The potential impact of broader central clearing on dealer balance sheet capacity: a case study of UK gilt and gilt repo markets

The Prudential Regulation Authority, PRA, has published a working paper which analyzes the impact of a broader clearing requirement on dealers‘ balance sheets and thus their ability to „intermediate financial markets“ which could be especially beneficial in times of market stress.
Specifically, the analysis uses regulatory transaction data pertaining to UK gilts and gilt repos to evaluate the impact of a central clearing requirement for such instruments on dealers‘ balance sheet and capital ratios. The objective is to determine dealers‘ ability to intermediate the market had such clearing requirement been in place prior to the March 2020 market crash.
And indeed, the analysis shows the following: In the gilt repo market, introducing central clearing would have reduced gilt repo exposures on UK dealers‘ balance sheets by 40%, resulting in a 3 basis points increase in their aggregate leverage ratio. If repo maturity dates had on top been standardized to fall on the same day of the week (excluding overnight repo), the reduction in exposures would have been 60%, and the increase in the aggregate leverage ratio would have been 5 basis points. These improvements in netting rates would have allowed dealers‘ repo desks to expand trading during the beforementioned market crash significantly.
For cash gilt trades, central clearing would have only reduced unsettled trade exposures for dealers using a specific accounting treatment. However, for that group, the reduction could have been as high as 80%, resulting in a 0.4 basis points increase in their aggregate leverage ratio. Additionally, changes to the computation of the Basel III leverage ratio implemented in January 2023 would have had similar effects on cash trades.
The findings suggest that widespread central clearing, along with standardized maturity dates for gilt repos, could have significantly reduced exposures on dealers‘ balance sheets, increased aggregate leverage ratios, and allowed for more trading activity during the crisis. Additionally, the expansion of central clearing requirements would reduce settlement failures and counterparty risk both in turn may lead to increased trading. Therefore, the author suggests that reviewing the current scope of the central clearing obligation may be a good idea to improve financial stability and increase market trading particularly in times of significant market stress.