Murine embryonic stem (ES) cell-derived haematopoietic progenitor cells (HPCs) engraft and populate lymphoid organs. In vivo, HPCs engraft across MHC barriers protecting donor-type allografts from rejection. However, the underlying phenomenon remains elusive. Here, we sought to determine the mechanism by which ES cell-derived HPCs regulate alloreactive T cells. We used the 2C mouse, which expresses a transgenic T-cell receptor against H2-L(d) to determine whether HPCs are deleted by cytotoxic T lymphocytes (CTLs). Previously, we reported that HPCs express MHC class I antigens poorly and do not express class II antigens. In vitro stimulated 2C CTLs failed to lyse H2-L(d) HPCs in a standard 4-hr (51) chromium release assay. Similarly, when the HPCs were tested in an ELISPOT assay measuring the release of interferon-γ by CTLs, HPCs failed to induce CTL degranulation. In addition, mice that were injected with HPCs showed a marked decrease in T-cell responses to alloantigen and CD3 stimulation, but showed a normal response to PMA/ionomycin, suggesting that HPCs impaired T-cell signalling through the T-cell receptor/CD3 complex. Here, we show that HPCs secrete arginase, an enzyme that scavenges l-arginine, leading to metabolites that down-regulate CD3 ζ chain. Indeed an arginase inhibitor partially restored expression of the CD3 ζ chain, implicating arginase 1 in the down-regulation of T cells. This previously unrecognized property of ES cell-derived HPCs could positively enhance the engraftment of ES cell-derived HPCs across MHC barriers by preventing rejection.