This article describes the complex nature of liquidity in the markets for US Treasury cash bonds and exchange-traded futures contracts. Using a risk-adjusted measure of trading volume, we find that, although overall volume is greater across all cash securities than across all futures contracts, certain futures contracts are more liquid than certain cash securities, and vice versa. Furthermore, futures contracts play a special role in liquidity-challenged environments. Finally, average trade size, in risk terms, is much higher for cash securities than for futures contracts. These findings can be useful to investment practitioners, who constantly weigh the relative values of various securities against their liquidity.
We measure market liquidity for large-sized orders in the ten-year treasury futures market by estimating mean-variance frontiers for their execution cost during the period 2012 to 2017. We identify large orders from regulatory transaction data and introduce a methodological innovation to infer the urgency of a large order from the pattern of its execution. We find that the mean-variance frontier becomes significantly worse as order size increases, but that the frontier has improved over the time period studied. We also find that the costs of executing large orders on behalf of customers are significantly greater than the costs of executing orders for house accounts.
This paper proposes Entity-Netted Notionals (ENNs) as a metric of interest rate risk transfer in the interest rate swap (IRS) market. Unlike the ubiquitous metric of notional amount, ENNs normalize for risk and account for the netting of longs and shorts within counterparty relationships. Using regulatory data for U.S.-reporting entities, the size of the market measured by notional amount is $231 trillion, but, measured by ENNs, is only $13.9 trillion 5-year swap equivalents, which is the same order of magnitude as other large U.S. fixed income markets. This paper also quantifies the size and direction of IRS positions across and within various business sectors. Among the empirical findings are that 92% of entities using IRS are exclusively long or exclusively short. Hence, the vast majority of market participants are prototypical end users, and the extensive amount of netting in the market is attributable to the activity of relatively few, larger entities. Finally, some sector-specific empirical findings are inconsistent with widespread, prior beliefs. For example, pension funds and insurance companies are typically thought to be long IRS to hedge their long-term liabilities, and these sectors are indeed net long, but approximately 50% of individual entities in these sectors are actually net short.
The vast majority of large businesses use derivatives to hedge their business risks. Anheuser-Busch, for example, uses exchange-traded wheat futures and over-the-counter aluminum swaps to hedge the risk of higher wheat aluminum prices eroding profitability.
Derivatives also provide implicit leverage. When Anheuser-Busch buys wheat futures, it gets the economic exposure of owning wheat without actually purchasing wheat—though it does have to post some collateral. But leverage magnifies both returns and losses and can be dangerous if misused. In 1995, Barrings Bank was bankrupted by Nick Leeson, whose leveraged bets with Japanese stock market futures lost $1.4 billion.
The losses and failures of the financial crisis of 2007-2009, however, were predominantly the result of excessive nonderivative leverage and investments in nonderivative mortgage products that fell dramatically in value. The only significant exception was AIG, whose failure and bailout were due to losses partly from credit default swaps and partly—and comparably—from nonderivative mortgage products.
AIG is sometimes invoked to claim that derivatives caused or triggered the financial crisis. By the time AIG failed, however, many large financial institutions had already experienced large losses and many others had already failed, including Bear Stearns, Countrywide Financial, Fannie Mae, Freddie Mac, and Lehman Brothers.
Derivatives appeared at other points in the crisis narrative, but were not systemically important. The liquidation of Lehman Brothers’ derivatives books and the settlement of credit default swaps triggered by Lehman’s default did not disrupt markets. Synthetic mortgage collateralized debt obligations did cause losses throughout the crisis, but those losses were small relative to nonderivative losses and, in some cases, large banks were able to reduce risk by using those derivatives as hedges.
Finally, there are two broad problems with the current approach to regulating derivatives. First, rules that treat derivatives in isolation are unlikely to reduce the overall risk of individual financial firms or the financial system. Second, rules that make derivatives harder to use will reduce derivatives risks, but the reduction will be at the expense of increasing business risks. Policies aimed at holistic risk management, reporting, and supervision would be more successful in reducing systemic risk.
Although the direct effect of lender-of-last-resort (LOLR) facilities is to forestall the default of financial firms that lose funding liquidity, an indirect effect is to allow these firms to minimize deleveraging sales of illiquid assets. This unintended consequence of LOLR facilities manifests itself as excess illiquid leverage in the financial sector, can make future liquidity shortfalls more likely, and can lead to an increase in default risks. Furthermore, this increase in default risk can occur despite the fact that the combination of LOLR facilities and reduced asset sales raises the prices of illiquid assets. The behavior of U.S. broker-dealers during the crisis of 2007-2009 is consistent with this unintended consequence. In particular, given the Federal Reserve’s LOLR facilities, broker-dealers could afford to try to wait out the crisis. Although they did reduce traditional measures of leverage to varying degrees, they failed to reduce sufficiently their illiquid leverage, which contributed to their failures or near failures. Several mechanisms to address this unintended consequence of LOLR facilities are proposed.
This article shows that a derivative contract essentially bundles i) a spot or cash position in an asset or set of cash flows, and ii) an agreement to finance that asset or set of cash flows throughout the life of the contract.
The embedded financing feature of derivative contracts is often underappreciated. First, with respect to pricing, the applicable interest rate is not some abstract “risk-free” rate but rather the financing rate of a particular security for a specific term. Second, since long-term cash financing arrangements are extremely illiquid, derivatives play a central role toward completing financing markets. Third, by virtue of embedded long-term financing, a derivative position has significantly less financing risk than an equivalent levered cash position using existing, i.e., short-term, financing arrangements. Fourth, from a public policy perspective, controlling for total leverage, derivatives pose less systemic financing risk than levered cash positions.