As talks over raising the US government's $31.4 trillion debt ceiling go down to the wire, Wall Street banks and asset managers have been preparing for the fallout from a potential 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 reaching a compromise has bankers on edge, said one senior industry official.
Less than two weeks remain until June 1, when the Treasury Department has warned that the federal government might not be able to pay all its debts, a deadline US Treasury Secretary Janet Yellen reaffirmed on Sunday.
Citigroup CEO Jane Fraser said this debate on the debt ceiling is "more worrying" than previous ones. JPMorgan Chase & CO CEO Jamie Dimon said the bank is convening weekly meetings on the implications.
What would happen if the US defaulted?
US government bonds underpin the global financial system so it is difficult to fully gauge the damage a default would create, but executives expect massive volatility across equity, debt and other markets.
The ability to trade in and out of Treasury positions in the secondary market would be severely impaired.
Wall Street executives who have advised the Treasury's debt operations have warned that Treasury market dysfunction would quickly spread to the derivative, mortgage and commodity markets, as investors would question the validity of Treasuries widely used as collateral for securing trades and loans. Financial institutions could ask counterparties to replace the bonds affected by missed payments, said analysts.
Even a short breach of the debt limit could lead to a spike in interest rates, a plunge in equity prices, and covenant breaches in loan documentation and leverage agreements.
Short-term funding markets would likely freeze up as well, Moody's Analytics said.
How are institutions preparing?
Banks, brokers and trading platforms are prepping for disruption to the Treasury market, as well as broader volatility.
This generally includes game-planning how payments on Treasury securities would be handled; how critical funding markets would react; ensuring sufficient technology, staffing capacity and cash to handle high trading volumes; and checking the potential impact on contracts with clients.
Big bond investors have cautioned that maintaining high levels of liquidity was important to withstand potential violent asset price moves, and to avoid having to sell at the worst possible time.
Bond trading platform Tradeweb said it was 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, has a playbook detailing how Treasury market stakeholders - the Federal Reserve Bank of New York, the Fixed Income Clearing Corporation (FICC), clearing banks, and Treasuries dealers - would communicate ahead of and during the days of potential missed Treasuries payments.
SIFMA has considered several scenarios. The more likely would see the Treasury buy time to pay back bondholders by announcing ahead of a payment that it would be rolling those maturing securities over, extending them one day at a time.
That would allow the market to continue functioning but interest would likely not accrue for the delayed payment.
In the most disruptive scenario, the Treasury fails to pay both principal and coupon, and does not extend maturities. The unpaid bonds could no longer trade and would no longer be transferable on the Fedwire Securities Service, which is used to hold, transfer and settle Treasuries.
Each scenario would likely lead to significant operational problems and require manual daily adjustments in trading and settlement processes.
"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.
The Treasury Market Practices Group - an industry group sponsored by the New York Federal Reserve - also has a plan for trading in unpaid Treasuries, which it reviewed at the end of 2022, according to meeting minutes on its website dated Nov. 29. The New York Fed declined to comment further.
In addition, in past debt-ceiling standoffs - in 2011 and 2013 - Fed staff and policymakers developed a playbook that would likely provide a starting point, with the last and most sensitive step being to remove defaulted securities from the market altogether.
The Depository Trust & Clearing Corporation, which owns FICC, said it was monitoring the situation and has modeled a variety 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.