Term LIBOR Swaps: The Futures Fix-It Kit

March 2016

© 2016 The Fixed Income Group at R.J. O’Brien

Make Term-LIBOR SWAP Performance Behave Like Term Cost of Funds Again

Time to STOP Fighting Dodd/Frank & Use the Tools.

Treasury Changes, Swap Spread Inversions, Why LIBOR RATE SWAPS “Don’t Work Like They Used To” & The Futures Fix-It Kit MARCH 7, 2016

This write-up is intended SOLELY for INSTITUTIONAL CONSIDERATION. The topics within require advanced capital markets and considerable

derivatives expertise, coupled with substantial regulatory knowledge. If this description does not fit your institutional profile, please return,

delete or shred this document. Read our comprehensive disclaimer on page 14.

The Treasury Piece of the Puzzle- Cash Treasuries are NOT a Wise

Short. There are significant pressures, both issuance and regulatory,

that are changing this market for the long term.

There are so many factors influencing swap spreads currently, it’s hard to separate the transitory

irritants from the structural change risks. The fog is clearing on several long-term influences.

Historically, several of the catalysts for swap movement are:

1) Treasury Coupon Supply (long and short term)

2) Broad-based credit events/cycles (intermediate-term)

3) Volatility spikes (swap spreads have good correlation to large VIX moves; short-term)

4) Balance sheet availability for financing (“repo room”- short, intermediate & long-term)

5) Regulatory change (long-term)

From (1) above, the issue is not as simple as “how much debt?” It’s the disposition of the issuance.

Initially last year, the blasting cap in swap spread dynamite appeared to be the “taper” statement.

Because, if The G is done buying Treasuries and the word was “taper” not “twist”, the market reaction

was to look down and say, “Now, we have to look hard at the quantities and maturities of the Treasury

debt on the government’s balance sheet.” And the swap spread reaction anticipated a move toward

heavy supply—a need to re-issue the maturing Treasury securities.

Taking a look at the upcoming SOMA maturities with data from NY Fed (as of 1/13/16)

http://nyapps.newyorkfed.org/markets/soma/sysopen_accholdings.html:

http://nyapps.newyorkfed.org/markets/soma/sysopen_accholdings.html

The Right Hedge Tools to Do The Job Right March 2016 [email protected] 800-367-3349

© 2016 The Fixed Income Group at R.J. O’Brien pg. 2

Graph # 1: SOMA Treasury Asset Purchase—Maturity and Values

The average issuance maturity is 5 years (actually 5.1ish), consider expected issuance versus swap

spreads (basically, add 5 years to the above graph’s x-axis to find the average expected issuance):

Graph # 2: SOMA-based new issuance vs Swap Spread levels—Influence of Issuance Expectation?

In effect, expected issuance based on maturing SOMA T’s plus 4 to 5 years creates a virtual mirror image

in swap spreads—the curve location or, “where” issuance is expected to come, coincides with increasing

and decreasing levels of intermediate swap spreads (Graph 2 above).



The rule is: Treasury supply causes swap spreads to narrow (or “go more negative”). Not necessarily.

Treasury COUPON supply is the pressure source. And there is absolutely a foreseeable change coming

here. The change, though, is now going the other way- LESS COUPONS and more T-Bills. In fact, the

change is dramatic.

“There’s a big drop in US Treasury supply coming in 2016…Net issuance of U.S. notes and bonds will

tumble 27 percent next year, according to estimates by primary dealers that are obligated to bid at

Treasury debt auctions. The $418 billion of new supply would be the least since 2008.” Bloomberg,

11/30/2015.

The knee-jerk reaction seems to be, “Bogus- that’s the Treasury trying to talk down yields on the back

end of the curve.” I don’t think so. The reason is (5) above; Regulatory Change.

Don’t fret, there’s going to be plenty of Treasury debt coming. The fundamental shift is to vastly

increase the T-Bill issuance to satisfy global need for High Quality Liquid Assets (HQLA to the Basel

brigade). There simply aren’t enough T-Bills out there to fulfill the expected need required by HQLA and

exchange collateral (estimated by me to be around $1.75-2T by 1/1/2017). Currently:

Graph #3: Where are all the T-Bills? (Source Bloomberg™)

The smart/insider Primary dealer folks are saying:

“The government will boost bill supply by $173 billion in 2016, according to JPMorgan, another primary

dealer. That would be the biggest increase since 2008. The bank also sees net Treasury sales of coupon-

bearing securities falling to $313 billion next year, compared with their 2015 estimate for $627 billion.”

(Bloomberg, 11/30/15)

“Deutsche Bank AG says net sales could even fall as low as $293 billion, based on a scenario where the

Treasury reduces debt auctions by 8 percent across the board to make room for more bills. That would

represent a more than 50 percent drop from the bank’s 2015 projection of $629 billion.” (Bloomberg,

11/30/15)



Bottom line- Basel III and the “exchange-i-fication” of derivatives clearing are mandating an issuance

shift away from coupons and toward T-Bills. This fundamental shift will absolutely impact swap spreads

over the upcoming years—driving Treasury yields lower and swap spreads wider.

Graph #4: The last decade in swap spreads (2-, 5-, 7- and 10-year) Source: Bloomberg™

The point is—the “headline” swap spreads are at unprecedented negative levels. The talk about credit

and the junk market really surged in August 2015. Cages rattled with VW and BMW and the system was

feeling some real stress at quarter-end in Sep’15. Swap spreads started to widen out.

Then the Saudi Riyal unpinned. Rumors of China problems were everywhere and action on Yuan began.

Oil continues to puke and all of Emerging Markets joins Junk on the list of “Uh oh.” All anyone could see

(or, apparently still can see) is the likely unloading of Treasuries by America’s favorite investors. Being

the Fixed Income Group, this currency stuff isn’t our “power alley”. But facts are facts.

1) The Dollar Index is a negligible 2.5 handles below decade+ highs set back in November. That doesn’t

really look like dollar liquidation.



Graph #4.2—A Decade of the US Dollar Index—Not suggestive of liquidation. (Source: Bloomberg ™)

2) China may have around $1.2T in Treasuries. But—and this is no more than good guesswork from what

little published (and timely) info is out there—looks like less than a quarter of that is in Treasury

coupons between 5yr and 10yr maturities. Call it $300bb.

3) The Treasury separates data for Foreign selling of Notes and Bonds (ie COUPONS) from “any ole’

Treasury”. Countries liquidating T-Bills would potentially put pressure on the USDollar but have no

bearing on swap spreads. According to the Treasury’s TIC data

(http://ticdata.treasury.gov/Publish/tressect.txt), NET Foreign Buy/Sell from 1/15 to 10/15 (most

current info available) looks like this:

Data #1: Treasury TIC- Note & Bond Activity by Foreign Interests (NOT T-Bill)

http://ticdata.treasury.gov/Publish/tressect.txt



And what if China dumped all those $300bb-ish Treasury coupons they own in the intermediate (5-

10yr) swap sector? How huge is that in terms of Treasury market liquidity?

Graph #5: Trade Volume US Treasury Futures (Source- www.cmegroup.com)

Well- as scary as it sounds—that would be like one day’s worth of volume in the 5- through 10-year

sectors of Treasury futures trading. Huh?- One DAY’S volume? That’s all. Oh, it would be UGLY trading

and there would be market slippage (especially if “we” know it’s “them”, heh, heh). But let’s keep this in

perspective. 1 DAY’S VOLUME – just in Treasury Futures and just in the 5 through 10-year sectors.

So, all of this evidence provided above helps to prove what IS NOT causing Swap spreads to invert

beyond two years. And, going forward, issuance of intermediate Treasury notes will most likely be a

catalyst for swap spread widening in ensuing years. That’s the Treasury side of the swap spread.

Anecdotally, if short positions in the Cash Treasury market haven’t been enough of a problem yet. Stick

around. There are abundantly liquid Treasury futures available to use from the short side that help

eliminate the ongoing and increasing Repo squeeze issues pervasive in Cash Treasury on-the-run

trading. The bell tolls before the new year: If someone really wanted to scorch the waning liquidity in

Treasury Coupons going into year-end of 2016—right in front of the next Basel blow, they’d bid non-

comp for the entire 10-year auction in December. I’ve set up my delayed-send email to alert the super

powers already- so don’t actually contemplate it for more than a smirk’s-worth of time.

As a transition to the LIBOR-SWAP side of the equation, consider this: 10-year Swap Spreads show

Treasury Rates some 15+ basis points HIGHER in yield than 10-year LIBOR Swap Rates, right? So, buy a

Treasury, enter into a fixed-payer swap, and simply make 15+bps, right?

http://www.cmegroup.com/



To avoid trying to evaluate all of the perimeter costs that may explain the difference using cash T’s or

single-issue forward T’s vs forward starting swaps, try this dv’01-neutral futures-based exercise since

futures costs are constrained to instrument price (or ask our desk for the write-up).

Take the June Ultra 10-year Treasury Future and price it, rates unchanged out to the June’16 delivery

(account for full basis convergence). Then value a nearly-identical-maturity-dated Eris swap future (LIYZ5

closest to CTD maturity), to the same date. What do you see? You see that the change in the NPV of the

swap future (forward-dated) is greater than the change in the Treasury Future value. And, by jostling

rates around a bit (+/- 50bps, same forward date), the Swap Future gains more with rates declining and

loses less as rates rise. Huh? Right—the swap future is more convex. That option value should result in a

higher price/lower yield—given that both futures have the same counter party; clearing the CME.

Hmm… [email protected]

The LIBOR-SWAP Piece of the Puzzle- “Old” (pre-D/F)

Term Swaps had Credit Sensitivity. “New” exchange-

cleared and collateralized Swaps do not. Here’s the fix. The “LIBOR fixing scandal” was about some bad behavior that resulted in short-term (<=1yr) LIBOR being

marked artificially low, rate-wise. Why? So that entities that PAY LIBOR on floating-rate debt would pay

less than what was “fair”. But, today, the front end of the LIBOR curve (assuredly 6-months and in) is

functioning properly. If a LIBOR-based swap is a short-term funding hedge, it works; at least as a proxy

for, and accurately settling to, cost of funds. As an example, consider 1-month LIBOR vs 1-month repo vs

1-month commercial paper.

Graph #6: Compare 1-mo Funding Alternatives (Source: Bloomberg™):

What IS functioning is the front end of the LIBOR curve (Graphic #6 above). That said, TERM LIBOR (>2

years) IS NOT ANYTHING RESEMBLING A PROXY FOR EQUAL-TERM CORPORATE FUNDING COST—in

terms of rate NOR credit sensitivity. (Graphic #7 below)

1-mo Commercial Paper

1-mo LIBOR 1-mo Term Repo

mailto:[email protected]



Graph #7: The Functioning Part of the LIBOR Swap Curve, and

The NOT-Functioning Remainder (Source: Bloomberg™- my coloring added)

The 30-year Swap Rate is 2.35%. Nothing, including the full faith and taxing ability of the US

Government, allows anyone to borrow dollars at current 30-year LIBOR swap rates. But if looking at a

random “AA-Rated” company (no names), their ACTUAL 30-year debt (bonds trading YTM) is 4.90%.

What’s up with that-right? A “AA-rated” company has debt trading at SWAPs+255 bps? For ultra-high

quality debt, term LIBOR is supposed to approximate Cost of Funds. There’s kind of a “notable”

difference between LIBOR SWAP rate at 2.35% and AA-Corporate cost of funds at 4.90%.

Longer-Term Cost of Funds for the Non-Inter-Dealer Community used to be expressed as Swaps + X.

“Swaps” were the Term LIBOR Swap Rate and “+X” was the spread, or incremental cost (in yield) for

some unique institution to borrow—“+X” changed with supply/demand, perception of the institutions

credit, competitive yields from other institutions, etc. Fannie and Freddie typically borrowed at Swaps

–X, because—though potentially a credit risk—a better credit risk than the Inter-Dealer Swap

Network. That’s the way it was, before Dodd/Frank.

What’s the problem? High-Quality, Longer-Term Corporate debt USED TO trade at Swaps + X. 10yr @

Swaps + 50ish and 30yr @ Swaps + 100ish (with variation in the “+ X” due to idiosyncratic factors).



Graph #8: Treasury, SWAP & Corporate Yield Levels- March 2011 (Source: Bloomberg ™)

Graph #9: Treasury, SWAP & Corporate Yield Levels—MARCH 2016 (Source: Bloomberg™)

Again- What’s the problem now, in 2016? Term Corporate debt STILL trades at Swaps + X.

WHOA! 10yr AA @ Swaps + 125ish and 30yr AA @ Swaps + 200ish-- What happened? Swap + X, YES—

but the “+ X” more than DOUBLED.



Both in the context of LIBOR Swap rates relative to Treasury and to AA Corporate Debt, LIBOR Swaps

simply dove lower in rate, faster and further. While that’s obvious, WHAT CHANGED WITH LIBOR

SWAPS?

LIBOR is technically fine and doing what it always did (other than the little stretch of bad behavior)—

approximating short-term funding costs. SWAPS—term LIBOR greater than a year—IS what appears

broken. It is not broken. The CREDIT of SWAPS HAS CHANGED.

Swaps used to be off-balance-sheet, uncollateralized, credit obligations, credit-exposed to the dealer

that acted as counter party. Ask end-users who, a decade later, are still seeking to settle swaps that

were exposed to Lehman Brothers. AND, considering inter-dealer swap exposure (one dealer’s

exposure to another dealer due to holding each other’s swaps), the entire swap complex took on the

credit behavior of the weakest credit link in the dealer chain.

In the pre-Dodd/Frank days, SWAPS + X were an excellent proxy for term borrowing costs because the

SWAP RATE (then) was impacted by the credit risk of the inter-dealer network. By extension, the “+ X”,

was the incremental cost to borrowers (X varying and being dependent upon the perceived credit of the

individual borrower) relative to the credit of the dealer network.

Of course if this projection is accurate, even with massive variation in rates, curve shape and credit over

the last half decade, the general interest rate relationship between very high quality financial

institutions and general corporate credit—at all points on the maturity ladder—should remain largely

unchanged. Using AA financials as a surrogate for “inter-dealer network” and the Investment Grade

corporate index to represent IG cost of funds:

Graph #10—Inter-Dealer Risk (as AA Financials) VS Investment Grade Corporate Yields (2011 & 2016)

The point should be clear: The relationship between the Inter-Dealer Rates (highest quality financials)

and Investment Grade Corporate borrowing costs remain consistent. So, given:



TERM COST-OF-FUNDS = LIBOR SWAPS + X, The “+ X” has remained relatively constant relative to the

“old” inter-dealer credit benchmark—it’s TERM LIBOR SWAPS (not the “+X”) that have materially

changed. This change of intrinsic credit sensitivity manifests itself as increased “+X” volatility—i.e.

increased OAS volatility in securities vernacular.

Dodd/Frank set out to obliterate the “credit kiting” that posed geometric risk to the dealer network by

one dealer failing. Because these risks were off-balance-sheet AND these risks were functionally

uncollateralized, the solution was to eliminate the ability for inter-dealer credit contagion to exist.

Dodd/Frank solved this problem with one simple mandate: “If it can be cleared, it must be cleared.” And

“it” was and is a swap. And “cleared” meant all transactions would be audit-ably maintained, regulated,

collateralized and exposure-netted with a central counter party—an exchange.

And it is HERE: switching from an unsecured “Inter-Dealer counterparty credit” to a collateralized,

make-whole-every-business-day, “EXCHANGE-as-universal-counterparty credit”-- the “credit”

sensitivity of SWAPS has forever changed.

Graph #11: The Pyramid of Post-Dodd/Frank Credit: Hierarchy of SIFIs

Not shockingly, the US Basel III HQLA hierarchy lays out accordingly: Level 1) Treasury Securities,

Ginnies, Funds on deposit at the Fed (no haircut). Level 2) Fannie, Freddie (Agency-wrapped mortgage

pools and Agency corps), a few muni GO’s, a few short-maturity sovereigns, a few ultra-high-grade corps

(all getting a massive 15% haircut). After that, haircuts jump to 50% on a few other securities or the

securities are simply excluded (like CMBS and non-agency RMBs in the US).

So pre-Dodd/Frank and pre-Basel III, as understood here in the States, The US Government totally

guaranteed—“credit wrapped”—US Treasuries, The Fed’s balance sheet and Ginnie Mae issues. Fannie

and Freddie were in the soft spot of “maybe/maybe not” depending on the fancy of the then-current

administration. Everything else stood on its own credit merits—making “Swaps” trade at some slightly-

better-than-money-center-bank outright credit levels. Swaps, term-LIBOR, already HAD a substantial

credit component to their trading levels. In effect:

“OLD” LIBOR SWAP RATE ≈ (“NEW” LIBOR SWAP RATE) + (“OLD” HI-GRADE FINANCIAL CREDIT) and

“OLD” Inter-Dealer SWAPS ≈ “NEW” Exchange Cleared/Margined SWAPs + “NEW” Exchange IG Credit



So here’s the FIX If the goal is to make “new” exchange-cleared LIBOR swaps

behave more like “old” term LIBOR swaps—THE CREDIT COMPONENT THAT

EXISTED IN “OLD” TERM LIBOR SWAPS HAS TO BE ADDED TO “NEW” EXCHANGE-

CLEARED LIBOR—which will RETURN THE CREDIT SENSITIVITY AND INCREASE

THE EFFECTIVE INTEREST RATE—and return correlation to corporate cost-of-

funds.

Because of Dodd/Frank, this “synthetic old TERM LIBOR Swap” credit sensitivity

and rate can be easily constructed—by virtually any institution-- from existing,

currently trading FUTURES CONTRACTS.

NO ISDAs, NO FCM ADD-ON OTC-CLEARED FEES, NO INCREASED OTC-CLEARED

MARGINS, NO SEFs, NO SDRs, using naturally Dodd/Frank compliant and

naturally Dodd/Frank margin minimum FUTURES—the INTEREST RATE

COMPONENT can be executed in PLAIN VANILLA SWAP FUTURES and the

CREDIT COMPONENT EXECUTED IN INVESTMENT GRADE (IG) CDX FUTURES.

RIGHT NOW. TODAY. Well, if the market is open or via EFP.

Look back at Graphics (#8) and (#9). Then consider Graphic (#10). We, The Fixed Income Group, love

research—but we prefer not to eat it. Bring your futures business to us. We have a lot more to share on

this topic. [email protected]

There is a much larger issue of asset valuations tied to LIBOR SWAP rates. Many institutions deploy

“audit-blessed” models that discount off the SWAP curve that may or may not have a “+X” component.

So, on this topic, I’m going to do like I was taught to do if I ever catch myself on fire: stop-drop-and-roll.

I’m out on this but the critical nature and global overlap of a universal LIBOR-Euribor-CDOR-EuroYen-

etc—a currency-transcendent valuation metric-- is well presented by PIMCO’s Harley Bassman here:

https://www.pimco.com/insights/viewpoints/viewpoints/finding-sea-level-for-interest-rates.

For the “I need a hard mark” quants, modelers and valuation people out there, here’s the great part. In

USD interest rate swaps, there is an every-business-day, FUTURES-SETTLED, hard mark for every

quarterly (IMM) date from 3-months to ~10+ years—for swap futures; not just Eurodollar futures, as

well as on-the-run IMM settles at 12, 15, 20, and quarterly again from 27-30 years. These are the Eris

USD Interest Rate Swap Futures. Our clients have been using these contracts for over 3 years now. Eris

swap futures clear at the Chicago Mercantile Exchange (CME) and cross-margin against other cleared

interest rate futures and options. Our valuation models are tied to strict ERIS SWAP FUTURES settlement

levels so hedges ACTUALLY tie to valuations AND asset pricing is derived from trade-able hedge levels.

One snippet here with a very insightful quote:

http://www.erisfutures.com/EE/Eris_Launches_Major_Expansion_of_Standard_Swap_Futures.pdf

For over a quarter-century of my career, what we’ve lacked on the fixed income futures hedge side has

been an isolated CREDIT future—CDX. Like rate swap futures, the first iteration of CDX Futures was a

flawed contract. That’s over. The new ICE-Eris construct settles to the same valuation as the billions of


https://www.pimco.com/insights/viewpoints/viewpoints/finding-sea-level-for-interest-rates

http://www.erisfutures.com/EE/Eris_Launches_Major_Expansion_of_Standard_Swap_Futures.pdf



dollars of OTC-Cleared swaps at The Intercontinental Exchange—the ICE: Same settlement as OTC-

Cleared, less than half of the margin requirement (again, a Dodd/Frank thing that makes futures the

much more economic choice). https://www.theice.com/products/Futures-Options/Credit

The Fixed Income Group at R.J. O’Brien clears and executes IG Credit Futures contracts on a near-daily

basis. We’ve traded both IG and HY Credit Futures by voice on the CLOB (central limit order book—the

visible, streaming, actionable bid/ask) via the WebICE platform. We’ve traded the IG future in block-

trade format. We have executed IG contracts through Bloomberg ™ EMSX and have had client execution

and straight-through processing to RJO clearing through EMSX.

What “people” may tell you about the CDX Futures is, “Look, there’s little open-interest! Look, there’s

limited frequency of trading!” Well, the futures just started trading a few months ago BUT that isn’t the

answer either. “They” are right about what can be seen—but “they” are not telling you what isn’t seen.

Because a market maker can take an opposite position in OTC-Cleared (if they choose to), the market

depth of the OTC-cleared market is largely transferrable. And, if you were a market maker, would you

rather have to post more than $2X for margin (for OTC-Cleared) OR would $1X (for FUTURES) seem

like a better use of capital? “They” also are not likely to mention that once the ball drops on 1/1/2017

and the full hit of Basel III lands, the incremental capital cost and leverage effect will likely drive

everything that can be traded as a future TO BE TRADED AS A FUTURE. But, this year’s bonus is based on

this year’s production. I also have a lot to say on this topic—but like the “what to do when I catch myself

on fire” thing above, I will again simply leave this explanation to—well, this one I’ll offer on the phone

maybe. Our desk has had no problem getting a $100 million up IG market, on top of the streaming

bid/ask level, when block execution is sourced. We haven’t traded on those levels, but they’ve existed

on demand.

Our expectation, in the post-Dodd/Frank era, is an a la carte derivatives market. Dodd/Frank really seeks

to:

1) Separate and isolate interest rate risks and credit risks (regulate small identifiable isolated

derivative risks; not small variants in multi-risk derivative structures)

2) Commoditize those risks into generic, highly-liquid, trade-able pieces (create universal market

access to risk transfer vehicles and liquidity through generics)

3) Have the specific risks cleared through a central clearing entity (create cancellable/offsetting

risks based upon a shared credit counter party)

Sure, there’s more to Dodd/Frank than those three points. The theme of liquid, generic, a la carte risks—

easy to regulate, easy to trade, easy to offset—is the essence. Then all of us, the traders, structurers,

end-users in total, are supposed to take these exchange-cleared financial lego-blocks, take the risk

pieces we want, and stack ‘em up/structure ‘em/press together all of the generics it takes to best offset

our specific risks as closely as possible. If the risk management community can hedge 95% of their risks

this way, with 100% liquid generics, Dodd/Frank is successful. When we tried offsetting 100% of the

risk with highly-customized derivatives that were 5% liquid… Well, that didn’t work out.

Swap Future + IG Future—If we want term LIBOR Swaps to act like they used to, we have to put the

rate and credit pieces together, on our own, because we live in an “a la carte” derivatives world now.

JC—for the Fixed Income Group at R.J. O’Brien 800-367-3349 [email protected]

https://www.theice.com/products/Futures-Options/Credit




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Term LIBOR Swaps: The Futures Fix-It Kit

Economy & Finance