The short answer is that the markets get messy and uncertain; we’ve seen this before with Fed Funds and OIS. Now the same situation could occur with US Treasuries, Gilts, other OECD government bonds and corporate bonds. What are the implications for this new market dynamic?
Before jumping to conclusions, let’s look at the evidence so far:
1) This week International Financing Review published an article, “Leverage burden drives cash-to-swaps shift,” looking at this topic. They noted correctly that “with no let-up in the need for macro rates products, some dealers expect a widespread shift from cash to derivatives that confounds additional regulatory measures intended to curb over-the-counter swaps trading. “Government bond trading is very expensive on a leverage ratio basis and markets are going to evolve to adjust to that. Ultimately we expect trading to move towards derivatives,” said the global head of markets at one US house.”
2) Liz McCormick’s recent Bloomberg articles on liquidity, including last month’s “Bonds’ Liquidity Threat Is Revealed in Derivatives Explosion,” walked through similar ground. She notes that “while futures trading of 10-year Treasuries is close to an all-time high, bond-market volume for some maturities has fallen a third in the past year…. As a lack of liquidity in Italy caused transaction costs in the world’s third-largest sovereign bond market to jump last month, Lombard Odier Asset Management helped propel an eightfold surge in Italian futures by relying more on derivatives.” (As we said last week, we’re not sure that we agree with her article on bond anxieties tied to repo market failures, so we’ll put that aside for now.)
3) Data from the Bank for International Settlements show the steady rise in listed options and futures volumes for interest rate products across almost every region globally. The exchange-traded derivatives numbers are cleaner number than OTC derivatives volumes, which require accounting for compression, notionals vs. netted exposure, and natural market growth or shrinkage.
4) In our August 2012 deep dive into interest rate benchmarks (“Repo Indices, Overnight Index Swaps and Other Alternatives to LIBOR,” we noted the absurdity of Fed Funds volumes of $60 billion compared to OIS much inflated figures (some US$8 trillion, according to a later BIS working paper). This trend has continued unabated; Fed Funds continues to languish while ISDA notes that OIS volumes almost doubled between Jan 2013 and Jan 2014. Can OIS be credible with such a small actual trading amount of unsecured lending backing such large notional volumes? That seems unreasonable.
Turning towards today’s question, are derivatives trading the future for bond markets, the answer for now appears to be yes, but this creates a serious problem in the stability of those same derivatives markets. Trading derivatives on products that are (relatively) thinly traded means high volatility in the derivative prices and wide bid/offer spreads. Liquidity in the derivative product may be attractive and this may help drive spreads lower, but a failure of an underlying to trade until mid-afternoon in some cases means no good way to price the derivative in the morning. This is the stuff of classic academic papers on market illiquidity: the more illiquid the underlying, the greater the possibility that markets can be highly volatile or worse, can be gamed outright. That’s the set up that we are walking into now.
We understand the Leverage Ratio argument for using derivatives and we’d do the same thing. We think however that this is a regulatory failure, and that some exceptions must be made for holding government and corporate bond assets in order to maintain a liquid underlying market. Otherwise a market that relies entirely on derivatives in order to avoid balance sheet impacts is a set up for a future failure, and possibly a big one.