Leveraging Futures' Liquidity - Useful LIBOR Replacements

LIBOR is the first cash market price that futures built – reversing the usual direction whereby futures markets are “derivatives” of spot markets. The implication of the word “derivatives” to describe futures is the mistaken belief that a vital liquid spot market is necessary to open futures trading of the same instrument.

But a spot index might well be defined by a futures or futures-like exchange. In this case, the spot market, as with LIBOR, would be the derivative market. Interestingly, the liquidity could remain in the futures version of this spot-futures combination. And, the market would satisfy both participant and regulator needs.

LIBOR spot market trading and regulation were informal before the Chicago Mercantile Exchange, now part of CME Group (CME), moved to list the Eurodollar futures market. The presence of the highly visible Eurodollar futures, priced at LIBOR, encouraged the creation of the British Bankers Association (BBA) to formalize the management of LIBOR pricing. The BBA became the official source of the daily LIBOR fixing, which in turn became the source of the LIBOR index.

But, now, the financial futures market that regulators once considered snuffing might be the salvation of the LIBOR replacement process. Indeed, this moment is an opportunity to bring order (and trading volume) to debt markets, in general, by leveraging the liquidity-creating technology of financial futures. By applying futures technology to cash market trading, generating spot markets trading interest rate indexes, the crisis of LIBOR replacement may produce a positive outcome for all. This article explains why and how.

The path forward is illuminated in part by the International Organization of Securities Commissions (IOSCO) standards for a financial benchmark. The IOSCO requirements are consistent with a benchmark index that is valued in an exchange-traded market. But such an exchange-traded index would necessarily be a spot value determined in a liquid market daily, according to IOSCO standards.

The use of futures technology both limits and liberates the building of new spot instruments. The limitation is that futures markets gain much of their strength by avoiding the very costly transfer of ownership. Thus, a futures-like cash market would not successfully trade a single corporate issue of debt or equity – in these markets, ownership is important. The strength of futures-like trading is in trading indexes. A well-designed index would both seek and enhance greater liquidity in the trading of spot and futures markets in the same index.

There is a dividend for futures markets in listing a spot version of an index. There would be no repetition of the disastrous loss of the LIBOR spot rate that settles the Eurodollar futures market since both spot and futures are located in a single market that controls both.

What financial futures were

Futures are a Jekyll and Hyde world. When futures were making the transition from trading agricultural products to trading financial products circa 1980, there was concern among some senior Fed officials that the futures markets would somehow inhibit monetary policy or reduce policy’s economic impact. Worse, officials worried about the possibility that futures markets in Treasury issues would increase the cost of financing the debt.

And to some white-shoe New York investment bankers, futures traders were a foreign culture. The East Coast establishment vs. Midwest gangsters and other rabble-rousers in their minds. Business Week vilified futures markets, likening them to a casino. Futures were Mr. Hyde.

There was an official Fed study of financial futures that began in 1980 and continued throughout that year. The study presented a chance to foster behind-the-scenes interaction between the Fed staff economists that conducted that study and futures executives. The ebb and flow of ideas that were produced from the interaction of the Fed and the CME during that study helped build a mutual understanding between futures markets and Washington financial regulators that was missing before the study. The study built a bridge between futures market participants and market regulators that has served the markets well ever since. Futures became Dr. Jekyll.

What financial futures are

Fast-forward to today. Now, the shoe is on the other foot. The cash markets for debt are in eclipse since the two body blows the 2007-2008 Financial Crisis dealt.

• First, the LIBOR scandal that was precipitated by the chaos of the Financial Crisis. The conduct of some LIBOR traders during the Crisis embarrassed the dealer banks to the point that they asked the Financial Conduct Authority (FCA) to permit them to opt out of providing the daily estimate of LIBOR used to construct the LIBOR index. The FCA prevailed upon them to continue until the end of 2021.
• Second, pressure from bank regulators globally to reduce commercial banks’ interest rate risk exposure, inspired by Dodd-Frank and related market regulation, diverted the flow of funds through a different conduit. The commercial bank deposit markets such as Eurodollars dried up, replaced by overnight collateralized markets like the Treasury repurchase agreement (repo) market.

Carpe Diem

The sudden disappearance of LIBOR creates an opportunity for markets to seize the moment. This unprecedented situation is threatening the world’s most liquid futures contract, Eurodollars, along with the even more enormous LIBOR-based interest rate swaps market (IRS). The two markets will soon have no spot LIBOR market for valuation purposes. But this is a life-threatening problem for Eurodollar futures and IRS only if financial specialists fail to deconstruct the reason for financial futures’ success, leading them to create synthetic term markets.

The narrow unhelpful answer to the question “What are financial futures?” is that they are “derivative” financial instruments that depend on the existence of a related cash market to find their market values.

A broader more helpful definition focuses on financial futures technology. In this second definition, futures are a technology for managing markets and the price risks that markets transfer from traders seeking to avoid risk to those who specialize in managing that same risk.

By the second definition, markets might use a successful futures contract to spawn a “derivative” cash market. Financial futures, in this more helpful way of thinking about their function, could design spot instruments and markets that meet the needs of the liquidity-seeking users of futures.

What do futures friendly spot markets look like?

Why are financial futures so successful in creating liquidity? Reasonable people may produce different answers, but here is mine. Financial futures:

• Do not require sellers to transfer ownership of a financial instrument from sellers to buyers, reducing the resource cost of trading by about a factor of three.
• Do not distinguish between the costs and risks of sellers and buyers. The seller pays the same fees and is assessed the same margins as the buyer.
• Are traded on an exchange that is the counterparty of both buyer and seller, resulting in a credit risk that is only that of intraday price changes since the gains and losses from trading are passed through the exchange from the seller to buyer daily.
• Have margin payments that protect the exchange and participants from counterparty failure that are determined by an exchange that measures intraday price risk and sets margins to cover these risks.

Bottom line, there are no unnecessary costs or risks in trading futures, for customers whose objective is to take or avoid the risk of changing prices. Yet the technology of futures trading has shown itself to be safer than spot technology.

How to transfer futures trading technology to a spot index market

To transfer the advantages of futures to a spot index instrument, it is useful to look at an intermediate marketplace, the when-issued market for new issue Treasuries. When issued transactions are a contingent trade, made conditionally because the Treasury security has been authorized but not yet issued. The when-issued market for Treasuries is open following the Treasury’s announcement of a new issue and closed by the settlement of outstanding when-issued trades on the index' issue date.

Trading

This convention of a week of spot trading with no delivery to be closed at the market's closing price on the issue date seems an attractive midway-between-futures-and-spot kind of transaction in a spot index. Modifications would be desirable, however. Treasury when-issued trades are not margined which requires that seller and buyer “know” each other, in the credit sense of “know.”

To open synthetic index trading to the public, an exchange would be needed to vet the clearing firms (firms that are regulated and monitored by the exchange), who would, in turn, vet their customers. Both clearinghouse and customer would assess margin charges appropriate to the price risk of the traded index. All this structure is futures normal. As with futures, and unlike Treasury when-issued trading, variation margin would be assessed daily to further insulate market participants from counterparty credit risk.

Settlement

The all-important issue that would make or break index trading would be the exchange settlement of weekly futures-like trading by delivering a spot synthetic debt instrument to create the deliverable issue. The possible settlement practices of an index trading exchange are outlined in some detail in my instablog posts.

The basic method is to use the exchange definition of a deliverable index, in combination with the closing price on settlement day, to identify buyer’s cash payment, the exchange commitments to buyer and seller, and seller's obligation to the clearinghouse, to settle market-on-close (MOC) orders. Following the settlement, the exchange-designated index originator is responsible to determine obligations between the counterparties and provide changes in the value of the originated index and the fund the originator manages with the cash provided by the buyer and with margin payments for seasoned issues of the index.

Where is the liquidity?

A key issue is the compliance of the indexes created with IOSCO index requirements. The IOSCO requirements assume the existence of an administrator and a liquid market that produces a transparent set of transactions from which the index is determined. The listing exchange fits the IOSCO administrator requirements so well that one suspects IOSCO may have expected an exchange to be the index administrator. The liquid market, once cash and futures are jointly traded, would be the MOC transactions during the week that create synthetic instrument settlement open interest.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.