The scandal impairing confidence in the London interbank offered rate, a benchmark for $360 trillion in securities worldwide, has made bankers and investors seek alternative interest-rate measures that are based on actual trades rather than submitted quotes. Traders in the $400 billion general collateral repo market have said they prefer that interest-rate measure to the U.S. federal funds rate, because it’s more widely traded and administered by an independent third party.
“The issue is the fed funds market is very small and doesn’t capture that many transactions with that many players,” said Paul Scurfield, head of North American short rates at Bank of America Merrill Lynch in New York. “That market’s really withered away right now because of current Fed policy.”
The swaps will use the DTCC GCF Repo index for Treasuries as the floating portion of transactions. The index is a weighted average of all general collateral finance repurchase agreements that are traded between dealers each day through the so-called tri-party market. Several dealers, including UBS and Nomura, have signed the licensing agreement for the index, said Bari Trontz, a DTCC spokeswoman in New York.
Daily bank demand for fed funds has dropped as reserves at the central bank surged after asset purchases were made to spur growth. Banks’ excess reserves at the Fed were $1.46 trillion as of July 11, versus an average $1.9 billion in 2007. The Fed pays banks 0.25 percent on the reserves held at the central bank in a program started in October 2008 to try to keep the benchmark U.S. overnight interest rate close to the Fed’s target.
Only counterparties to the Federal Reserve that can’t make deposits with the central bank are willing to lend in the overnight market now, Scurfield said. The Fed’s target rate for overnight loans between banks has been locked in a range of zero to 0.25 percent since December 2008.
“It’s a way to take a view on the funding market in an efficient manner,” he said.
The average rate for borrowing and lending Treasuries for one day in the repo market was 0.143 percent today, according to the DTCC’s GCF Repo index for Treasuries.
The swap, which may have maturities of as much as 30 years, similar to those based on Fed funds, will also benefit by having a futures contract based on the same rate, because the two instruments will create demand in support of each other, Scurfield said.
NYSE Liffe U.S., the New York-based derivatives exchange of NYSE Euronext (NYX), began offering futures based on the DTCC GCF rate this week. The contracts were developed to give banks a more direct method of hedging changes in the cost of GCF repos.
Yesterday, 6,680 futures on the DTCC GCF index had changed hands on NYSE Liffe U.S., said spokesman Eric Ryan. That’s up from 2,647 on July 16 and 3,541 trades July 17, he said.
While swaps on the repurchase rate have existed for several years, the banks are now tying the contracts to the DTCC GCF Repo index for Treasuries, which was created by DTCC in November 2010. Interest-rate swaps are private transactions negotiated between two counterparties, one of whom agrees to take fixed interest payments over time while the other agrees to a rate that can change, or float.
Swaps with the shortest maturities are known as overnight index swaps, which use the fed funds effective rate as the floating leg of the deal.
“A case can be made for the development of a swap market using GC Repo in its own right, somewhat similar to the OIS market. It is unlikely though, for GCF Repo based swaps to replace either the OIS market or the Libor-based swaps market, contrary to the expectations of some market participants,” Citigroup Inc. analysts Neela Gollapudi and Timothy Chung wrote in a July 6 note to clients.
In a tri-party arrangement, a third party, one of two clearing banks, functions as the agent for the transaction and holds the security as collateral. The Fed advised participants in this market for borrowing and lending securities to cut reliance on intra-day credit from clearing banks and enhance risk management, according to a statement on the Fed Bank of New York’s website yesterday.
To contact the reporter on this story: Matthew Leising in New York at firstname.lastname@example.org.