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I am building analytics for futures and have a theoretical understanding. If implied repo > actual repo then I can short futures and go long the security and finance it in repo.

ON my Bloomberg screens for the 2-yr contract (March 2020), I see the implied repo is about 25 basis point above the actual repo. Isn't this a no brainer then? I am guaranteed to earn 25 basis points if I hold the position to expiry.

Wouldn't market participants jump on this such that this opportunity goes away? The other way to look at it is that the net basis is also negative (-2 to -3 ticks). Assuming the CTD doesnt switch, it should converge to zero so easy money?

I must be missing something.

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  • $\begingroup$ Do you mean the implied repo to maturity is 25bps above the short term repo ? If so then it’s only a no brainer as long as you can roll the short term repo at the right price. $\endgroup$ – Ivan Nov 9 '19 at 13:47
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    $\begingroup$ If the CTD were to switch the net basis (on this current bond) would increase above zero making the trade potentially more valuable. $\endgroup$ – Attack68 Nov 9 '19 at 22:15
  • $\begingroup$ You're right, if the CTD switches it will be above zero so it's more profitable. I guess the risk would be if the net basis goes even more negative for some reason and you're long the basis. $\endgroup$ – decaybeta Nov 10 '19 at 23:50
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By coincidence I was looking at this yesterday. The implied repo on the TUH0 contract is about Fed funds + 38, which indeed is around 25bp higher than the term repo to March. Why does this apparent arbitrage exist ? The answer is that consumes financial resources- in particular it will be an on-balance sheet transaction. There is a risk that these resources will be taken away from you at some point during the trade. In particular, the trade goes over year end, when banks try to reduce their balance sheet. The effect of this is to reduce the number of banks able to participate in the trade, and it also reduces the number of non banks because these need financing from the banks. Why do banks reduce balance sheet over year end? Basically to make the bank look smaller for a number of regulatory and accounting reasons.

Bottom line : go ahead with the trade, but ask your boss whether she can guarantee the balance sheet will not be taken away for year end.

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  • $\begingroup$ I agree that balance sheet constraints limit the economics of the trade so why not just lock in term repo that I see on the screens. If you can earn 25bp above term repo and you've already locked in term repo, then what else is there since you know you're return on an ex-ante basis. $\endgroup$ – decaybeta Nov 10 '19 at 23:49
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Capital Requirements

In addition to @dm63 answer, I recall the primary concern in the repo space was the impact to the 'exposure measure' in the regulatory Leverage Ratio (LR). Globally Systemic banks (in different jurisdictions) have historically had relatively tough minimum requirements for the LR (6% in the US), which leaves a 2 or 3 tick profit (or 200k per 1bn notional), regardless of the maturity of the bond, particularly unappealing, especially compared to other potential allocations of the capital.

If you consider the return on capital employed, since 6% of capital is required per exposure (in the worst case) this trade (if the exposure is increased by 1bn) requires 60mm capital. The return of 200k is 0.33%.

Even if you take the best case where only 3% of capital is required and the return is 0.66%. This is still pretty useless: I have seen an investment bank turn down trades which yield 5% return on capital regularly.

Technical Requirements

From what I remember about net basis trading (going back 10 years) it was also something that many people struggled to fully appreciate the nuances of managing the risk. If I remember correctly you had to calculate the specific amount of futures that were needed on an ongoing basis (i.e. to hedge MTM) and then going into settlement (EDSP) you needed to trade additional futures lots to ensure your notionals for delivery matched.

If you get that wrong those 2 or 3 ticks disappear away fairly easily.

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  • $\begingroup$ different banks have different constraints- for US banks the Supplementary Leverage Ratio has been a big factor but they are now mostly in the 6.5% area, so a bit unclear if that constraint is currently binding. What seems to be important also is the GSIB bucketing which is based on a year end snapshot only, hence the cheapness of the March basis. And you're right about the technical requirements of futures delivery. $\endgroup$ – dm63 Nov 10 '19 at 13:36
  • $\begingroup$ If you're trading the basis on the CTD, then using the conversion factor means you should also be duration hedged so why would you need to worry about MTM exposure. Can you explain the point about trading additional futures to ensure notionals for delivery are matched? In a world where conversion factors are less than 1, you would generally hold more of the underlying bond than the futures contract. So you would just sell the tail risk to ensure you're delivering 1 for 1 $\endgroup$ – decaybeta Nov 11 '19 at 0:07
  • $\begingroup$ The CTD basis trade = long the CTD (spot) versus short the futures (like a forward on the CTD). Hence, you are exposed to the repo rate between now and futures delivery. $\endgroup$ – dm63 Nov 11 '19 at 4:20
  • $\begingroup$ Correct, what if you lock in term repo to the term delivery? That's the issue I'm struggling with. If I see 2.00% implied repo and I see 1.75% term repo to the delivery date, the 25bp is a no brainer. $\endgroup$ – decaybeta Nov 11 '19 at 13:23
  • $\begingroup$ If you trade everything correctly and don't incur large execution fees then you will accrue the profit, yes. The capital usage to term (from a regulated banks perspective) on the trade is so inefficient, though. As I explained a US bank needs to hold 60mm in regulatory capital to execute this trade. If this capital can be allocated anywhere else it certainly would be and a bank trader would be prohibited from doing this. I know many that have, and in the worst case you might have to unwind the trade at year end for a MTM loss. $\endgroup$ – Attack68 Nov 11 '19 at 15:09

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