How is Wall Street preparing for a US debt default?

NEW YORK/WASHINGTON (Reuters) – As talks about raising the $31.4 trillion U.S. government debt ceiling descend, Wall Street banks and asset managers have been bracing for the fallout from a possible default.

The financial industry has prepared for such a crisis before, most recently in September 2021. But this time, the relatively short time frame for a compromise has bankers on edge, a senior industry official said.

There is less than two weeks left until June 1, when the Treasury Department warns that the federal government may not be able to pay all of its debts, a deadline confirmed by US Treasury Secretary Janet Yellen on Sunday.

Jane Fraser, CEO of Citigroup (CN), said this debt ceiling debate is “more troubling” than previous ones. Jamie Dimon, CEO of JPMorgan Chase & CO (JPM.N), said the bank holds weekly meetings about the implications.

What would happen if the United States fell behind?

U.S. government bonds underpin the global financial system, so it’s difficult to fully gauge the damage a default would do, but executives expect massive swings across stocks, debt, and other markets.

The ability to trade in and out of treasury positions in the secondary market will be very weak.

Wall Street executives who have advised treasury debt operations have warned that Treasury market dysfunction will quickly spread to derivatives, mortgage and commodities markets, as investors will question the validity of Treasuries widely used as collateral to secure deals and loans. Analysts said that financial institutions may ask counterparties to replace bonds that have been affected by missed payments.

Even a short breach of a debt limit can lead to a rise in interest rates, a fall in stock prices, and a breach of covenants in loan documents and leverage agreements.

Moody’s Analytics said that short-term financing markets are also likely to freeze.

How do organizations prepare?

Banks, brokers, and trading platforms are preparing for treasury market turmoil, as well as broader volatility.

This generally involves planning the game how to handle payments on Treasury bills; How finance markets will react will be critical; ensuring adequate technology, staffing capabilities and cash to handle high trading volumes; and checking the potential impact on contracts with customers.

Large bond investors have warned that maintaining high levels of liquidity is important to withstand potentially violent asset price movements, and to avoid having to sell at the worst possible time.

Bond trading platform Tradeweb said it is in discussions with clients, industry groups and other market participants about contingency plans.

What scenarios are being considered?

The Securities Industry and Financial Markets Association (SIFMA), a leading industry group, owns a Playbook It details how stakeholders in the Treasury market—the Federal Reserve Bank of New York, the Fixed Income Clearing Corporation (FICC), clearing banks, and Treasury dealers—will communicate before and during the days of potential missed Treasury payments.

SIFMA considered several scenarios. You will likely see the Treasury buy time to pay off bondholders by announcing before payment that it will renew those outstanding securities, extending them one day at a time.

This would allow the market to continue to operate but would likely not accrue interest on late payment.

In the most disruptive scenario, the Treasury fails to pay both the principal and the coupon, and does not extend the maturities. Unpaid notes can no longer be traded and will not be transferable on the Fedwire Securities Service, which is used to hold, convert and settle Treasury notes.

Each scenario is likely to lead to significant operational problems and require manual daily adjustments in trading and settlement processes.

“It’s challenging because this is unprecedented, but all we’re trying to do is make sure we develop a plan with our members to help them get through what could be a devastating situation,” said Rob Twomey, managing director of SIFMA and Associate General Counsel. for capital markets.

The Treasury Market Practice Group — an industry group sponsored by the New York Federal Reserve — also has a plan for trading in unpaid Treasury notes, which it reviewed at the end of 2022, according to the Minutes of the meeting on his website on November 29. The Federal Reserve Bank of New York declined to comment further.

In addition, in previous debt-ceiling showdowns—in 2011 and 2013—Federal Reserve staff and policymakers developed evidence that would likely provide a starting point, as the last, and most sensitive, step was to remove distressed securities from the market altogether.

Depository Trust & Clearing Corporation, which owns FICC, said it was monitoring the situation and had designed a variety of scenarios based on SIFMA’s handbook.

“We are also working with our industry partners, regulators and participants to ensure activities are coordinated,” she said.

Reporting by Davide Barbuscia. Editing by Megan Davies, Michelle Price, and David Gregorio

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