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Market Liquidity

Potential flaws in derivative markets:

FT.com / Home UK - On Wall Street: Derivatives cannot take the pressure: By John Dizard: The recent difficulties settling futures contracts in Chicago have highlighted a growing problem: there are big derivatives markets out there that aren't built to take the strain being put on them.... In June, some large holders of the June 10-year Treasury futures contract, including Pimco, demanded settlement -- taking delivery of actual bonds -- instead of, as usual, rolling their positions into the next contract. The scramble to find the necessary notes was made worse by the fact that one account, possibly the hedge fund Citadel, already held the bulk of the cheapest notes to deliver.

Whether or not Citadel, or Pimco's bond dealers, intended to make some extra money by squeezing out other bidders, it couldn't have happened if the structure of the futures contract had kept up with the times. The Chicago Board of Trade's 10-year T-note futures contract is one of the older financial derivatives around today. That's good, in that it has been tested through a range of crises and cycles, and it's bad because it was designed based on the classic requirements of grain dealers, rather than the current requirements of interest rate markets....

The 10-year futures contract is based on a theoretical Treasury note that doesn't exist... the CBOT have formulas to convert the value of existing Treasuries into the theoretical ones. For example, the cheapest bond to deliver to settle the current September contract is the August 2012 bond. So you are really getting delivery of, and contracts are priced from, the seven-year stuff rather than 10-year stuff.... There is now about eight times the number of outstanding futures contracts as bonds eligible and available to fulfil them.

The obvious solution is to go to cash settlement. That would mean the exchange changing the terms of the 10-year contract, so that actual bonds would not be delivered. Instead, those now obliged to deliver would make cash payments equal to the value of a reference price. That is how Fed funds futures contracts are settled....

The real problem is that the US economy is just too leveraged. Starting with the housing industry, the country is too dependent on derivatives markets to create the illusion that interest rate risk can be conjured away. The technical problems of the 10-year are just another early warning sign of this fundamental weakness.

I don't know enough to know whether this is a serious issue or not.

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