Friday, 22 April 2011

Mrs. Watanabe - Meet Sovereign Bond Trading; Next Up - 10 Year Bond Circuit Breakers


As if insane FX vol (has anyone looked at the EURUSD chart recently) and failed LCH.Clearnet margin hikes to prevent surging vol in Irish and Portuguese bond was not enough, the CME is doing its best to make sure developed world sovereign bonds, which had for the time being been recently stable, follow in the footsteps of all other assets that actually trade (read: not stocks) and see volatility surge (perhaps so the Fed can sell more of it). The CME has just announced it is launching cash-settled Sovereign Yield Spread futures beginning May 22 for a trade date of May 23. What this means simply said, is that after discussions with Dealers, the CME has realized that its biggest clients are all too willing to hedge sovereign risk (pocketing wide bid/ask spreads in the process). It also means that the market for sovereign bonds is about to be opened up to all Mrs Watanabes in the world who are willing to express a direction bias in the 10 Year bonds of France, Germany, Italy, Netherlands, UK and, of course, the US. Now on the surface there is nothing wrong with that, however it does open the Treasury market to two traditional risk factors always seen when an otherwise ration market is opened up to everyone: 1) the herd, which tends to be always wrong, steps in and exacerbates prices moves in either direction and 2) here comes HFT: very soon the spread arbs will be trading the living daylights out of Treasury bonds, which courtesy of market reflexivity, where the derivative actually sets the price of the underlying, means that a bunch of computers will soon be the reason for why 10 Years trade at 0 or 10%. Coming next: circuit breakers in the Treasury market. At least this means that CDS traders will no longer be scapegoated for sovereign insolvency.

From the press release:

London, April 21, 2011 /PRNewswire/ — CME Group, the world’s leading and most diverse derivatives marketplace, has announced today that it will introduce cash-settled Sovereign Yield Spread futures beginning May 22 for a trade date of May 23. The six countries represented in the initial launch phase include France (OAT), Germany (Bund), Italy (BTP), Netherlands (DSL), United Kingdom (Treasury Gilts), and United States (Treasury Notes). These products are listed by and subject to the rules of CME, and further diversifies CME Group’s Interest Rates product portfolio.

“We have had many discussions during the past several months with asset managers, investment banks and hedge funds about their U.S. and European government bond portfolio needs, and the message to us was clear — design a contract that provides capital efficiencies through one clearing facility that is cost effective and meets the regulatory requirements,” said Robin Ross, Managing Director, Interest Rate Products for CME Group. “Our new Sovereign Yield Spread contracts will be key risk management tools for anyone with exposure to U.S. and European government bonds and will help facilitate the price and risk transparency that global central banks desire.”

Key features and benefits of the new contract include the following:

  • Sovereign Yield Spread futures wrap a sovereign yield spread exposure into a single futures contract — with no need to execute and manage individual legs in cash bond/repo markets or across multiple futures exchanges.
  • Sovereign Yield Spread futures make trading and monitoring of sovereign yield spread exposures simpler, more cost-effective, and more capital efficient than ever before.
  • Sovereign Yield Spread futures are cash-settled and trade exclusively on CME Globex.

Key facts:

  • Pair-wise spreads among 10-year sovereign bond yields of:
    • France (OATs)
    • Germany (Bunds)
    • Italy (BTPs)
    • Netherlands (DSLs)
    • UK (Treasury Gilts)
    • US (10-Year Treasury Notes)
  • Reference Bond price evaluations provided by a designated third-party price evaluation service
  • Price basis: Modified IMM Index = 100 + Yield Spread
  • Yield spread = "Sold" Nation yield minus "Bought" Nation yield
  • Contracts expire by cash settlement on last trading day
  • Block minimum: 250 contracts
  • Electronically traded on CME Globex
  • Centrally cleared

And just to make sure every retail investor is aware they will now be able to offload dealer exposure, the CME has even provided a video.

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