Traders are wary of being triumphant, but the slump of more than a year in listed fixed income derivatives definitely seems to be over.

In February, all three of the big exchanges – CME Group, Eurex and NYSE Liffe – enjoyed a strong recovery in trading of interest rate futures and options.

These products, like many financial instruments, were left stranded by the big retreat from risk of late 2008 and early 2009.

Hedge funds and other investing institutions slashed their positions and deleveraged their balance sheets, leading to sharp falls in trading volume and open interest.

Many dealers were able to capitalise by widening their bid/offer spreads, profiting from investors that had to put on trades. However, wider spreads could not make up for the fact that many of what were once big players in these highly liquid markets had seized up or died.

Nor could it hide the fact that interest rates themselves had lost their usual zing. Nearly every major central bank cut rates to rock bottom during the first quarter of 2009, and it was perfectly obvious that rates were only going to stay on that bottom for a long time.

Not surprisingly, much of the gusto was knocked out of the fixed income derivative markets.

Interest rate trading declined by 30% at CME Group in 2009, compared with 2008; by 29% at Eurex; and by a more moderate 7% at NYSE Liffe. The London exchange was buoyed somewhat by healthy trading of Euribor options, which swelled by 22% in 2009 as hedge funds and treasury desks sought to hedge bank risk.

Now, however, the news has a very different ring.

At the beginning of March, CME reported February’s interest rate volume up 37% compared to February 2009, and 26% above even December’s level. Among its biggest climbers were US Treasury futures, which were 55% more active than a year ago, while Eurodollar futures trading had quickened by 28%.

Options are recovering too, though not as fast, with US Treasury and Eurodollar options respectively traded 14% and 6% more often than a year ago.

Eurex and NYSE Liffe were partying too. The Frankfurt exchange’s rates volumes were 30% ahead of last year’s, while NYSE Liffe celebrated a 44% rise in the asset class.

Volume in the Short Sterling futures contract on sterling Libor is up 73% so far this year, while Euribor futures gained 50%. The two options markets are up 17% and 36%.

Liquidity is back

The resurgence is due to a variety of factors, according to Robin Ross, CME’s managing director of interest rate products in Chicago. “Liquidity is back to pre-Lehman levels in our order book in many cases, both for short term interest rate products, Eurodollar futures as well as our US Treasuries complex,” she says.

Research analysts agree. JP Morgan’s weekly Interest Rate Derivative Report for February 26 states that “market liquidity, measured using our concept of market depth as a proxy, appears to have stabilised around pre-crisis levels, levels considerably higher than the average seen over the last two years”.

Rates specialists say the most important trigger for recovery was the US Federal Reserve’s decision in mid-February to raise its discount rate, the rate charged to banks for direct loans, from 0.5% to 0.75%.

“The Fed increasing the discount rate really was a major driver of our volume increases in the early part of this year, particularly through our Fed Funds and Eurodollar futures,” says Ross.

In 2010, sensitivity has returned to rates markets. As before the crisis, the mood among debt traders is one of heightened alertness to releases of economic data, and of anxiety about how they are going to affect monetary policy.

Peter Best, head of product development for fixed income at NYSE Liffe in London, says: “This uncertainty as to whether rates will rise sooner rather than later is promoting speculation in the market and therefore much more activity.”

According to Basil Kaye, who trades interest rate futures at London-based prop firm Met Traders, the raising of the discount rate, simply put, indicates that central banks are going through a normalisation phase before raising official rates, perhaps later this year. “They are really setting the stage for a more normal trading environment, which in this case will mean increasing volumes in futures,” says Kaye.

Greek anxiety

Another major factor contributing to increased trading of interest rate derivatives in recent months has been Greece’s debt crisis, which has influenced currency markets and stimulated a desire for hedging.

A significant amount of the recent interest rate trading on Eurex can be attributed to Greece’s debt issues, according to Brendan Bradley, the exchange’s global head of product strategy. Speculation as to whether Greece will be able to refinance itself and the potential for spillover effects on Italian, Spanish and Portuguese debt have created a lot of activity, he says.

In September Eurex responded to the changed market for European government debt, in which the bonds of weaker countries have been trading at much wider than usual spreads over German Bunds.

Eurex launched a futures contract on the 10 year BTP, the Italian government bond. The idea was to give market participants a new benchmark, other than the German debt futures, that was more appropriate for hedging or taking exposure to the weaker euro zone states.

The turmoil around Greek debt this year suggests that Eurex may have been on to something. Trading in the BTP future has increased by more than 60% since December. “In uncertain times there is going to be a flight to liquidity and we are seeing people using our BTP future as a proxy to cover general fixed income risk exposure,” says Bradley.

Another important generator of trading volume, particularly in CME’s Eurodollar contract, which was particularly buffeted last year, has been the normalisation of Libor, according to Joseph Burke, a senior fixed income trader at Greenwich, Connecticut-based Interactive Brokers. “Because Libor levels have normalised,” he says, “hedge funds and commodity trading advisors are again starting to engage in the normal trades that they used to once do, such as butterflies.”

Hedge funds revive

Peter Rogers, head of the interest rate options desk at interbank broker BGC Partners in New York, noticed a stirring of activity from proprietary traders, hedge funds and institutions that started in November last year. This has now been translated into faster flows.

“Since the beginning of the year we have seen a pretty broad base of trading from gamma trades, collars, and a lot of the basic caps and floors, as well as swaptions straddles. Nevertheless, the exotics business, whose volumes plunged some 90% in some quarters during the crisis, has yet to see a real recovery,” says Rogers.

He estimates that BGC Partners’ interest rate options business is now running about 20% higher than the 2009 average.

Movement has also resulted from hedge funds engaging in large options trades, attracted by the fact that premiums are so cheap because interest rates are low.

As the year progresses, Rogers believes there will be orderly rises in official US rates, mostly at the short end of the curve, due to their having been held down by the Fed for such a long time, and to the flattening of what is currently a steep yield curve.

“Once that starts to happen we will probably see a pick-up in business,” he says. “It is just going to be a question of how orderly it occurs and whether anything comes along that will pose a shock to the system. But I do not expect a shock. The feeling in the market is very much of getting back to business as usual.”

Taking on the CME

This renewed sense of trading vigour, however, will not be the only story surrounding interest rate futures and options in 2010.

On the horizon, especially in the US, is the possibility of change in the structure of the market. New exchanges want to enter the fray, challenging the CME’s long-held dominance of listed rates trading.

In July 2009, the New York-based ELX Futures began its challenge by launching trading of US Treasury futures, a product set which had long been the sole property of CME Group. Other attempts to loosen the CME’s grip on that market have been made in the past, but none have really got off the ground, let alone taken flight.

So far, ELX’s flight status might still only be described as just getting off the ground, with the seatbelt signs still on. But the fact that it has managed to attract some 2.8% of US Treasury futures trading away from CME has set tongues wagging. The speculation is that perhaps this challenge may indeed alter the exchange landscape.

So far, ELX has had more success at the short end of the curve, managing to capture 6% of volume in two year Treasury futures and 5% in five years. It also offers 10 and 30 year bond contracts, and has plans to introduce Eurodollar futures, another CME crown jewel, and Federal Funds futures in the second half of 2010.

“Now that we are off the ground and have cleared the initial hurdles, we are getting more ambitious and we are expecting that something of a network effect will begin to take place soon,” says Neal Wolkoff, chief executive of ELX.

The seriousness of ELX Futures’ challenge to CME is clear not so much from its ambitious intentions as from the names of its founding partners. Many of the biggest Treasury futures trading houses have backed the venture, including Bank of America Merrill Lynch, Credit Suisse, Deutsche Bank, Getco, Goldman Sachs, JP Morgan and Morgan Stanley.

Not rolling over

However, CME is not going to give up its market share easily.

To create fungibility for those trading similar contracts, such as US Treasury futures, no matter where they trade, and presumably to attract greater trading volume from CME’s clients, ELX Futures has petitioned the Commodity Futures Trading Commission to allow contracts initiated at one exchange to be closed at another.

The ability to facilitate such an arrangement is known as exchange of futures for futures (EFF). It involves a transaction that is privately negotiated where one party must be the buyer/seller of a futures contract on one exchange, such as ELX Futures, while simultaneously being the seller/buyer of a related futures contract on a different exchange, such as CME. By taking opposing positions in similar products on different exchanges, the positions can then be migrated between the respective exchanges’ clearing houses.

The benefits of the arrangement for ELX Futures are clear: EFF gives investors who may want to try dipping their feet in ELX’s liquidity pool the safety of knowing that they can switch to CME if they determine that ELX’s waters are not as deep as they had hoped. That should make them more willing to try out a new market.

Proponents of CME’s view, on the other hand, see EFF as an unfair attempt by a new player to benefit from liquidity that CME has created (see Comment, page 16).

When the CFTC affirmed its acceptance of EFF rules in 2009, the game of regulatory ping pong was not over – though CME has refused to play ball.

Wash trade claim

In correspondence with the CFTC on the matter, the CME has said it does not consider EFF transactions legal under its own rules, considering them to fall into the category of “wash trades” – a form of illegal trade in which something appears to be sold but actually does not change hands.

In a January letter, the CFTC said the CME had “mischaracterised” the law by claiming EFF trades were illegal. Then in February, the CME replied that the trades would harm its liquidity and undermine price discovery.

The question now is whether the CFTC can and will enforce upon the CME its decision to allow ELX’s rule on EFF. When contacted for this article, a spokesperson for the CFTC said only that the policy was currently under internal review, with its results to be handed down at a time yet to be determined.

“We have only ever lived with one model in interest rate derivatives, but we think by having at least two competing exchanges it is good for investors and will result in a deeper overall market than one exchange could achieve on its own,” says Wolkoff.

He believes creating new trading venues and therefore new voices to promote investments in interest rate derivatives will help to draw customers’ attention. “A gas station located on an intersection with other gas stations is inevitably going to attract more business than a gas station located all on its own,” he says.

When asked to give CME’s position on ELX Futures and its rejection of the EFF rule under its own guidelines, Robin Ross did not comment directly. “Our main focus is on our clients and what products and services they need,” she said. “The CME Group continues to execute and reach out to clients.”

NYSE weighs in

Nevertheless, this is not a topic the CME can wish away. Another challenger, vastly more powerful than ELX Futures, is also gearing up to trade interest rate derivatives, in the form of NYSE Liffe US.

While the New York-based futures exchange has not announced any specific interest rate products yet, they are widely expected to include US Treasury futures.

The exchange declined to be interviewed regarding its plan. However, a spokesperson confirmed that the launch would occur “in the coming months”.

So far, NYSE Liffe US lists futures on gold, silver and equity indices. Unfortunately for CME, however, its new rival does not plan to stop there. It also covets one of the golden crowns of the CME’s model: its futures clearing business.

At present, the CME clears all futures contracts traded on its exchanges through its own clearing house, known as CME Clearing House.

New York Portfolio Clearing, a new clearing house for Treasury futures set up by NYSE Liffe in collaboration with the Depository Trust & Clearing Corporation, is set to be launched in July. DTCC is the main US securities settlement house.

Not surprisingly, in March, NYSE Liffe US came out in support of EFF, which would allow migration between not only futures trading markets, but also clearing venues.

With new venues emerging not only for trading of interest rate derivatives, but also for their clearing, both the front end and the back end of CME’s business are under attack.

And yet the CME’s enemies are divided. While Neal Wolkoff at ELX Futures is no doubt pleased with NYSE Liffe’s support on the issue of EFF, he is not happy about everything NYSE Liffe does. In particular, he does not relish the prospect of having to compete in the trading war for US interest rate futures with an exchange that has its own clearing mechanism aligned with the DTCC.

At the centre of Wolkoff’s issue is whether a ‘low cost’ utility clearing house such as the DTCC should be permitted to have an exclusive arrangement with a marketplace like the NYSE Liffe, and then lock out other exchanges for a period of two years, as they plan to do.

Joined-up margin

In addition, NYPC is planning to offer margin offset across fixed income, cash and derivatives markets – an industry first.

“A utility combining with one marketplace that is going to offer Treasury derivatives, and then locking us out from having a similar arrangement, is incompatible with securities laws and is incompatible with what the SEC has allowed in regard to other regulated clearing houses under its jurisdiction and it is inappropriately anti-competitive,” says Wolkoff.

To date, ELX Futures has not made a formal complaint. “We would expect anything that is going to be done will be filed in an open and public manner, that we will have the opportunity to study it carefully. To the extent we find there is an anti-competitive concern, we will address it then, formally,” says Wolkoff.

The challenges to the exchange status quo in the US will also come from across the Atlantic, with NYSE Liffe in the UK getting ready to implement more favourable tax treatment for US participants trading its contracts, rather than US domestic contracts. “After many years of lobbying,” says Best at NYSE Liffe, “all reports are telling us this will be happening in 2010.”

By this time next year, the landscape of interest rate derivatives is unlikely to have been transformed.

But this piece of real estate is attracting a lot of interest and development work has begun at several sites. By next year, the skyline is likely to show some new landmarks.