Brighter futures

On 19 March, RBA governor Philip Lowe noted that “the functioning of major government bond markets has been impaired” – to an extent that necessitated the introduction of extraordinary support measures.

The impairment was clearly acute. Speaking at a KangaNews-Westpac Institutional Bank roundtable in late June, Rob Nicholl, chief executive at the Australian Office of Financial Management (AOFM) in Canberra, revealed that at the height of the crisis even the sovereign borrower only had access to short-term liquidity while its Australian Commonwealth government bond (ACGB) tender outcomes “did not reflect any meaningful access to the market”.

He added: “I think it was the first time the AOFM had ever faced anything like this – it was totally unprecedented.”

Users restricted to participation in physical markets would have experienced similar conditions. By contrast, the ASX futures platform continued to offer liquidity and tight bid-offer spreads throughout this most tumultuous period.

The three-year government bond futures contract recorded average daily volume of 236,474 in the period 16-20 March, compared with 213,157 for full-year 2019. Average trading volume during the same period of maximum stress was 189,655 in the 10-year bond contract, compared with 174,053 last year.

Futures also provided a highly tradeable option. According to ASX data, bond futures contracts consistently offered half-tick bid-offer spreads even in a period when cash bond spreads were observed to be at 15 basis points and even wider at times.

“It was really noticeable during the March period of turbulence that the futures market continued to perform even as some OTC markets struggled,” says Helen Lofthouse, executive general manager, derivatives and OTC markets at ASX in Sydney. “It was clear that the futures market was the primary point of price discovery for multiple reference markets.”

The futures complex provided an avenue for market participants to hedge risk and manage positions at a time when many were undertaking an urgent hunt for liquidity. When even the most liquid physical asset was struggling to find a competitive bid, users could come to ASX and find a deep and liquid market even beyond the on-screen trading of the benchmark three and 10-year ACGB futures.

For instance, Lofthouse says ASX also observed the importance of exchange for physicals (EFPs) during the March-April period. These transactions price a bond or swap trade as a spread to futures. Executing an EFP enables both parties to get better pricing in a risk-neutral trade.

“In a market where a lot of investors were selling bonds to realise cash, this was a crucial way to get tight pricing on their asset sales and subsequently access futures-market liquidity to reduce positions in a flexible and cost-effective way,” Lofthouse explains.

Average daily EFP volume was approximately 114,000 lots in March this year, compared with 78,000 in March 2019. Lofthouse says the EFP market demonstrates the value of the futures complex to physical traders and asset managers.

The March period saw some cash-market transactions move to the futures environment, though in many cases the cash transaction still had to be completed – selling physical bonds, for instance. In this case, futures provided a better price by allowing holders to sell bonds in EFP format and buy futures. The futures market also allowed bond price-makers to transact with much less risk by allowing them to hedge simultaneously with cash execution.

Lofthouse tells KangaNews: “In a really difficult set of circumstances, market makers were able to be much more confident about making prices by using EFPs. On the other side, asset sellers were able to get EFP prices that were much tighter than outright sales. They were left with futures positions to unwind but those in turn were much easier to exit because of the liquidity of the futures market.”

The reason liquidity is able to hold up in the futures complex even when it falls away in the OTC market is the scale of participation in the exchange-traded product. This does not just mean the number of users but their varying reasons for being involved.

“The fact that all these global users, with different types of businesses, come together in the same place is what makes futures such a critical source of liquidity and is what allows futures to provide this liquidity even in the most challenging times. Not everyone is doing the same thing at the same time,” Lofthouse explains.

The breadth of users also applies geographically. The ASX bond futures suite is a liquid market throughout the day including active trading throughout London and US trading hours as well as in the Asia-Pacific time zone. In fact, the exchange sees nearly a third of its volume through the night session.

Increased issuance from the AOFM, targeting 3-5 and 10-12 year maturities, along with the RBA’s intervention in the Treasury bond market, has accelerated ASX thinking about a new contract in the bond suite. On 26 June, the exchange disclosed plans to introduce a new five-year Treasury bond futures contract to complement the existing three-, 10- and 20-year futures.

The RBA has committed to anchoring Australia’s three-year sovereign-bond yield at 0.25 per cent for the foreseeable future, which has had the effect of greatly suppressing volatility at this point on the curve.

With around A$175 billion (US$121.6 billion) of ACGBs already on issue between the three- and 10-year futures buckets and the expectation of plenty more to come, hedging in the mid-curve was already an important requirement for many market participants. This has become harder to do using the existing futures contracts alone.

Lofthouse explains: “In the past, users might have hedged ‘in-between’ exposures using a mixture of three- and 10-year bond futures contracts. But there is a question about whether this approach will create the right hedge when the three-year is stable while the 10-year is still moving.”

The substantial pickup in AOFM issuance in conjunction with RBA intervention has brought consideration of a new contract to the top of the agenda for ASX. “We think it makes sense to have a five-year point on the curve anyway and it is something our customers were asking for even before yield-curve control,” Lofthouse comments. “What’s different now is that we believe market conditions will help generate early liquidity at the five-year point.”

ASX says the contract listing is expected to come late this calendar year, subject to regulatory approval and market readiness. The first expiry month is likely to be March 2021. The exchange also plans to complement the five-year contract with new spread products, including a 3-5 year and a 5-10 year, to add to the existing 3-10 year and 10-20 year spreads.

ASX is currently engaging with users – including trading and clearing participants and their vendors – as well as regulators and other stakeholders in preparation for the launch.

Market participants seem to support the rationale behind the new listing. Anthony Morriss, Sydney-based head of Australian and New Zealand economics at BofA Securities, says the RBA’s success in controlling three-year ACGB yield has made the five-year part of the curve more attractive for investors. He expects the forthcoming ASX five-year futures contract further to increase demand in this part of the curve and says it should also facilitate issuance.

Once introduced, the new five-year contract will remain part of the ASX suite on an ongoing basis – regardless of whether or when the RBA lets the three-year bond yield float freely again at some future point.

Lofthouse tells KangaNews: “Our expectation is that there will be enough issuance in the physical market to support liquidity between the three- and 10-year points on an ongoing basis. In fact such liquidity already exists, even without the AOFM’s issuance profile changing very much.”

An expanded physical Treasury bond market should also give a boost to activity in the 20-year futures contract. This has been less actively traded than the three- and 10-year futures. Lofthouse says this is not a surprise given the lower level of issuance at the long end, the inherent risk profile of the contract and the focus of a greater proportion of market participants on the shorter-dated part of the curve.

She continues: “We don’t expect the 20-year futures to have the sort of volume we see in the 10-year – it’s a riskier contract. But it is an important point on the curve that we remain committed to, and in the current environment more significant interest in the long end is also bringing opportunity back to 20-year activity. Breadth of access and liquidity both have a chance to step up.”