Investors rely on CME’s futures to manage bond risk, but “it’s not an optimal design.”
(Bloomberg Markets) — Chas Mancuso spent the first 20 years of his Wall Street career learning the head-spinning ins and outs of Treasury bond futures and teaching customers how to make money with them. He’s spent the past seven years on a crusade for a better way.
The 59-year-old former trader, who moved from New York to Myrtle Beach, South Carolina, in 2016, could devote all his time to golf, pickleball and flipping town homes if he chose to. Instead he spends hours on the phone and in meetings trying to convince Wall Street dealers—his former customers—as well as institutional investors and regulators that the gargantuan US government bond market should scrap the risk-hedging mechanism the Chicago Board of Trade created in 1977 in favor of the simpler one he devised. Mancuso and his partners at Next Level Derivatives LLC have secured patents and a list of prominent backers for what they call Treasury Risk Forwards, or TRFs (pronounced “turfs”) for short.
Investors have typically focused on the interest-rate risk of Treasuries, which TRFs are designed to manage, instead of the credit risk because they’ve viewed the odds of a US default as extremely low. Fraught negotiations in Washington this month over raising the debt ceiling have started to change that calculation, however.
To say that Mancuso’s effort is a heavy lift is an understatement. The current system is a golden goose for CME Group Inc., the Chicago-based exchange operator that swallowed the Board of Trade in 2007. But in the past decade, the Treasury market has been rocked several times by episodes of dysfunction, giving rise to regulatory scrutiny. The emerging consensus among regulators is that requiring central clearing of trades—a post-trade process in which gains and losses cancel each other out—can help avert future breakdowns.
Mancuso says he views the regulatory ground-shifting as a chance to pull off an historic upset. Treasury Risk Forwards—for which Next Level Derivatives is seeking approval from the US Securities and Exchange Commission—could be centrally cleared alongside Treasury securities in a way that CME futures are not, averting the need for a regulatory mandate.
“There are frailties that need to be addressed,” Mancuso says. The Treasury market “is not as bulletproof as we had hoped.”
Mancuso is widely known in the US interest-rate markets. He grew up in the New York City borough of the Bronx and Ridgewood, New Jersey, and studied business administration at Fordham University, aspiring to make a fortune as a Wall Street trader. Eventually he fell in with the legendary team of Stan Jonas and Pierre Wolf at Fimat USA Inc., a powerhouse in fixed-income derivatives. He worked there for almost a decade, until the financial crisis began to unfold in 2007.
Over the next several years, he took on a couple of special projects, including an unsuccessful one for the New York Stock Exchange that he says prematurely wrestled with the same problem Treasury Risk Forwards try to address. He traded for his own account and started making real estate investments around Myrtle Beach. But he came back to the question of how to reinvent Treasury futures.
Institutional investors use Treasury futures to change the amount of risk they’re taking without having to buy or sell bonds, which can be time-consuming and costly. For example, a fund manager seeking to protect her portfolio from rising interest rates can sell futures as a hedge. Futures have some key trading advantages over actual bonds—speed, anonymity and leverage, to name a few. As of May, CME’s six main Treasury futures contracts numbered more than 15 million, representing about $1.8 trillion of underlying bonds. “The success of Treasury futures speaks for itself,” says Agha Mirza, CME’s head of interest-rate and over-the-counter products.
Prior attempts to storm the castle have ended in failure. In 2004, Eurex AG introduced a competing product and gave up a year later. But the amount of Treasury debt has since grown fivefold, to more than $24 trillion, and the emergence of lightly regulated automated trading outfits that compete with the once-dominant Wall Street dealers has made interactions riskier. A principal hedging tool so complicated that pricing it is a rarefied skill, even within the sophisticated community of bond traders, has become a dangerous liability, Mancuso says.
The yields of the most recently issued Treasury notes and bonds are among the most widely recognized metrics in global finance, but they’re almost completely disconnected from the futures market. Treasury futures oblige a buyer (a “long” in futures parlance) to take delivery from a seller (a “short”) a specified quantity of notes or bonds. The contracts define the characteristics of deliverable securities, and several typically qualify. Traders identify the one that’s cheapest to deliver (CTD), and the futures contract tracks that one—in price, not yield, terms.
For esoteric reasons, the CTD Treasury securities for futures have for years been older notes and bonds that, except for their value as deliverable securities, would be of little interest to the market. For the June 2023 10-year note contract, the CTD security as of mid-May was a seven-year note issued in January.
“It’s not an optimal design,” says Darrell Duffie, a professor of finance at Stanford University who specializes in Treasury market structure. “If you were to start from scratch, you’d do something cleaner.” Still, he adds, “we’re nowhere near the end of the life of CME futures contracts, which are extremely heavily used by investors—which may be because there’s nothing better.”
Treasury Risk Forwards, which Mancuso formulated in 2014, aspire to be better.
TRFs are yield-denominated agreements to deliver (or take delivery of) the next Treasury security to be issued of a given maturity. For example, a 10-year note auction such as the one in May, which produced a yield of 3.448%, would have been profitable for those who set longs in the forward contract at a yield level higher than the auction’s, and vice versa.
Such a market already exists in a limited way. In the “when-issued” market, professionals buy or sell new Treasuries before the government auctions them. They keep track of their gains and losses by comparing the when-issued yield at which they bought or sold with the yield in the actual auction. But the when-issued trading window is short because a Treasury security’s main risk metric—its duration—is determined by its fixed interest rate, which is a function of the auction result.
The “risk” in Treasury Risk Forwards means market participants are agreeing to buy or sell a certain amount of duration, not a certain number of bonds. For example, the May 10-year note auction determined that the notes would pay a fixed rate of 3.375% and have a duration of 8.37 years, meaning that a basis-point change in yield on $1,000 of face value would move the price in the opposite direction by 83.7¢. TRFs are agreements to buy the face amount of bonds that supplies $100 per basis point of risk. At a duration of 8.37 years, it would take about 119.5 notes, a face amount of $119,500, to satisfy a single forward contract. At a lower duration, it would take more; at a higher one, fewer.
The risk-certainty afforded by the product’s design would allow auctions to begin trading months in advance, Mancuso says, improving their overall efficiency in a way that could lower the US government’s borrowing costs. At the same time, Treasury Risk Forwards would predict the yields of the new crop of notes and bonds that the financial world is most interested in. When, as now, political wrangling over the need to raise the US debt ceiling threatens the auction schedule, TRFs valuations would amount to a market-implied risk of a delay.
The other problem Treasury Risk Forwards could solve is the risk created by the separate clearing systems used by traders involved in both futures and cheapest-to-deliver securities. Daily changes in the value of futures positions are reconciled to margin accounts at CME. The corresponding position in a CTD security is cleared separately—some by a central clearinghouse, more in a hodgepodge of bespoke arrangements.
In volatile markets, that clearing process can lead to a situation in which intraday margin calls on losing futures positions can’t be met with profits on a corresponding position in CTD Treasury securities in a way that might stabilize the market. These circumstances deepened losses in the flight to cash that was unleashed by the declaration of a pandemic in March 2020.
A linchpin of Next Level Derivatives’ pitch to regulators is that Treasury Risk Forwards could be cleared by the Fixed Income Clearing Corp., which also clears trading in Treasuries. (The FICC is the unit of securities clearing giant Depository Trust & Clearing Corp. that handles government and mortgage-backed debt transactions.) The SEC has made central clearing a centerpiece of its plan to protect the Treasury market against future disruptions. In September it proposed requiring nondealers to participate in central clearing.
Dozens of stakeholders have responded with critical letters.
“A mandate is painful for the Street,” Mancuso says. “They’re expensive. This product could circumvent a full mandate and provide relief.”
Mancuso says he tried to propose his new product to the CME itself, even enlisting the help of a former regulator, but the CME passed. The CME declined to comment on that point. Subsequent licensing agreements with three other exchanges Mancuso won’t name eventually lapsed. These obstacles led to the strategic shift to design it as a forward contract, rather than a listed future, that the FICC could centrally clear.
Mancuso has been a tireless evangelist since hatching the idea, says Christopher Scaring, 57, who joined Next Level Derivatives as a founding partner in 2016 after a 26-year career trading and selling Treasuries. He says Mancuso has been particularly adept at bringing in new investors and board members. The company’s advisers include Brian Quintenz, a member of the Commodity Futures Trading Commission from 2017 to 2021, and Arthur Certosimo, a former head of global markets at Bank of New York Mellon Corp.
Still, this influx may not be enough to overcome CME’s massive first-mover advantage. “It’s hard to leave a big, liquid market for one which in principle might be better designed but which doesn’t have liquidity,” says Stanford’s Duffie.
Mirza says CME’s customers are satisfied with Treasury futures. “Simplicity may sound appealing, but it often doesn’t align with market reality,” he says. “Our customers are very open with us and would candidly let us know if they wanted alternative designs.”
Stanton is an editor on Bloomberg News’ FX/rates team in New York.
More stories like this are available on bloomberg.com
©2023 Bloomberg L.P.