P2T9 market and funding liquidity

[sebseb5557]

Hello,
On this new topic study note page 12 regarding negative spread between IRS and Ties, it is written :"... unattractive for dealers to arbitrage away this dislocation."
Could you explain or reformulate the idea expressed here ?
I'm french ans I don't get what this sentence mean?
Many thanks
Seb

 

[David Harper CFA FRM]

Hi @sebseb5557 That's a fascinating assertion in Dudley's speech (full R8 text at https://www.dropbox.com/s/zbqevk0l3slek2h/R83-Dudley-Market-Funding-Liquidity.pdf?dl=0). Here is the relevant section of his speech (emphasis mine):

"For example, we can see this in the difference between the fixed-rate paid on a 10-year interest rate swap and the secondary market yield on a 10-year Treasury note (Exhibit 13). Whereas historically this spread has been positive – reflecting the fact that an interest rate swap has more credit risk than a Treasury security – the spread has been negative since September 2015. Market participants suggest that this shift has occurred because the higher capital requirements have made it unattractive for dealers to arbitrage away this dislocation. Similarly, dealers apparently are unwilling to provide the funding and the balance sheet capacity necessary for their leveraged clients to arbitrage away this dislocation. The degree to which this shift in the yield spread between Treasury and interest rate swap yields is due to the differential capital requirements imposed on cash versus derivative instruments warrants more investigation."

He first observes the recent negative swap spread, which has been somewhat well covered over the last year+; e.g., https://www.treasury.gov/connect/bl...-Implications-for-Funding-the-Government.aspx

Because swaps have counterparty (credit) risk and Treasuries are safe, the historical norm is a positive spread such that you'd pay a higher fixed rate on the swap then you would pay to the (safer) US government. But this swap spread shifted to negative, which can have a mult-factor explanation. The spread has two quantities such that supply/demand can impact either quantity; e.g., less demand for Treasuries by itself puts downward pressure on the spread defined as [IRS swap rate - Treasury rate], more supply of US Treasuries also by itself puts upward pressure (issuance of more debt by government). With respect to the swap rate, more corporations entering the swap market as receivers (payers) of the fixed rate will put downward (upward) pressure on this spread. I always like to start with all four demand/supply forces that can act on a spread .... supply of Treasuries, demand for Treasuries, supply of swaps, demand for swaps.

But Dudley's point here is specific. If the swap rate (which has credit risk) is less than the safe rate, (hedge) funds should be stepping in to arbitrage this away. How would they? They would receive the higher fixed rate (i.e., buy Treasuries) and pay the lower fixed rate in the swap (which is not only lower, but riskier). But even a hedge fund has to fund this trade, and traditionally they'd borrow from a bank/dealer in a repo trade. But capital requirements have tightened this up; eg, the simple leverage ratio brings most of that off-balance-sheet into the exposure denominator. Dudley's saying that capital requirements have held back the lenders ability to (repo) fund the arbitragers ability to put upward pressure on the spread with a buy Treasuries/pay-fixed-swap trade. Or, even more generally, any bank that wanted to conduct this arbitrage directly would be adding the swap to their exposure denominator. I hope that clarifies!

 

[sebseb5557]

Hi David,

Thanks for the explanation and links, it's clear now.
Cheers

Seb