Op risk taxonomy, a Euribor futures spike and Sonia swaptions

Dealers dip toe into Sonia swaptions market

NatWest and HSBC print trades, Barclays offers prices

New op risk taxonomy set for October debut

Project is being closely watched by banks and regulators amid frustrations with legacy Basel approach

Euribor futures spread spike strangles prop traders

Safe-haven butterfly trades savaged by shock divergence in mid-term contracts

COMMENTARY: The price of liquidity

It hasn’t been the calmest few years for the European rates market, but at least the big market structure issue – how to manage the transition away from Euribor to its replacement benchmark rate, whenever and however that may occur – is one that can be dealt with carefully and with plenty of time for thought. Meanwhile, in the market itself, liquidity remains high and proven low-risk trades such as butterfly trades (sell a short-dated and a long-dated future, and buy two intermediate ones) and their relatives remain low-risk, low-cost ways of playing on small intraday variations in the yield curve.

That, at least, was the plan. But on July 24, in just 15 minutes in the early evening, prices on two Ice Clear Europe-traded Euribor futures at the heart of many butterfly trades leapt 55 basis points apart – having almost never diverged more than a couple of points – and then rejoined each other as quickly as they had diverged. 

The unprecedented move, ironically, caused most damage to the conscientious, one trader said: still in his office at 6:42pm London time, he responded to the divergence by cutting his positions at a loss. But the rebound followed so quickly that “if you were on holiday or in the pub, it was so quick you wouldn’t even have noticed”.

‘Flash crash’ is the first reaction from a lot of market observers. And that sounds plausible enough, as it does for any extreme market movement without an obvious cause. But not so fast, others say: the sudden move could be the result of a massive trade put on during normal business hours in Chicago (six hours behind London) anticipating a rates decision from the European Central Bank the next day.

There’s no way yet to know for sure. And, in one sense, it doesn’t matter whether the July spike was the result of a badly written trading algorithm, a fat-finger error, a Chicago hedge fund taking a huge punt on the next day’s news, or an errant cosmic ray. The bigger issue is the dilemma of volume or quality: should Ice and its fellow exchanges fling open their doors for as long as possible, bringing volume and tight spreads at the expense of creating a possibly volatile market dominated out of hours by fast algorithms? Or the alternative, as one trader puts it: “Exchanges need to encourage more quality participants, and the only way they can do that is by turning down the dial of the high-frequency traders, which means cutting the hours and slowing things down.”

It’s perhaps a little cynical to say the choice is obvious – that traders (and therefore exchanges) will always choose to pick up nickels in front of steamrollers, and accept occasional disaster as the cost of slightly better pricing. But it’s certainly the way these markets have conducted their expansion so far – and it’s likely that change will only come after a far larger blowup than occurred in July.

STAT OF THE WEEK

Rabobank slipped back in its efforts to meet its bail-in capital buffer requirement over the first half of this year, despite issuing more eligible debt. The ratio of qualifying capital and debt for meeting minimum requirements for eligible liabilities (MREL) to risk-weighted assets dropped to 27.8% at end-June, from 28.2% six months prior at the Dutch lender. Its regulatory requirement for 2019 is 28.58%.

QUOTE OF THE WEEK

“We know some of the largest institutions in London, they perform tens if not hundreds of thousands of these lifecycle events in total on a weekly basis. So having legal uncertainty or an inability to perform lifecycle events when lots of other things are going on and there is lots of volatility – which would happen with a no-deal Brexit in our view – is not sensible. You can debate the scale of the risks, but it is just not a sensible risk to take” – Mark Carney, Bank of England