Treasury 10-Year Note Repo Shortage Risks Rise in Failed Trades

Treasury 10-year notes are in such short supply in the $1.6 trillion-a-day market for borrowing and lending securities that it may lead to a surge in failed trades.

Traders are willing to pay to borrow the notes in the repurchase-agreement market in exchange for loaning cash overnight for the most actively traded 10-year maturity, with rates reaching negative 2.95 percent today, according to data from ICAP Plc tracked by Bloomberg. Many times traders short, or sell securities they’ve borrowed in the repo market, before a Treasury sale to profit if prices of the securities fall after the auction. The U.S. is selling $21 billion of the securities tomorrow.

As repo rates approach negative 3 percent, its often more economical for market participants to fail to make good on delivery commitments for the securities rather than risk being forced to pay a 3 percentage point penalty on uncompleted transactions. Repo rates approached negative 3 percent in March and June 2013 as investors sought to short 10-year notes before government auctions and a Federal Reserve meeting, sparking a rise in what’s known as fails.

“The specialness in the 10’s has to do with the auction cycle as well as the very big short base in the market,” said Stanley Sun, a New York-based interest-rate strategist at Nomura, one of the 22 primary dealers that bid at Treasury auctions. “Some shorts are getting emboldened and others may be setting up ahead of the next Federal Open Market Committee meeting, as they did last June. You have the stars aligned for the 10-year notes getting failed again.”

Fails Data

Total U.S. Treasury settlement delivery failures, excluding inflation protected securities, were $48 billion in the week ended May 28, according to the latest available Fed data. Fails surged to $95 billion in the week ended March 13, 2013, and to $163 billion in the week end June 12, according to Fed data. Fails have averaged $43 billion per week since the start of 2012.

In a repo agreement, one party provides securities as collateral to another in exchange for cash; in a reverse repo, the opposite takes place. U.S. securities in scarce supply are traditionally traded in the repo market at so-called special rates, below the general collateral repo charge that’s typically close to the federal funds rate, which has been set at a range of zero to 0.25 percent since 2008.

“There’s a structural short related to hedging activity given the onslaught of new corporate issuance as well as increasing outright Treasury shorts based on global macroeconomic views,” said Russ Certo, managing director of rates trading at Brean Capital LLC in New York. “We also have a 10-year note auction, and often in the repo market as you approach new supply things heat up in repo, until the new supply eases the pressure.”

Fails Fee

Corporate-bond sales in the U.S. since the Memorial Day holiday are off to the fastest pace in five years as companies from Verizon Communications Inc. to Baytex Energy Corp. lead more than $48 billion of issuance.

Repo rates have traded below zero frequently since May 2009, when the 3 percentage point penalty for failing to meet security delivery obligations was put in place. The fee, instituted at the time to reduce failed trades, means that at a repo rate below negative 3 percent it is more economical for a counterparty to fail to deliver than to obtain the needed security in the repo market.

“The fails penalty of 3 percent kind of serves as the floor for repo specialness,” said Sun, who predicted rates would move higher again in repo after the 10-year note auction.

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