The Hedgers Played Hardball
How they won the battle for less volatile bond futures
For more than a year, the Chicago Board of Trade was the scene of a running battle between hedgers and speculators over the future of the world's most heavily traded derivative--the U.S. Treasury-bond futures contract. Hedgers clamored for the CBOT to change the futures contract so its price would more closely track the ups and downs of the cash market in Treasury bonds. Reducing volatility would have made it cheaper for big bond investors to hedge their portfolios. That would have lowered the borrowing costs of everyone from the U.S. Treasury to corporations to home buyers. But speculators liked the volatility of the contract. The more prices move, the more money they can make from trading. With local traders owning many of the 3,600 seats on the exchange, they managed to stave off action.A GUN TO THE HEAD. The hedgers and their Wall Street advisers have finally won the day, though, and with a new weapon. It appears that in mid-February a major broker-dealer shifted some of its business to the Cantor Exchange, a fledgling electronic competitor started by bond broker Cantor Fitzgerald. Since Cantor began trading Treasury-bond futures last fall, its daily volume had averaged below 1,000 contracts. But volume leaped to 4,000 contracts on Feb. 18, and to over 7,000 on Feb. 19.
That did it. CBOT's directors held an emergency meeting on Feb. 22 and voted to make the change hedgers sought. "It was a long time coming," says Jim Keller, a derivatives strategist at Pimco Funds, which has $160 billion in assets. "I guess they felt enough heat and urgency to do the right thing."
What the CBOT did was to lower the coupon rate on the contract from 8% to 6%, beginning with the March, 2000, contract. The lower rate will bring the contract's rate closer to actual yields on Treasury bonds. For complicated mathematical reasons, that will make the futures contract less volatile and thus more useful to investors who want to use the futures to offset long or short positions in Treasuries.
Even before the Cantor gambit, some investors were so upset with the volatility of the CBOT's bond futures contract that they were taking their business elsewhere. Paul Johnson, director of government securities trading at ING Baring Furman Selz and head of the CBOT task force that recommended changing the contract, estimates that the exchange has lost more than 100,000 contracts in the past six months over the issue. Pimco's Keller puts the figure at over 200,000. That compares with total open interest of about 770,000 contracts. Many hedgers, including Pimco Funds, have used alternative tools, such as interest-rate swaps.
But the surge in volume on the Cantor exchange seems to be what finally spurred the CBOT into action. "I would have preferred to keep the contract the same," says one local trader. "But if you put a gun to my head, I'd probably change my mind." The Cantor development, he says, was that gun. Better to compromise, the locals figured, than to open the door to an electronic competitor. Then again, it may be too late: Trading on the Cantor Exchange kept going strong even in the days immediately after the CBOT's vote.By Andrew Osterland in Chicago