NYSE Liffe’s Futures Based On the DTCC GCF Repo Index

by Bari Trontz

DTCC began publishing the first index to track the daily $400 billion market in general collateral finance repurchase agreements (GCF Repos®) in 2010. The DTCC GCF Repo Index®, which has gained significant traction as a reference rate by which certain derivatives, such as U.S. Treasury futures and credit default swaps (CDS) are traded, provides traders with an effective tool to hedge their short-term interest rate exposure.

@DTCC sat down with Thomas Callahan, CEO of NYSE Liffe U.S., the U.S. futures exchange of NYSE Euronext, to talk about the successful July 16, 2012, launch of its innovative futures contracts based on the DTCC GCF Repo Index.

Why did NYSE Liffe create a futures contract linked to the DTCC GCF Repo Index?

Thomas Callahan, CEO of NYSE Liffe U.S.

In the wake of the U.S. financial crisis, we made the observation that there had been a fundamental shift in the way that money markets were operating. Pre-crisis, there was a high correlation between secured funding rates, like GCF Repo, and other traditional floating rate benchmarks like Fed Funds. In the post-crisis environment, those correlations broke down as Fed Funds ceased to function as an effective short-rate benchmark and the market started to see secured rates and Fed Fund rates diverge in a way that was difficult for clients to hedge. If you think about most banks, their primary source of funding is the secured market. So, to have a futures contract that tracked and matched their primary funding source was only logical. Given our close partnership with DTCC in New York Portfolio Clearing [NYPC], and the tremendous success of the DTCC GCF Repo Index since its launch in 2010, it was an easy decision to list futures based on this new benchmark.

How do market participants use the futures contracts?

We intentionally made the design of the contract traditional and familiar, so most market participants could quickly get comfortable trading GCF Repo Futures once they gain familiarity with the underlying index. The innovation is in the underlying reference benchmark, which is the DTCC GCF Repo Index.

We have a large number of global banks active in these contracts every day that use the product as a risk management tool for their Repo portfolios. We have a large number of large hedge funds active in the contracts, many of them who use the product to hedge funding risks in their relative value fixed income portfolios. We also have a large number of tier-one asset managers active in the product, who use it to manage their term funding risk as well as to manage interest rate exposure. One of the most encouraging things about this new product is that we really have client diversity and a tier-one list of players in each of those segments I described.

How do the contracts help traders manage interest rate risk exposure?

Secured funding rates are highly correlated to the level of short-term interest rates. If the Fed raises rates or lowers rates, general collateral rates will track that movement closely. So, as an interest rate hedging tool, it is very effective, but we are living in a zero interest rate environment for at least the next couple of years. One of the reasons this product has been so successful is that even with the Fed holding short rates at zero, the market has experienced reasonable volatility in secured rates as the daily supply/demand balance between cash and collateral shifts. This is due to dynamics such as U.S. Treasury auctions and Fed intervention via Operation Twist. This makes GCF Repo futures a valuable hedging tool even in a zero rate environment.

Why is a benchmark tied to actual, collateralized repo transactions more reliable than one based on estimates?

There are many qualities about the DTCC GCF Repo Index that give it credibility. First, an index that is based on real transactions, rather than theoretical or estimated transactions, is always going to have the highest level of accuracy. The fact that it is collateralized, versus most other reference benchmarks like Fed Funds or Libor that are based on unsecured rates, makes it highly credible because the primary source of funding for most banks is in the secured markets. The index is also centrally cleared – both the underlying cash repo transactions that are cleared by DTCC, and then our futures contracts that are cleared by NYPC – which gives it another level of credibility.

Do these futures contracts help improve overall liquidity across the funding market?

DTCC created the GCF Repo Index in 2010 at the request of the Treasury Markets Practice Group as an effective method to improve transparency and liquidity in the U.S. funding markets, and it has been a very effective tool in accomplishing that objective. Now, for market participants to have a liquid, transparent and centrally cleared futures contract on that index only serves to further advance liquidity and transparency, particularly in the term markets where balance sheet constraints have diminished volumes in the cash secured funding markets.

What part of the overall marketplace do you think may benefit most from this product?

Initially, as you would expect, the bank funding desks have been the main beneficiaries to hedge their large repo books. We have also seen initial activity from relative value hedge funds that never before had a futures contract that allowed them to hedge the implied funding risk in their books. But, as I mentioned before, we are also seeing asset managers and securities lenders and other types of participants using these contracts. It’s been diversity that makes us so optimistic that these contracts are going to emerge as the new short-rate benchmark.

How successful has the product been since its launch on July 16, 2012?

It’s been extremely successful. New futures contracts, as most people know, are notoriously difficult to launch and they tend to have a high failure rate. The fact that we have been able to launch this contract, develop the volume, generate a high level of open interest and attract a diverse client base has been very rewarding. I was recently in London and we received an award from Futures & Options World Magazine for DTCC GCF Repo Index futures as the most innovative product of 2012. It was a nice independent validation that people are looking at this as a successful and innovative product.

What have been some of the drivers of the overall demand for the product?

I think it is the innovative nature of the product. If you look at the global futures market, there has never been a futures contract tied to secured funding rates. It simply did not exist. This is the first time that any exchange or clearing house has brought a product of this nature to market and the timing is just right as the market is looking for products that are based on real transactions, products that are centrally cleared and, most importantly, they are looking for products that allow them to manage risk associated with secured funding rates. It’s the right product at the exact right time.

Where are the futures cleared?

GCF Repo Futures are cleared at New York Portfolio Clearing, the 50/50 joint venture between DTCC and NYSE Euronext.

How do the futures benefit from the “one-pot” margin efficiencies of New York Portfolio Clearing [NYPC]?

GCF Repo futures are highly correlated with the underlying cash repo activity that clears each day at DTCC’s Fixed Income Clearing Corporation, so there will be meaningful capital efficiencies delivered by bringing those two products together in a single margin calculation.

Additionally, NYSE Liffe U.S. Eurodollar futures are cleared by NYPC in the single pot, which will allow market participants to receive margin offsets between GCF Repo futures and our Eurodollars. This will be extremely beneficial due to the high correlation between those products, particularly for customers wishing to express views on asset swap spreads by trading GCF against Eurodollars.

In addition to NYSE Liffe’s futures contracts, what other products would be needed to help the DTCC GCF Repo Index migrate to a significantly used short-term benchmark?

Simultaneous with the launch of GCF Repo futures on NYSE Liffe U.S. in July, the market began trading a GCF-linked over-the-counter product called “GCIS Swap.” GCIS is a traditional overnight index swap [OIS], where the Fed Funds floating rate leg is replaced by the DTCC GCF Repo Index. As liquidity develops around GCF in the OTC market, it can only benefit GCF futures.

Importantly, the U.S. Treasury is planning to launch floating rate notes for the first time in 2013. One of the benchmarks currently under consideration as the reference benchmark for this program is the DTCC GCF Repo Index. If the index is selected by Treasury as the reference benchmark for this program, it will create demand for both listed and OTC GCF-linked derivatives as market participants swap floating rates for fixed. @