In an earlier post we introduced Single Treasury Futures (STFs) as well as the Exchange Future for Physical (EFP) market that will support basis trading. This article looks at who may benefit from trading STFs and why.
Securities financing is increasingly under pressure to adopt broad-based central clearing; look no further than the Financial Stability Board for evidence. Transitioning to central clearing can be painful and expensive, as evidenced by the movement of OTC derivatives onto CCPs. Innovative substitutes that move bilateral trading activities onto CCPs without the creation of major new infrastructure or processes may tend to gain traction if they are low cost, low risk and offering a simple execution mechanism.
The regulatory pressures that could lead to the repo market contracting include simplified leverage ratios that don’t take into consideration RWA, additional capital rules mandated by the Supplementary Leverage Ratio for G-SIFIs that go above and beyond Basel III’s 3%, and explicit transaction taxes on repo. While repo will retain the ability to net, not all netting is created equally. Some of the solutions being considered by the Federal Reserve to tackle the issue could easily add layers of complexity and cost to the repo business. All of these factors point in one direction: balance sheet size for repo businesses will continue to be under pressure and banks will ration its use for low return business segments. As a result, a CCP-cleared option like STFs that could move risk off the balance sheet may become very attractive.
Let’s look at some possible users:
• Client-facing businesses like prime brokers might use STFs to allow their clients to access financing in a more balance sheet friendly way, rather than margin financing. This follows the trend of prime brokers already looking for CCP-cleared synthetic financing alternatives to physical transactions. (for more on this, see Finadium’s June 2013 report, “Hedge Funds on Leverage, Repo and Prime Custody: A Finadium Survey.”)
• Cash investors looking for a term repo return that are constrained from accepting term repos themselves could turn to STFs to capture income while maintaining a CCP-cleared product profile. For many investors, while term repo may not fit their investing profile, futures may be a mainstay of their trading program. STFs could also be a repo replacement for cash investors in the event of overnight repo scarcity.
• Market participants limited in their ability to take advantage of tight repo markets may hold US Treasuries but be excluded from major repo market access. However, they can trade futures. Selling securities in the cash market and buying a STF on the same instrument (executed via an EFP, and avoiding the problem of legging into a trade) then reinvesting the cash at a rate above the implied repo rate can capture the specials versus cash reinvestment spread. A similar argument could be made about a future iteration of the STF product that focuses on Agency MBS.
• STF could also be a trading instrument. As repo rates on hot on-the-run US Treasuries ebb and flow, STF prices will change accordingly. Trading a fungible futures contract as a proxy for repo rates via the STF markets will widen the number and types of market participants in repo, providing greater liquidity to the market.
• Derivatives investors who need collateral to support central clearing may be able to achieve a better cash return and hedge their collateral price risk by buying US Treasury paper to submit to their CCP or clearing member and hedge the risk by selling STFs. This can be executed efficiently via the EFP.
STF futures and the EFP market have the potential to add both liquidity and new participants to the US Treasury term repo markets, filling a vacuum created by shrinking bank balance sheets and greater regulatory burdens on securities financing books. We believe that 2014 will be a pivotal year for STF and other exchange-based financing products as regulatory issues and developments turn to proposed rules.
This article was sponsored by NASDAQ OMX.