Could you live forever? Could you see the day? Could you feel your whole world fall apart and fade away?
- Steely Dan
In my last installment, considering the ailments of the bank deposit and OTC interest rate derivatives markets, I argued to replace LIBOR with a term certificate of deposit, based on the risk of individual bank overnight commercial paper. Called a synthetic CD, the CD is designed as described “Replacing LIBOR.”
The salient characteristics are:
- Synthetic CDs are term liabilities.
- They are market-priced, traded on electronic platforms, funded by bank liabilities – but not themselves bank liabilities.
- They have structure akin to that of a money market fund.
As recounted in the previous article, the factor that propelled LIBOR from its somewhat important role, as a basis for pricing large floating rate loans, to its transcendent role as the basis for pricing more than $80 trillion in floating rate assets globally, was CME Group’s (CME) launch of Eurodollar futures. The Bank of England was motivated by CME’s innovation to take control of LIBOR pricing, with an unending chain of disastrous results that have led us to the current dire circumstances surrounding LIBOR.
Thus a key to the success of any candidate for a LIBOR replacement is to enable a futures exchange to successfully list the accompanying exchange-traded term deposit derivatives. This article lists the changes that might lead to a successful result.
The existing Eurodollar markets, both spot and futures, have been based on settlement by an index. As pointed out by FCA Chief Executive Andrew Bailey, this index is now largely fictional, since the LIBOR market has dried up. Furthermore the index method for pricing bank debt has proven itself dysfunctional. As Bailey indicates:
- LIBOR is not considered to be sustainable;
- the [LIBOR replacement] market should work to transition to alternative rates by the end of 2021;
- firms should not rely on LIBOR being available after the end of 2021.
This is bad news for the CME, since Eurodollar (E$) futures are by far the exchange’s most successful contract. CME has listed alternatives to E$ futures based on the poohbah-proposed instruments with little success. The way out is to drop index settlement and to return to the more common approach of settlement through physical delivery.
There have been sporadic attempts to list contracts in financial instruments with physical delivery – an S&P futures contract settled by use of an index exchange traded fund (ETF), a futures contract in domestic bank CDs, and an interest rate swap contract settled by transfer of an interest rate swap. None have been successful. The reason is that a few of the canons of futures delivery, designed appropriately for the settlement of agricultural contracts, make no sense for financial futures contracts.
Some changes that would resolve physical settlement issues associated with financial futures:
- Give the seller’s right to select the delivery instrument to buyer. For the original agricultural futures, seller was put in control of the choice of the delivered commodity. The reason was that sellers might be “squeezed” by buyers. A buyer could potentially acquire the entire deliverable supply of the commodity in the period before delivery, putting seller at buyer’s mercy when deliverable stocks must be acquired. But a squeeze on sellers is absurdly irrelevant in the market for a privately issued liability. If buyer attempts to acquire all the currently available bank commercial paper, the cost would be in the 100’s of billions, and the banks would see the cost of acquiring money fall. Is there any doubt that these same banks would willingly issue more commercial paper at the new lower rates? None. No buyer can squeeze the market for bank commercial paper.
- Greater standardization of contract terms. The same issue of squeezes that created seller’s choice inspired the CME to permit CDs with multiple possible contract terms to be deliverable. This was to alleviate the assumed scarcity of available CDs. This put individual banks in a position to suit themselves when they delivered CDs into the market. It was thus impossible for buyer to know what the terms of the CD she was acquiring would be in advance, leading to problems with pricing in advance of settlement. This made even the vagaries of LIBOR rates attractive by comparison, eventually destroying the CD futures contract. A fixed $1 million face value payment at a market-determined yield, the liability priced by the current E$ contract, would eliminate the standardization problem.
- Replace quarterly settlement dates with optional spot settlement. Again, in the case of agricultural futures, quarterly settlement deals effectively with the very high cost of transferring ownership of a boxcar full of wheat, for example. And there is an important market for forward delivery of agricultural commodities that exists alongside the futures markets. Commodities such as agricultural goods and crude oil are most often sold from storage, weeks or months before delivery can be effected. Common shares, in contrast, are priced at spot prices instantaneously, and accounted for at market closing prices daily. Common stock delivery is itself too inefficient, given the electronic nature of ownership transfer, but could be easily changed to the Treasury’s method, where delivery and transaction are accomplished on the same platform with the same electrons.
How would buyer’s choice of deliverable security affect pricing and settlement?
As described in the earlier article, the deliverable instrument would be a term deposit built from the commercial paper of a named bank. So, for example, a three month deposit with maturity date on the settlement date of the next futures contract month, face value $1 million could be the deliverable security. Allowing buyer to choose the delivered CD will elicit the CD with the lowest yield. Two advantages immediately result.
- There is no need to list the deliverable names, another problem with the old CD contract. I can recall Continental Bank’s CD dealer calling around to the other deliverable names, asking “What will it take?” to avoid being struck from the deliverable list. A buyer-driven settlement would have simply passed Continental by. Any bank could be permitted to satisfy settlement since only the most valuable, lowest yield, CDs will be chosen.
- The pressure on the banks would be reversed. To raise money through this market, their CD yield must be low relative to the other banks in the market. Thus virtue is rewarded.
How would standardization of contract terms affect pricing and settlement?
Standardization will put the focus of futures traders squarely on the issue with greatest significance to the banking market. Which bank can issue its debt most cheaply? Other benefits:
- Greater liquidity. A homogeneous, exchange-traded instrument which may be traded in three separate modes. Spot valuation, when-issued valuation, or futures priced; would provide all investors, as well as regulators, with both the market’s opinion of the riskiness of each bank, and access to the least risky paper in the market. The option to buy and sell at the close, the most popular order in most trading platforms, would be available in these markets for the first time.
- Maximum flexibility for bank borrowers. While banks today focus for the most part on overnight paper, longer-dated paper would be even more attractive to the custodian banks manufacturing the synthetic CDs. Thus the banks would find it easier to reduce their maturity mismatch on their own, simultaneously reducing the risk faced by the custodian banks.
How would optional spot settlement work?
Optional spot settlement would reduce transactions costs for traders, expand access to the trading of wholesale deposits to individual investors, and add alternative ways to participate in the market for term bank debt.
- Reduces transactions costs. Much like trading at the close in the market for shares, broker-dealers would manage delivery imbalances (for example, an excess of parties wanting to sell the CD over those wanting to buy it) by stepping in to absorb the remaining residual supply. This is a customer service, and could be priced accordingly.
- Individual investors’ access. Requirements to participate in the spot market would be identical to participation in the futures market, including margining, and marking to market at least once daily. This would be the first spot market where traders could reverse their positions at the close without taking or giving up ownership.
- Alternative ways to participate in the market. No other market simultaneously trades a spot market, a when-issued market, and a futures market – all without mandatory delivery.
It is truly rare when an apparent financial market catastrophe can be turned to the benefit of the traders of a financial instrument without federal intervention in any form. The only outstanding issue is which of the financial regulators would regulate the market? This change tears down many of the already dubious distinctions among the markets that lead to designated regulators. It seems evident that one regulator should be responsible for regulation of every form in which synthetic CDs should be traded. But which regulator?
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.