Daily Management Review

What Wall Street Is Doing To Prepare For A Probable US Debt Default


What Wall Street Is Doing To Prepare For A Probable US Debt Default
Wall Street banks and asset managers have been bracing for the consequences of a potential default as negotiations over raising the $31.4 trillion debt ceiling for the United States government are nearing their conclusion.
A recent preparation for such a disaster was made by the financial sector in September 2021. But this time, a senior industry insider claimed, the narrow window for finding a solution has bankers on edge.
U.S. Treasury Secretary Janet Yellen reiterated the ultimatum on Sunday. The Treasury Department has warned that the federal government may not be able to pay all of its bills by June 1, which is less than two weeks away.
This debt ceiling discussion, according to Citigroup CEO Jane Fraser, is "more worrying" than past ones. Jamie Dimon, CEO of JPMorgan Chase & CO, stated that the bank is holding weekly meetings to discuss the ramifications.
It is difficult to properly assess the harm that a default would cause because U.S. government bonds support the whole global financial system, but executives anticipate extreme volatility in the equity, debt, and other markets.
It would be very difficult to buy and sell Treasury positions on the secondary market.
Wall Street executives who advised the Treasury's debt operations cautioned that the instability in the Treasury market would swiftly spread to the derivative, mortgage, and commodity markets because investors would doubt the legitimacy of the extensively used Treasuries as collateral for trades and loans. Analysts said that financial institutions should ask counterparties to replace the bonds impacted by late payments.
Even a brief overdraft could trigger an increase in interest rates, a drop in stock prices, and covenant violations in loan agreements and leverage contracts.
According to Moody's Analytics, short-term funding markets would likely also become frozen.
The Treasury market disruption as well as general volatility are being prepared for by banks, brokers, and trading platforms.
This often entails scenario planning for how payments on Treasury securities would be handled, the reaction of crucial funding markets, the availability of adequate technology, human resources, and cash to manage high trading volumes, as well as assessing any potential effects on client contracts.
To avoid having to sell at the worst possible time and to be able to sustain potentially dramatic asset price movements, large bond investors have emphasised that keeping high levels of liquidity is crucial.
Tradeweb, a platform for trading bonds, reported that it was in talks regarding backup plans with customers, business associations, and other market participants.
The Federal Reserve Bank of New York, the Fixed Income Clearing Corporation (FICC), clearing banks, and Treasury market participants would communicate in advance of and during the days of potential missed Treasury payments, according to a playbook developed by the Securities Industry and Financial Markets Association (SIFMA), a leading industry association.
SIFMA has thought about various possibilities. The more likely scenario would be for the Treasury to announce ahead of a payment that it would be rolling those maturing notes over, prolonging them one day at a time, in order to gain time to repay bondholders.
That would enable the market to continue operating, but interest for the postponed payment would probably not accumulate.
The Treasury does not pay the principal or the coupon and does not postpone maturities in the worst-case scenario. The Fedwire Securities Service, which is used to retain, transfer, and settle Treasury securities, would no longer allow the trading and transfer of the unpaid bonds.
Each scenario would probably cause serious operational issues and call for daily human adjustments to the trading and settlement procedures.
"It is difficult 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 through what would be a disruptive situation," said Rob Toomey, SIFMA's managing director and associate general counsel for capital markets.
According to meeting minutes posted on its website on Nov. 29, the Treasury Market Practises Group, an industry group sponsored by the New York Federal Reserve, also has a plan for trading in unpaid Treasuries, which it will examine at the end of 2022. The New York Fed did not respond further.
Furthermore, in previous debt-ceiling standoffs – in 2011 and 2013 – Fed staff and policymakers created a playbook that would likely serve as a starting point, with the final and most sensitive step being to remove defaulted securities from the market entirely.
FICC's owner, the Depository Trust & Clearing Corporation, said it was monitoring the situation and has modelled a number of scenarios based on SIFMA's playbook.
"We are also working with our industry partners, regulators and participants to ensure activities are coordinated," it said.