEC’s jurisdiction over bond trades between non-US entities, even when trading US instruments, as established by the 2010 Supreme Court ruling in Morrison v National Australia Bank.
“There is a question first and foremost about the reach of this mandate to counterparties abroad,” Yadav explained.
The US does have broad extraterritorial jurisdiction in criminal matters, such as cases involving money laundering or market manipulation. However, such authority requires allegations of criminal conduct.
The paper explores other potential workarounds for market participants seeking to bypass the clearing mandate, including that trades could be restructured as “economically similar” securities lending transactions rather than Treasury repo deals, potentially avoiding clearing requirements.
In addition, repo agreements without fixed maturity dates may fall outside the scope of the mandate, while bilateral repos between two non-dealer counterparties are exempt from the SEC rule, even if a bank guarantees the trade’s settlement.
Despite the theoretical avenues for avoidance, the paper suggests the economic benefits of evading the mandate may not justify the effort. Hedge funds often rely on FICC clearing members for repo transactions, and dealers typically prefer to clear repos due to the capital and risk-weighted asset benefits of sponsored cleared repo transactions.
