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Gilt fantasyland
Aug. 22nd, 2005 12:57 pmI don't normally focus on the gilts market. I leave it to the likes of the latter-day Lord Oakeses of Waterloo to spot that an issue should be priced at 97 and 5/8 rather than 97 and 9/16, before lumping in 200 million quid of an investment bank's money for a quick spin and a 200 grand profit overnight. (Incidentally, did I tell you the Oakes tale of when he went for an interview at an investment bank for the job of head of gilt trading. He was asked what the maximum position was that he would be willing to leave open overnight. He replied "About a hundred million", and the bank decided that they did not want someone willing to take such big risks. The name of the bank? Barings.)
But all of a sudden the gilts futures market has got a bit interesting. It revolved around the hitherto uncommented-upon fact that CBOT's 10-year bond futures are derivatives based, in the main, on a non-existent reality. Now, provided the contracts are rolled over, this doesn't cause a problem. But when some large holders demand delivery, well, Chicago, we have a problem.
In a sense we almost had a Nelson Bunker Hunt silver situation. People who had sold the contracts to Pimco (for it was they who were demanding delivery) were scrambling around everywhere to actually get hold of the bonds on which they had happily sold futures. One can imagine the panicked board meetings.
"What do you mean, they've demanded delivery? Are they allowed to do that?"
"Well, yes sir, that's what a futures option is -- a right to buy at a future date."
"So how many of these options have we sold?"
"About 2 million sir."
"And how many of the actual items exist?"
"About 1 million, sir".
"So, we've promised to deliver 2 million of something and the government has only issued 1 million of them?"
"Well, actually they haven't actually issued any of them, not for that precise date, but they have issued a million of somethiing that looks a bit like them, if you view them in the right lighting. But it's worse than that."
"How can it be worse than that? How can it possibly be worse than that?"
"Citadel has about 800,000 of those 1 million, and it isn't selling".
"Shit, you're right, it's worse than that."
CBOT's 10-year T-Bond futures contract is in a sense a laugh and a half, because the actual note doesn't exist at all. Or, if it does, that is purely fortuitous. CBOT has a formula that converts existing T-Bonds into theoretical ones. There are currently about eight times as many open contracts on 10-year T-bond futures as there are "real" futures (say, the September 2012 expiry issue) that could be used to cover them, if everyone suddenly decided to go physical.
This is representative of a big potential problem. Denis Mahoney at Aon asked in speeches for many years "where has all the risk gone?" Company after company will show you complex derivatives transactions which, in theory, magic away interest-rate risk, catastrophe risk, political risk, reputational risk, operational risk and, for all I know, Risk The Board Game. But risk is a constant. It's still there, somewhere. The use of the derivatives market (and collateralized debt obligations are my big worry here, rather than 10-year T-bond futures) makes it look as if the risk has disappeared. But all that is smoke and mirrors. As LTCM found to their cost, when liquidity vanishes, all that risk turns out not to have vanished at all.
But all of a sudden the gilts futures market has got a bit interesting. It revolved around the hitherto uncommented-upon fact that CBOT's 10-year bond futures are derivatives based, in the main, on a non-existent reality. Now, provided the contracts are rolled over, this doesn't cause a problem. But when some large holders demand delivery, well, Chicago, we have a problem.
In a sense we almost had a Nelson Bunker Hunt silver situation. People who had sold the contracts to Pimco (for it was they who were demanding delivery) were scrambling around everywhere to actually get hold of the bonds on which they had happily sold futures. One can imagine the panicked board meetings.
"What do you mean, they've demanded delivery? Are they allowed to do that?"
"Well, yes sir, that's what a futures option is -- a right to buy at a future date."
"So how many of these options have we sold?"
"About 2 million sir."
"And how many of the actual items exist?"
"About 1 million, sir".
"So, we've promised to deliver 2 million of something and the government has only issued 1 million of them?"
"Well, actually they haven't actually issued any of them, not for that precise date, but they have issued a million of somethiing that looks a bit like them, if you view them in the right lighting. But it's worse than that."
"How can it be worse than that? How can it possibly be worse than that?"
"Citadel has about 800,000 of those 1 million, and it isn't selling".
"Shit, you're right, it's worse than that."
CBOT's 10-year T-Bond futures contract is in a sense a laugh and a half, because the actual note doesn't exist at all. Or, if it does, that is purely fortuitous. CBOT has a formula that converts existing T-Bonds into theoretical ones. There are currently about eight times as many open contracts on 10-year T-bond futures as there are "real" futures (say, the September 2012 expiry issue) that could be used to cover them, if everyone suddenly decided to go physical.
This is representative of a big potential problem. Denis Mahoney at Aon asked in speeches for many years "where has all the risk gone?" Company after company will show you complex derivatives transactions which, in theory, magic away interest-rate risk, catastrophe risk, political risk, reputational risk, operational risk and, for all I know, Risk The Board Game. But risk is a constant. It's still there, somewhere. The use of the derivatives market (and collateralized debt obligations are my big worry here, rather than 10-year T-bond futures) makes it look as if the risk has disappeared. But all that is smoke and mirrors. As LTCM found to their cost, when liquidity vanishes, all that risk turns out not to have vanished at all.
