The introduction of repo futures on the NYSE Liffe US in July could be a game changer. The contract will be based off the DTCC GCF Repo Index™, created to track the daily overnight general collateral repo market. DTCC and NYSE Liffe are hoping the product will be a benchmark for short-term cash investment. We hope so too.
A vacuum was created when LIBOR and Fed Funds lost their luster. Replacing unsecured investment benchmarks with a secured index reflects the market push toward collateralization and comes none too soon.
New York Portfolio Clearing (NYPC), a joint venture clearinghouse of DTCC and NYSE Euronext, will clear the Index. There are two major advantages to this structure. First, DTCC is where the General Collateral Finance repurchase agreements (aka GCF Repos®) market lives so there are no issues around using their repo index data. Second, DTCC’s Fixed Income Clearing Corp (FICC) already acts like a Central Credit Counterparty (CCP) for US Treasury/Agency cash and repo trades. Adding the repo index to the mix allows for efficient cross margining against the cash, repo, and repo futures markets. They got the memo about the need to do cross product clearing and margining. Very smart.
We wonder if there won’t be another advantage to the repo futures market, albeit somewhere down the road. Dealers and CCPs had used LIBOR to discount cash flows when marking to market swap exposure for margining. But the financial crisis taught a difficult lesson when the LIBOR – OIS spreads when crazy. LIBOR was full of credit risk, making the forward rates inefficient. The stories about LIBOR panel manipulation didn’t help either. The market shifted to using Overnight Index Swaps (OIS) curves instead. OIS was based on an achievable rate – Fed Funds. But Fed Funds still has its issues. With a Fed target at or near zero, the market can behave strangely. The imposition of FDIC insurance on Fed Funds further convolutes the market. And Fed Funds is an unsecured loan. The credit risk potential, albeit very short term, is still there. On the bright side, when marking to market long dated swaps one needs curves which extend out pretty far. Long OIS curves can be bootstrapped using LIBOR forwards and LIBOR – OIS spread curves.
What about repos? Their advantage over OIS is that repos are naturally collateralized with “safe assets”. But long dated repo curves are rare and not easily executed on. Enter repo futures. Current plans are to have contracts with monthly maturities and markets out 24 months. If the market is successful and prices start to trade beyond the planned 24-month horizon, then long dated repo curves could be a reality. Using repo curves to discount swap exposure, both bilateral and in CCPs, might be the way forward.