January 6th, 2009 6:51 pm | by John Jansen |

Yesterday I posted the release from the Treasury Market Practices Group and its suggestions for a solution to the fail problem and a timeline for implementation of those suggested reforms.

I think that a very succinct summary is that if you are delivering securities versus payment , you will be charged 3 percent if you fail to make timely delivery.

I spoke with several traders today who suggest that the new rule would impair rather than improve market liquidity. It would virtually destroy relative value trading as a trader will not want to short an issue for fear of getting caught in this 3 percent trap.

One trader suggested that the Treasury could solve the problem with larger issue sizes. The current 10 year note will be over $50billion dollars strong following the auction Thursday. He suggested that the Treasury should make reopening the standard practice for all benchmark issues.

I believe the last 2 year note issue was $38 billion. In this traders view the Treasury should reopen that issue at the end of January and make the issue a $76 billion behemoth. It is unlikely that there would be many fails in an issue that size.

This idea would apply to all of the benchmark issue.

Additionally, the Treasury could become more aggressive in reopening off the run issues. Last year when the fail issue first surfaced the Treasury responded by reopening four issues in the 7year through 10 year part of the curve. I recall that on one afternoon they gave the dealers about one hour to set up for $20billion of issuance.

That temporarily put the fear of God in traders and repo desks and alleviated the problem for a time.

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  1. 6 Responses to “FAILS”

  2. By GP on Jan 6, 2009 | Reply

    It will be interesting to see what effect this has on MBS and IRS trading desks as their trading models generally assume you can be infinitely short treasury hedges.
    It also seems to me that it might encourage sinister players to create short squeezes.

  3. By Bond Girl on Jan 6, 2009 | Reply

    Larger issues seems like such an obvious solution to this problem.

  4. By jonathan Kurtzman on Jan 6, 2009 | Reply

    Why should Treasury care about shorts getting squeezed when the game now encourages fails? Why should Treasury need to reopen issues to address recurring fails? Why not say: people will adjust to a charge and if that constricts one investment opportunity then so be it. Life is full of choices. I can’t tell you how many times I’ve looked at a deal and said the numbers don’t work.

  5. By Ettaroo on Jan 6, 2009 | Reply

    how will this new rule affect the nascent credit rally? Will this keep relative value players from playing the spread tightening between government bonds and corporate bonds?

  6. By Joe on Jan 7, 2009 | Reply

    Someone is complaining that $38b issues aren’t big enough? Restrain me or I’ll fall on the floor I’m laughing so hard.

    These secret-handshake traders want the ability to naked short an issue, and then complain that the issuer didn’t make it big enough for their shorting. Perhaps, if I drive off a cliff, I will compain that God didn’t make the cliff long enough for my excessive speeding.

    I’ll take jonathan’s point one step further: not only should the Treasury not care about a proposal that would prevent shorts getting squeezed, I think Treasury should oppose this. I’d favor reopenings except reopenings almost always do a hair worse than new issue auctions. So this proposal protects the hedge funds _at the expense of the taxpayer_.

    OTOH, I completely agree with the second part of the proposal. Reopening off the run issues is simple logic: You want the amount of outstanding 6, 7, 8, 9, 10 yr. notes about equal. (Because a lot of buyers are insurance companies or pension funds that have a nearly continuous outflow to protect.) You don’t want a huge bubble at the 10 year that takes 5 years to work through the curve.

    Plus, as John wrote in another thread, you don’t want a huge issue coming due all at once in 10 years.

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