DT Primers

Dollar Swaps

A FX (forex; foreign exchange) swap is essentially a foreign currency loan secured by domestic currency collateral. You can think of it as an agreement to simultaneously borrow one currency and lend another at an initial date, then exchanging the amounts at maturity. It is useful for risk-free lending, as the swapped amounts are used as collateral for repayment.

There are two legs to every FX swap: first, a spot transaction, where the parties swap amounts of the same value in their respective currencies at the spot rate (exchange rate), and a forward transaction at the predetermined forward rate at maturity. The parties swap amounts again, so that each party receives the currency they loaned and returns the currency they borrowed.

FX swaps are useful for borrowing/lending amounts without taking out a cross-border loan. It also eliminates foreign exchange risk by locking in the forward rate, making the future payment known. Another similar type of swap (a cross-currency basis swap) eliminates interest rate risk.

The FX Swap market is enormous, with estimates of daily dollar-denominated volume around $3.2 trillion. And, as we can see from the fourth image (source), despite global central bank dollar reserves only around 60%, the dollar continues to dominate 88% of all FX transactions – trillions of dollars swapped and exchanged between international banks every day.

Walking that volume back during peacetime would take a slow-bleed over decades.

(If interested, we also have several videos on FX swaps)

Treasury Repo

A repo (short for repurchase) transaction involves the sale of assets with an agreement to buy them back (repurchase) them on a specified future date (usually overnight, o/n) at a prearranged price. Think of it as a cash loan secured by collateral - the pawn shop analogy is accurate.

The exhibits above (source) are very basic models of the dollar flows in repo. The collateral (usually Treasury securities) flow in the opposite direction of cash. Like a pawn shop, the borrower sells his collateral, receives cash, and agrees to repurchase the collateral. If he fails to repurchase the collateral, the lender keeps it: hence, it is a secured loan. Also note that "cash lenders" can include all types of financial entities like the Fed, banks, money funds (MMFs), and asset managers.

The haircut represents the difference between the market value of the securities and the amount of cash or other collateral provided by the borrower. For example, if a Treasury has a market value of $100, and a 5% haircut is applied, the lender will only provide financing up to $95, providing a buffer against potential declines in the value of the collateral. The borrower, however, is expected to repurchase the collateral for $100 (or whatever the market value is).

Reverse repo (RRP) describes the role of the cash lender. The distinction between calling a transaction repo or reverse repo is tenuous, but normally described from the dealer's PoV. For example, dealers will repo (borrow) dollars from cash lenders like money funds, but will reverse repo (lend) those dollars to cash borrowers such as the Fed (at the overnight RRP facility) or hedge funds (on uncleared bilateral).

Repo transactions occur in four different "private" venues, and the differences can seem tenuous but only involve a third-party custodian bank to hold the collateral, and a central clearing service.

The size of dollar repo is estimated to be almost $4 trillion in daily volumes.

(If interested, we also have several videos on repos)

Dollar Funding

On the left is a 2019 schematic of the U.S. dollar funding network. It still exists today in that same form, but volumes have grown significantly larger. It also omits the US stock market which, while not systemically critical, is certainly an example of a dollar market.

Dollar funding means trading (borrowing/lending) in dollar denominated terms. Entering a EUR/USD swap to borrow dollars using euros as collateral, using those dollars to buy Treasury bonds, and then posting said Treasury bonds as collateral to obtain funding in a repo transaction are three different examples of a dollar funding transaction.

It can be thought to mean dollar access since the reality is that most institutions - businesses, banks, and investors - all over the world still prefer to make transactions in dollars.

On the right is a dollar funding chain from a BIS paper dated 2020 depicting a hypothetical cross-border flow of dollars that shows the two largest and most systemically critical funding markets, Treasury repo and dollar FX swaps, which we will examine next.

There's really no Chinese or BRICS equivalent in international scale to the dollar funding markets. As we will emphasize over the next couple posts, daily volumes regularly exceed $10 trillion cumulatively.

Why Dollars?

After helping visualize the exceptional dominance of the US dollar, FedGuy (Joseph Wang) offers a few answers to the question "why?" in this video (taken from our series on the topic here):

• Enormous liquid market. Many foreign financial markets are not as developed (capable) or deep (liquid) as the dollar markets.

Small deposits (up to the $250k FDIC insurance guarantee) are going to be keep in a bank, but larger quantities of capital will instead be parked in assets that can be easily sold for cash and/or borrowed against (i.e. in liquid assets). This is where the importance of well developed markets come into view – usually it requires a deep collateral market, and nothing compares to that for US Treasuries.

It often has little to do with politics, either. Or as little as can be afforded. Remember, these are major financial institutions from all over the world trying to make the most sound decisions possible. It follows that these firms are faced with a "Prisoner's Dilemma", where actually de-coupling from the dollar is only lucrative so long as dozens of other agnostic financial institutions do the same. But with no marginal advantage to do so, nor any political incentive, the result is a sure-fire way towards ostracization.

Other reasons named by Joseph include:

• Need USD for global trade. Most of global trade is conducted in USD, so many foreign businesses need USD even in transactions not involving the US.

• Cheap. Dollar interest rates have been historically low over the past decades, especially in comparison to interest rates in emerging markets (Joseph cites India and Mexico).

• Hedging/Diversification. Borrowers may have revenue in USD that can be hedged with USD debt, or seek to diversify their funding mix.

• Lenders are happy to lend to offshore borrowers because the returns are usually higher and it offers investors an opportunity to diversify their investments.

https://t.me/DTPrimers/98

Implementing Basis Trades

Understanding sources of risk for basis trades and where stress can manifest requires understanding the technical details of how these trades are implemented.

The basis — or the profitability of a cash-futures basis trade — is characterized by the implied repo rate (IRR), which reflects the cost of carrying the security (including financing costs) until the futures contract's expiration.

When the implied repo rate is greater than the actual repo rate, basis traders borrowing in the repo market can profit by buying the cash Treasury and shorting the corresponding futures. At delivery, the trader will earn the spread between the IRR and the repo rate. When the actual repo rate is greater than the implied rate, a "long basis" trade is not profitable.

The IRR is closely related to the yield on a Treasury bill because the cash flows from the basis trade replicate those from a Treasury bill maturing on the futures delivery date.

In particular, in times of relative illiquidity and high balance sheet costs, the implied repo rate has deviated significantly from the rate of return on bills.

One example of these deviations occurred following the collapse of Lehman Brothers in 2008 (see Figure 4 above). Immediately after that collapse, as liquidity dried up in financial markets, implied repo rates collapsed deeply negative across contracts. The IRR decline reflected a flight to safety in Treasury markets.

Because the futures price and the cash price of the Treasury are known to the basis trader, provided he also knows the repo rate, profits on these bets at delivery are guaranteed.

The basis trade does not, however, offer risk-free profits. Several risks threaten the profitability of the basis trade, and thus create potential consequences for financial stability.

5/6

The Cash-Futures Basis Trade

In early 2018, a string of events formed an exploit in America’s sovereign debt market. Following a surge in Treasury issuance and regulatory reforms, asset managers (pension funds, mutual funds, and insurance companies) began to shift out of cash bonds and into long positions of their associated Treasury futures contracts.

A Treasury futures contract is a standardized agreement to buy Treasury securities at a predetermined price on a specified future date. Unlike option derivatives, which provide a right but do not obligate, futures contracts involve a binding obligation to transact on or before the contract matures.

The reason the basis (the difference between the cash Treasury price and the Treasury futures price) exists is because said asset managers began piling into Treasury futures, thus raising the futures' price relative to cash Treasuries. They prefer the futures over cash Treasuries because futures are operationally simpler and have less impact on their expense ratios. Most asset managers are not set up for repo, for example.

The cash-futures basis trade, or simply "the basis trade", is a three-legged arbitrage trade that seeks to exploit the basis, spanning three crucial financial markets: the cash Treasury market, where investors purchase Treasuries today; the Treasury futures market, where investors agree on a fixed price to pay for Treasuries they will receive in the future; and the Treasury repo market, where investors leverage their cash Treasury purchases.

Basis trades buy cash Treasuries and short Treasury futures to construct a payoff that depends on the two prices converging as the delivery date approaches (see Figure 2 in the third image).

This is similar to a long/short equity strategy, and convergence is virtually guaranteed: at the delivery date, cash and futures prices must be equal because otherwise on that date a trader could just buy a Treasury in the cash market and immediately deliver it into the futures market for an instant profit.

Shorting a Treasury futures contract means entering into an agreement to sell the underlying Treasury at a future date and at a predetermined price. It is an obligation.

To "deliver on a futures contract" means to fulfill that obligation by transferring the underlying Treasury to the buyer on the expiration date.

The key is that, so long as futures prices keep rising markedly above the price of their underlying Treasury securities, traders would buy bonds at a discount to what they’d receive when delivering these securities into futures contracts. If the basis were to narrow (or, potentially, invert), the trade would no longer be profitable, and this marginal buyer for Treasuries would vanish.

Only certain futures contracts and Treasury securities are used in basis trading. On any given date, there is just one Treasury security that basis traders want to own for each contract to make a particular deal as profitable as possible, called the “cheapest-to-deliver” Treasury.

The CTD ("cheapest-to-deliver") is simply the Treasury security with the cheapest value that is eligible to be delivered onto a futures contract.

Otherwise-similar Treasuries will differ in whether they are deliverable into a futures contract. A conversion factor attached to the futures price is meant to account for the desirability of individual Treasuries (the CME provides updates on conversion factors).

Due to these conversion factors, only one Treasury will be cheapest-to-deliver into each futures contract. But which that is can change over the life of a contract.

4/6

Repo Financing

The repo market allows for relative value (RV) hedge funds engaged in the cash-futures basis trade to acquire significant leverage, thus generating correspondingly significant demand for cash Treasuries. This is called repo financing, or repo leverage.

For example, a hedge fund who wants to buy $100 in Treasuries can put down $1 of its own money and end up borrowing the remaining $99 in a repo transaction. Here is how that would work:

Step 1: A hedge fund agrees to buy $100 in Treasuries from a bank as part of a basis trade.

Step 2: At the same time, the hedge fund agrees to repo that $100 in Treasuries at a 1% haircut. This means the hedge fund will receive $99 in cash and agree to repurchase the Treasuries for $99.03 tomorrow (the $0.03 is the interest for the overnight loan, the repo rate). Note that the repo trade is a different counterparty than the original seller of the Treasury.

Normally, the hedge fund cannot sell the Treasuries for the full $100 because the dealer will ask for a small haircut to protect itself from any changes in the collateral value.

In the example we're using, the dealer sees Treasury collateral as very stable and is only looking for a 1% haircut (1% of $100, or $1). Note that in some bilateral repo markets, haircuts on Treasuries are nearly 0%, allowing for significant leverage (and risks).

The SEC’s proposal for mandatory repo clearing may reduce Treasury market liquidity by raising the cost of repo financing (haircuts in cleared repo are 2%), making the basis trade increasingly unprofitable.

Step 3: The hedge fund takes the $99 it received in the repo transaction, plus only $1 of its own money, and pays the bank $100 for the cash Treasury. The hedge fund is thus able to buy $100 of Treasuries with just $1 of its own money.

Note that up to this point, these steps should be thought of as occurring simultaneously.

Step 4: The next day the hedge fund is obligated to repurchase the $100 in Treasuries for $99.03, where $0.03 is the interest charged on the overnight loan. The hedge fund can either renew the repo loan or get out of the trade by selling the Treasury to the market for $100 and paying the dealer $99.03 with the proceeds.

With repo leverage, nominal demand for cash Treasuries is magnified.

3/6

Treasury Repo

We've covered what Treasury repo is and how it works, both in text and in a video series, but it's such a crucial piece to the modern financial system that it can't be reiterated enough. Fortunately, it's rather simple.

A repo (short for repurchase) transaction involves the sale of assets (collateral) with an agreement to buy them back (repurchase) on a specified future date (usually the next day) and at a prearranged price. By selling your collateral and agreeing to repurchase it, you are just borrowing cash. There's no need to make it any more confusing than that. The pawn shop analogy is accurate:

For example, at a pawn shop you may "sell" $1000 worth of gold (ex: a gold ring), and accept $950. The reason the pawn shop "dealer" would be willing to lend only $950 for $1000 in collateral is because he knows that gold has been quite volatile lately, and if gold's price were to fall 5% (the collateral value falls to $950) or more, he may lose money on the transaction. The 5% "premium" is called a haircut, and is a layer of insurance.

At the end of the transaction, which in repo is usually the next day, you would purchase the gold back from the dealer for $950 (plus any interest). You could also choose to extend the loan ("roll over the repo").

But in reality, you're not selling the gold item per se, because you're agreeing to repurchase the item back from the dealer at the pawn shop. If you fail to do so, the dealer keeps the collateral — hence it is "secured lending."

While "gold repo" is in theory totally possible, it serves better only as an example. Treasury repo, where Treasury bills/notes/bonds are the collateral, is a daily operation of several trillion dollars, with unreported venues comprising another estimated ~$2 trillion in daily volumes.

The exhibit above is a very basic model of the dollar flows in repo. The collateral (Treasury securities) flow in the opposite direction of cash, obviously. And while there are four major repo venues (Tri-Party repo, GCF & DVP interdealer repo, and uncleared bilateral repo), the only differences are a third-party custodian holding the collateral (in tri-party repo) and whether the transaction is cleared by the FICC (in interdealer repo).

But at the end of the day, a repo is mechanically identical across all venues.

2/6

VIX Gamma Squeeze

VIX (implied volatility on 30-day S&P500 index options) is at March 2020 levels this morning. There are a lot of shops who were shorting vol that have now blown up, so it's a good time to recap some of the mechanics and feedback loops likely driving this:

First recall that options buying drives implied volatility up and thus options prices up, not the other way around. Similarly, options selling drives implied volatility down and thus options prices down.

Gamma measures how quickly the delta of an option changes in response to a one-point move in the underlying, and delta measures the sensitivity of an option's price to changes in the underlying.

In this case, the "underlying" is the S&P500 volatility index (VIX).

The options market, unlike the stock market, is not an exchange. Options traders will buy and sell through market makers (dealers), who then are mandated to hedge out their risk by maintaining delta-neutral positions — this requires dynamically adjusting their holdings of an underlying in response to changes in options prices and movements in said underlying. In this case, the underlying is VIX.

To illustrate this, think of a micro example;

Let's say a dealer is short 10 out-of-the-money (OTM) VIX call options with a position delta of -20 each. This means the dealer has a net short position of -200 shares (10 options * -20 delta each) and so, in order to remain delta neutral, will buy +200 shares of the VIX.

Now, if there's a sudden unexpected increase in the price of the VIX, the delta of the calls will become more positive. This means that the dealer's position delta will become more negative (he sold the calls), leading him to buy more VIX to delta hedge against the rising delta. The dealer bid under VIX contributes to further price increase, and as these call options (which were initially OTM) pick up moneyness, they will move closer to at-the-money where they pick up delta most rapidly — at peak gamma.

As the price of the underlying (VIX) rises, more call options move further in the money, leading to more dealer delta hedging and more buying of those options. Also, as more VIX is bought to hedge, the upward momentum is amplified, creating a positive feedback loop known as a gamma squeeze.

At a certain point, the volatility shorts (namely short vol ETFs) would in theory become overwhelmed and quickly puke the trade.

Beta-Adjusted

Net exposure by itself is insufficient to analyze a portfolio’s risk because it neglects the different sensitivity of each position to market changes. A portfolio may consist of positions with a strong sensitivity to market changes (i.e., high-beta securities) whose weight in the portfolio is incomparable to the weight of more defensive securities (i.e., low-beta securities). Hence, introducing a more precise indicator of portfolio sensitivity to market moves is necessary.

Remember, beta measures the sensitivity of an individual stock's returns against a benchmark, typically an index like S&P500. For example, a stock with a beta of 1.5 is expected to move 1.5 times more than the benchmark. A stock with a beta of 0.8 is expected to move 0.8 times less than the benchmark.

Net exposure may be equal to zero, but the beta-adjusted exposure might not Net exposure is a static measure, while the beta-adjusted net exposure indicates the net market exposure considering the sensitivity of each portfolio position to the reference equity market.

For example, consider a fund with $80M long exposure and $40M short exposure (in the first image above). The net exposure of the fund is 80 − 40 = +40. If instead the beta of the long position is 0.5 and the beta of the short position is 1.5, the beta-adjusted net exposure equal to 80 * (0.5) − 40 * (1.5) = –20. Having a net exposure is equal to +40 and a beta-adjusted exposure of −20 is surprising.

Adjusting to beta is the key to hedging out market risk using L/S, especially within a sector. A neutral portfolio according to the beta-adjusted net exposure may not be neutral regarding sectors. Hence, the need exists to monitor the beta adjusted net exposure of each single sector comprising the portfolio.