Treasury-Backed Term Repo Futures | Seeking Alpha

Introduction

The existing CME Term SOFR Contract was foisted on the markets by the Fed to replace the defunct Eurodollar futures contract. There are many problems created by using an overnight Treasury repo rate to find the price of a three-month instrument, most notably that the price is unknown until three months after the contract settlement.

The article introduces better term repo futures contracts intended to provide the markets with spot instruments that open the Treasury market to individual and institutional investors on an equal basis with Government Securities Dealers.

This contract, if successful, would measurably improve the safety and liquidity of the Treasury securities market.

This article provides the first of two example markets based on the structure explained earlier here.

Purpose

The article’s objective is to describe a more useful market for a Treasury-based short-term instruments, improving upon the CME Group Term SOFR Futures Market in several ways. Specifically, the article proposes term commercial paper-based repurchase agreements (repos). This market would have these four properties.

1. Supported by general collateral Treasuries.

2. Stable deliverable assets that are not subject to redemption as are Treasury-based Money Market Mutual Funds (MMMFs).

3. Delivers Treasury-backed repo on settlement of the futures contract.

4. A market that is accessed by retail traders and institutional investors on the same footing as Government Securities Dealers.

Brief History

A three-month Treasury bill futures contract was listed by the Chicago Mercantile Exchange during the 1970s. It was successful until a shadow was cast upon it by the Treasury-Federal Reserve Joint Study of Futures Markets. The agencies felt that a Treasury-based futures contract settled by delivery of a single issue and listed in advance of the Treasury announcement of a new issue would constrain the Treasury to issue the security, counter to the national best interest of minimizing the cost of our debt. The contract was subsequently delisted.

Current Short-Term Treasury Offerings of CME Group

The current three-month Treasury-based contract at CME Group (CME) is the Three-Month SOFR Futures Contract. The contract prices SOFR in arrears. For example, the currently trading December 2023 contract averages the daily SOFR rates in December, January, and March. So, the December contract price is unknown until the day before the settlement day of the March contract. For details, see the CME rulebook, here.

An important weakness of SOFR futures is that it does not deliver an asset. Thus, the expansion of Treasury spot markets to include term repos or any other set of Treasury-based assets is not a possibility.

Reasons for a Term Repo Futures Contract

Since the successful listing of the Chicago Mercantile Exchange’s Three-Month Treasury Futures contract in the late 1970s, it has been evident that there was substantial demand for a Treasury-based futures contract, if one could be created that protects the Treasury’s discretion in deciding whether or not to list new issues. If so, the agency might not oppose it as it did the earlier Three-Month Treasury Bill Futures Contract.

Properties of the Proposed Term Repo Futures

The key properties are these.

1. Multiple maturities. Three-, six-, nine-month and one-, four-, and ten-year repo maturities trade for settlement weekly.

2. Physical delivery. Repos collateralized by general Treasury collateral.

3. Weekly listing. Contracts listed weekly on the Treasury announcement date.

4. Issued to match Treasury issues. Deliverable repos are issued on the Treasury issue date.

Multiple maturities. The objective is to provide a stable set of investments appropriate for institutional investors at maturities they seek.

Physical delivery. We seek to create high-volume institution-appropriate Treasury-based securities. Off-the-run Treasuries that linger in institutional portfolios increase risk management difficulty since they are illiquid and can only be sold at a discount.

That problem is addressed now by using them to collateralize overnight repurchase agreements, but the risk created by large overnight positions in institutional portfolios is itself substantial. Term repos would use off-the-run securities to create on-the-run term repos at maturities consistent with those on the other side of the balance sheet.

Weekly listing. Weekly listing would match the maturities of the repo futures to those of the Treasury when-issued market. Repo futures trading would thus be more inclusive than when-issued trading, which is limited to the Fed’s Dealer Banks.

The futures contract would dispense with the familiar March, June. September and December quarterly settlement cycle. Although infrequent deliveries are appropriate for agricultural and energy contracts where delivery is very expensive, financial instruments deliveries are nearly costless by comparison. For these proposed repo futures it is possible to closely align delivered maturities to buyer maturities on the other side of the balance sheet, making risk management substantially simpler while clarifying the risk-return properties of the combined balance sheet.

Issued to match Treasury issue dates. By matching Treasury issue dates, the repo would offer retail investors a more inclusive alternative to the insider-dominated Treasury auctions.

Why Are Deliverable Term Repo Futures a Good Idea?

There are three key reasons to trade these instruments.

1. They take advantage of the strengths of futures markets.

2. They potentially create a broader, safer market of Treasury-based institutional investments. These markets would be available to retail investors as well.

3. If approved by the CFTC, repo market regulation would be more innovation-friendly than SEC regulation.

Strengths of futures markets. This futures market is a safe way to open the Treasury market to retail investors because of two key properties – risk-based margins and futures-style clearing.

Futures’ risk-based margins have proven effective risk protection in every financial crisis since financial futures were introduced in the 1970’s. For example, when the Lehman bankruptcy disrupted both interest rate swaps trading and money market mutual fund investing in August 2007, futures contracts managed an eight-billion-dollar Lehman position by transferring the bank’s positions to Barclay’s futures subsidiary before Lehman’s lawyers made the bank aware of its impending bankruptcy.

Futures style clearing is a key part of the futures exchange risk management arsenal. Since the clearinghouse is the counterparty to both sides of an open position, the clearinghouse is exposed to a party’s failure, not another market participant. The capital of the clearing members is accessed to offset failures.

Because futures run an all-to-all book — read here for an explanation of all-to-all trading – there is no market separation into insiders and outsiders. All-to-all clearing assures us that markets provide an equal playing field for both retail and wholesale traders.

A broader, safer market of Treasury-based institutional/retail-assessable investments. Futures-exchange listing enables an exchange to list securities that have greater appeal to investors. Futures markets are not, like securities exchanges, focused primarily on the needs of the sell side of the market. Securities listed on futures exchanges are focused on the buy side instead. Repo trading is now limited to large institutions. Profitability throughout the market would be enhanced by opening the market to retail investors and expanding available maturities.

Regulation would be more innovation-friendly than with SEC regulation. The CFTC is open to change. In the early 1980s, the CFTC required exchanges to provide an extensive justification for any futures trading change — consistent with the then-in-vogue theory that for a futures exchange to do anything new was a bad thing, requiring the exchange to demonstrate that there would be an offsetting benefit.

CFTC regulation takes a laissez faire approach which makes the futures markets the place to introduce innovation in market structure.

A useful deliverable security

Unaffected by financial crises.

Two recent crises, the UK pension disaster of 2022 and the US regional banking crisis of 2023, were primarily the result of asset/liability maturity mismatches.

UK pension disaster. In the case of the UK pension disaster, overnight repos funded long-term investments (primarily gilts). The excuse for this extreme mismatch was that there is no market for term repo funding.

The resulting mismatch was inadequately hedged using various derivatives. The inadequacy of derivatives hedging is in part the result of the complexity of derivatives hedging but perhaps also in part of some institutions’ intent to bet on the future course of interest rates. Futures hedging easily disguises regulated institutions’ intern to take risk from their regulators.

The proposed repo futures would enable UK pension funds to sell gilt-based term repos directly to the exchange. This way, issuer access to the entire investment universe would be available instead of the current single bank source.

US regional banking crisis. In the US regional banking crisis, extreme mismatch was also the problem, but the missing market-based solution was the absence of demand for term commercial paper issued by the struggling banks. A solution along the lines of this one will be explained in the following post.

Stable

More stable than the supporting assets. The term repos deliverable on these contracts share several useful properties with the defunct Eurodollar futures contract. The deliverable instrument is not redeemable. The instrument held by the buyer, like deposits, is supported by assets changed by the issuer throughout the buyer’s holding period with no impact on the value of the repo.

Assessable.

The issuing cycle and listed issues match those of the liquid when-issued Treasury market. Unlike the when-issued market, this version of a term repo market would provide broad access to retail traders and institutional investors on an equal footing with the Fed’s government securities dealers.

Conclusion

The proposed repo futures contracts are assessable to retail and institutional investors on an equal footing with Government Securities Dealers. The market matches maturities with the Treasury when-issued market but accesses a far greater number of potential users.

The market compares favorably to the CME’s existing Term SOFR futures market in several ways. First, the market trades an asset, not an index constructed in arrears. Thus, the settlement value of this term repo contract is the market price of the spot instrument on the settlement day, not a value to be determined three months later.

It improves on all the financial futures contracts offered by the CME by settling contracts pricing a single Treasury-based security rather than at an index value that averages multiple Treasuries. It settles on Treasury issue dates, providing both retail access to Treasury-based securities, and minimizing the difference between the pricing of the futures contract and the equivalent Treasury securities.