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A Harry Koza rant


Cut the hysterics over 'shady' bond trading


Monday's Report on Business featured the main headline, "Shady bond trading prompts scolding from Bank of Canada." The story described how the Bank of Canada was going to "read the riot act" to Canada's 19 largest bond dealers and warn them not to take advantage of illiquidity by "manipulating" the market. The article went on to mention that there was no evidence of any actual wrong-doing or manipulation, and no rules broken -- so why the need to read the riot act to the domestic dealers?

The "shady" bond trading allegations stem from a collateral squeeze in 10-year Canada bonds last May. When a bond dealer makes a market on, say, 10-year Canada bonds, and a customer lifts his offering for, say, $100-million, the trader is usually short -- he didn't necessarily own the bonds he sold, but thinks he can buy them back at a lower price. If he can't do that over the few days, he has to borrow the bonds in the repo (repurchase) market (for a fee) to make delivery. (A repo is a kind of short-term borrowing for government securities dealers.) If bonds for borrowing are scarce, repo costs more. This is where the old dealer adage comes from: "He who sells what isn't his'n, must buy it back or go to pris'n."

In the late eighties, I was working the bond desk at -- let's call it The Desk With No Name -- that was on the receiving end of a similar Bank of Canada reprimand, and Monday's "shady" trading story reminded me of it.

At the time, the Bank of Canada was auctioning Treasury bills twice a month, and had just announced it was cutting the size of the one-year tranche in the next auction from $1-billion to only $500-million (auctions are much bigger nowadays).

Immediately before an auction, the new bills trade on a when-issued or "WI" basis. Dealers often set up for a new government bond or bill auction by getting short the WIs, as it gives them a natural bid for the new issue, and dealers always strive to demonstrate to the Bank of Canada what big shooters they are by participating aggressively in auctions. Our bill traders were thus happy to catch a few good sales. Fifty million dollars in bills to a Middle Eastern petrodollar investment fund here, 75 million to an Asian central bank there, another 75 million to a European central bank or two over there, and in minutes, we're short over half the new issue heading into the auction. Even worse, the day before the auction, the U.S. Federal Reserve Board cuts interest rates by half a percentage point (this was before fixed announcement dates) and bond and bill prices spike up. Yikes!

Our T-bill desk gamely tried to trade their way out of the hole, but had to cover most of their short by bidding high in the auction, ending up buying over half of the one-year tranche, and taking a $25,000 loss. Had they not scooped so much of the auction, their loss could have been 10 or 20 times larger.

The next week, the Bank of Canada chastised them for "grandstanding" at the auction and, shortly thereafter, announced a new guideline, stating that henceforth, no single participant would be allowed to buy more than 25 per cent of any given tranche at an auction. That's right, dudes, no more grandstanding -- just eat your losses.

Anyway, this time out, it was bonds, not bills, but with a similar cast of players -- offshore central banks (here's a thought: perhaps the Bank of Canada should be reading the riot act to some of its confreres at foreign central banks), commodity trading advisers (CTAs) and international hedge funds -- the usual fast-money suspects, all looking for a quick double whammy in Canadian bonds: falling interest rates and a rising currency.

These big pools plowed into 10-year Canada bond futures (CGBs) and cash 10-year bonds in, as traders say, size. Futures settle using a basket of real bonds, usually the benchmark that is cheapest to deliver -- in this case, the Canada 4.5-per-cent bond maturing June 1, 2015. The only problem was that the amount of bonds required to settle all those CGB trades was several times the total outstanding of the underlying issue.

This meant that dealers had to borrow bonds in the repo market to make their settlements, and the cost of borrowing the bonds was bid up to extremely high levels, causing a squeeze on those who were short, forcing them to cover by buying bonds, making repo even more expensive and pushing prices still higher. Eventually the hedgers and CTAs started taking profits on the trade, and repo rates eased and everyone relaxed.

There was no skulduggery by the domestic dealers, as The Globe suggested in a Tuesday editorial calling for new regulation of the bond market, and no one attempting to corner the market.

By the way, while there are no rules against trying to corner a market, attempt it at your peril, as the Hunt brothers found out to their considerable chagrin back in the early eighties, when the Chicago Futures Commission abruptly changed the rules in the middle of the game to foil their completely legal attempt to corner silver.

Bond traders make markets in bonds and provide liquidity. That's their function, and it's not their fault that there are giant pools of capital out there looking for illiquid markets to splash around in, although that's a risk they're used to managing. They do a pretty damn good job of it, too, and there's no need for histrionics about shady skulduggery. Get a grip.

Harry Koza,

Sr. Market Analyst,

Thomson Financial,

36 Green Meadow Crescent,

Richmond Hill, Ontario,

L4E 3W7




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