A Fed-endorsed industry recommendation will require traders to pay a three-percentage-point penalty on uncompleted trades, known as fails, starting tomorrow. That may reduce the number of bets on price declines, according to RBS Securities Inc. and Societe Generale SA.
While the new recommendations are meant to curb disruptions caused when traders fail to meet their obligations, some strategists are concerned it may do more harm than good in the $7 trillion-a-day repurchase market, where dealers finance their holdings. A reduction in trading would be a setback for the Fed as it seeks to lower borrowing costs by pumping cash into the banking system and purchasing as much as $1.75 trillion in Treasuries and mortgage securities.
“Making short-selling potentially costly can reduce market liquidity,” said Darrell Duffie, a Stanford University finance professor and member of the New York Fed’s Financial Advisory Roundtable. “Financial markets with relatively unencumbered short-selling perform better.”
The U.S. needs to raise $3.25 trillion this fiscal year to finances bank bailouts, stimulate the economy and service a deficit, according to New York-based Goldman Sachs Group Inc., one of the 16 primary dealers that trade with the Fed.
Trading is already down, with volume done through the primary dealers averaging $363.6 billion a day this year, compared with $655.6 billion in the same period of 2008 and $533.3 billion in 2007, according to Fed data.
Federal Reserve Bank of New York President William Dudley, who succeeded Geithner in January, said during a Nov. 12 interview that U.S. borrowing costs could rise if the logjam in the repo market, which dealers use to finance their holdings, wasn’t rectified. The New York Fed said Jan. 15 that it endorsed the Treasury Market Practices Group penalty recommendation, as well as other measures to reduce fails.
The changes should “provide an incentive for the prompt resolution of settlement failures, and with the expectation that these guidelines will contribute to the depth and liquidity of the United States Treasury market, Karthik Ramanathan, acting assistant secretary for financial markets at the Treasury, said in a statement yesterday.
Securities as Collateral
The penalty proposed by the TMPG, an industry committee formed by the Fed in 2007, would add an incremental cost of $833.33 dollars per day on a failure of $10 million worth of bonds, according to data compiled by Bloomberg.
In a repurchase agreement, one party provides securities as collateral to another in exchange for cash. The penalty would result in the lender receiving a reduced amount when it delivers the Treasury late.
“Where market makers may have felt comfortable in the past making outright short sales to investors, there certainly has to be a greater consideration of these negative costs,” said Ken Silliman, a Treasury bill trader in Greenwich, Connecticut, at RBS Securities Inc., another primary dealer. “The fails penalty has risk of reducing liquidity in bills and Treasuries all along the yield curve.”
Confidence Is Returning
Investor confidence in financial markets is returning after the U.S. government and the Fed agreed to spend, lend or commit $12.8 trillion to end the longest recession since the Great Depression. The London interbank offered rate, or Libor, for three-month loans in dollars fell yesterday to 1.03 percent, the lowest level since June 2003, according to the British Bankers’ Association.
Yesterday, the Fed refrained from increasing purchases of Treasuries and mortgage securities, signaling the worst of the recession may be over, as it kept the federal funds rate target at a range of zero to 0.25 percent for the third straight meeting.
There is little incentive to make good on delivery commitments when rates are close to zero because the main cost for failing to deliver a borrowed security is the loss of interest that would have been received on the money lent to obtain it.
Overnight general collateral repo rates were about 0.25 percent today, according to GovPX Inc., a unit of ICAP Plc, the world’s largest inter-dealer broker.
“If you have fails, then the market isn’t functioning properly,” said Eric Liverance, head of derivatives strategy at UBS AG in Stamford, Connecticut, another primary dealer. “That is what we saw last fall when we had massive fails. If you can lend a bond out and count on it coming back the next day, then those are properly functioning markets and it enhances liquidity.”
Trading failures fell to as low as $81.06 billion in the week ended April 8, before rising to $272.4 billion the following week, according to New York Fed data.
Primary dealers typically short Treasuries as a trading strategy to hedge their holdings in other securities. That’s changed this year, leaving them “long,” in part, because of the new repo recommendations. They held $75.1 billion of Treasuries as of April 8, the most since at least 1997, compared with an average of minus $60.6 billion, Bloomberg data show. The amount fell to $60.6 billion as of April 15.
“That is telling you that dealers really don’t know what all this will mean,” said Donald Galante, chief investment officer and senior vice president of fixed income at MF Global Ltd. in New York. “People are being prudent and saying I am not going to have a Treasury short now and I’ll wait to see how this pans out over the next two months.”
Galante advised his traders to not take short positions in the repo market or in short-term Treasuries going into May to allow time to analyze how the penalty and movements in repo rates evolve.
The threat of penalty will likely cause repo rates to drop below zero on Treasuries that have had high levels of fails or whose rates have traded close to zero in the repo market, according to Ira Jersey, head of U.S. interest-rate strategy in New York at RBC Capital Markets. Jersey cited the current five- year note as an example. The repo rate on that security was 0.05 percent yesterday, and 0.25 percent today, according to GovPX.
A negative repo rate means that investors who lend cash in exchange for obtaining securities as collateral actually pays interest instead of receiving it on the money they loan.
‘State of Anxiety’
Penalties for uncompleted trades will begin to accrue May 1. The due date for filing claims for fails to counterparties in trades that occur in May will be June 12, and payment or claim rejections will be due on June 30. In subsequent months the filing date will coincide with the 10th business day and the payment date will be on the last business day of the following month.
Because the penalties will be imposed across the government debt market, unregulated investors such as hedge funds will be held to the same standard as banks and bond dealers. Since it’s a recommendation, some dealers are still uncertain which counterparties will need to pay the penalty.
“The market’s heightened state of anxiety looks likely to produce unintended and unfortunate consequences,” said Ciaran O’Hagan, the Paris-based head of fixed-income at Societe Generale. “The fails penalty adds to the security of the market at the cost of liquidity. All this suggests that liquidity will be hurt across the board for U.S. Treasuries.”