Bond Futures Industry Debates Steps to Protect It From ‘Fails’

Key players in the bond futures industry are at odds over what steps, if any, should be taken to avoid a repeat of a situation in June that saw a large imbalance in supply and demand for a particular Treasury security used to settle futures trades.

The Chicago Board of Trade, a major trading venue for Treasury bond futures, said Thursday that limits it imposed on bond futures holdings in the wake of the June market disturbance were a “prudent and proactive” response to concerns that the problem could arise again.

But the Futures Industry Assn. is urging the exchange to rescind the limits for investors who use the futures contracts to hedge, or guard against losses in, their bond portfolios.

“There has been no indication that Treasury bond or note deliveries have either caused or exacerbated any market dislocations,” the association said in a recent letter to the Board of Trade.

The trouble in June revolved around scant supplies of the 10-year Treasury note that was cheapest to deliver against expiring bond futures. That set off a scramble to get the bond. Some traders’ inability to find securities -- or unwillingness to pay the prices sellers were demanding -- triggered “fails,” costing the traders hundreds of millions of dollars in penalty costs, by some analysts’ estimates.

Newport Beach-based bond investment giant Pacific Investment Management Co. is believed to have been a major player in the expiring futures contract, raising questions about whether it encouraged a so-called squeeze on bond supplies, driving prices up.

But on CNBC on Tuesday, Bill Gross, Pimco’s investment chief, gave an “unequivocal” denial that the firm had tried to orchestrate a squeeze.

The Board of Trade, responding Thursday to the futures association’s letter, said its new limits on trading positions were established “for the purpose of reducing the potential threat of market manipulation, congestion or price distortions.”

Starting in December, traders will be limited to holding $2.5 billion of 30-year bond contracts, $5 billion of 10-year note contracts, $3.5 billion of five-year note contracts and $5 billion of two-year note contracts in the last 10 days of a contract’s life.

In the meantime, the Treasury futures contract expiring in September could trigger the same kind of scramble that was set off in June, analysts have warned.

The U.S. Treasury’s top domestic finance official said Thursday that the Treasury was keen on addressing potential structural changes in the bond market that may increase the incidence of failed trades.

Treasury Undersecretary Randal Quarles said the question of whether there was wrongdoing during the June trading was of secondary importance.

“We think that the larger question is whether there have been changes in the way that markets operate, and particularly the derivatives market ... relative to the underlying stock of security that for structural reasons increases the likelihood of fails,” Quarles told Bloomberg television.

The Treasury last week proposed creating a lending facility to help boost liquidity in the Treasury market, which could lessen the number of failed trades.