They're loving Gary Gensler at the Chicago Board of Trade these days.
By making a speech this week that caused volatility in the federal agency bond market, the
official was apparently responsible for a spike in the trading volume of the CBOT's new agency futures contract.
The volume spike would have been appreciated in any case. But it came at a critical time. On the day before the CBOT launched its agency futures contract, its main competitor, the
Chicago Mercantile Exchange
, launched its own agency futures contracts and beat the CBOT to the punch.
Debt-derivatives analysts (futures contracts are debt derivatives) say there is room in the world for both sets of futures contracts. It depends on what one wants to do with them. If one wants to make bets on the value of agency securities in relation to eurodollars, one would do it at the Merc, which lists eurodollar futures.
Eurodollars are the interest rate paid on U.S. dollar deposits by banks outside the U.S., and eurodollar futures were the world's second-most-actively traded futures contract after German government bond futures last year. If, on the other hand, one wants to make bets on the value of agency securities in relation to U.S. Treasury securities, one would do it at the Board, which lists Treasury futures. Treasury futures were the third-most-active contract last year.
But for some reason, during the first several days of agency futures trading, the Merc ate the Board's lunch. For now, the Board is listing only a 10-year agency futures contract, while the Merc is listing a 10-year and a five-year. The two 10-year contracts are the same size, meaning that each represents $100,000 of underlying bonds. But traders bought and sold 6,383 Merc contacts on March 14, the first day they were listed, and traded 5,487 the next day. Meanwhile, over at the Board, only 1,450 contracts changed hands on March 15, the first day they were listed. From March 15 through Tuesday, agency volume on the Merc was 17,470, compared to 7,346 on the Board.
Then, on Wednesday, Gary Gensler spoke up.
speech to a
House of Representatives
subcommittee, the Treasury Department's under secretary for domestic finance expressed support for a bill that could make agency securities less appealing to investors.
Agency securities, issued by
Federal Home Loan Bank
, have long enjoyed lines of credit from the Treasury Department, meaning that Treasury would pay the agencies' creditors in the event the agencies could not. The agencies -- also known as government-sponsored enterprises, or GSEs -- have never availed themselves of the lines of credit, but their existence is a comfort to investors and, as such, is among the factors that enable the agencies to issue bonds at lower interest rates than comparable financial institutions have to pay.
Introduced by Rep.
(R-La.) and Rep.
(R-Iowa), H.R. 3707 would repeal the lines of credit, among other things.
Furthermore, in his testimony Gensler urged Congress to take an additional step to make clear that agency securities are not obligations of the U.S. government. He said lawmakers should repeal the exemption that allows banks to invest more than 10% of their capital in securities issues by a GSE.
Beyond Gensler's specific recommendations, his comments gave the bond market the general impression that the Treasury Department does not favor the adoption of agency securities as benchmarks. The notion has gained currency over the last year that the global bond market needs a new benchmark because the supply of Treasury securities is diminishing, and that agency securities can fill that role. The supply of Treasuries is shrinking because the federal government is using surplus funds to buy old Treasuries on the open market.
In any case, Gensler's comments sparked a repricing of agency securities relative to Treasury securities -- the very trade that the CBOT's agency futures contract exists for.
Either the CBOT's or the CME's agency futures contract can be used to hedge a portfolio of agency securities. In other words, an investor with a portfolio of agency securities who expects the price of agency securities to fall can take a short position in agency futures. If prices do fall, the profit on the short position will offset the loss on the portfolio.
But traders, many of whom don't make bets on the direction of the market as often as they make bets on inter-market spreads, will favor one exchange over the other depending on which spread they're trading.
Spreads are nothing more than yield differentials. For example, the difference in yield between the 30-year Treasury bond and the 10-year Treasury note is a spread, and traders trade it. If they expect that difference to increase, they can own the spread by buying the 10-year and selling the 30-year. Lots of traders trade spreads rather than the direction of the market because they see them as easier to predict.
For example, agency bond yields typically hover about 20 basis points below the equivalent swap rate, says Jerry Lucas, Treasury market strategist at
. A swap rate is the fixed interest rate the market demands in exchange for the floating, eurodollar interest rate. A trader who spotted an agency yield hovering only 15 basis points below the equivalent swap rate would buy the agency bond and sell the swap rate, expecting the relationship to return to its historical norm.
That's how traders are likely to use the Merc's agency futures, Lucas says. They will watch for unusually large or small spreads between agency and eurodollar futures and attempt to take advantage of them.
The Board's agency futures will be used to trade another kind of spread -- the difference between agency and Treasury yields, Lucas says. That difference is the amount of extra yield investors demand for taking a small amount of credit risk by buying agency securities instead of Treasuries, and it correlates to other types of so-called credit spreads, Lucas says.
It was those spreads that went haywire in reaction to Gensler's remarks, encouraging trading of the Board's futures. As the table shows, volume on the Board exploded on Wednesday and Thursday.
"An event like this was going to happen eventually," says Fred Sturm, senior economist in market and product development at the CBOT. "But it's convenient that
Gensler said what he did when he did." The CBOT is "the only exchange on God's green earth where you can isolate the agency-Treasury credit spread, and we needed an event like this to prove the point. We're glad it happened now. Better now than a month from now."
Indeed. The way things were going for the Board's agency futures, Lucas's prediction that while "both contracts are viable, eventually one will dominate" might have come to pass in short order.