Canada benchmark shaken by T+1 hedge fund influx

Shortened settlement cycle swept hedge fund trades into Corra, making the rate more volatile

A seemingly structural jump in Canada’s main overnight funding rate – which has remained above the central bank’s target level since May – is raising questions about the country’s benchmark reforms.   

The Canadian overnight repo rate average, or Corra, became the country’s main interest rate benchmark following the discontinuation of the Canadian dollar offered rate (CDOR) at the end of June.

Corra tracks the cost of eligible overnight repo transactions, which averaged C$21.6 billion ($15.4 billion) per day in the first half of 2024. Those volumes have more than doubled since the May 27 switch to T+1 settlement for government bonds, which swept billions of dollars of hedge fund repo trades into the overnight market. 

“The volume concern was always a big one for Corra and now you’ve done this T+1 shift you have more volume, but the majority is coming from hedge funds,” says Tiago Figueiredo, macro strategist at Desjardins Group, which operates the largest network of credit unions in Canada. “It means changes in Corra might not be a reflection of excess reserves but other factors that are driving it, and that’s something we have to adapt to.”

The Bank of Canada (BoC) estimates the T+1 switch has added 3 basis points to the rate. The central bank has boosted its overnight repo operations in a bid to return Corra to its target rate – to little effect. On November 7, Corra was quoted at 3.8% – some 5bp above the 3.75% target rate.

The additional volatility introduced by the inclusion of hedge funds’ trades – which often have higher funding costs and tend to skew one way – in the calculation of the rate has unnerved some in the market.

“There’s this extra factor you need to take account of when taking positions with respect to [central] bank policy that have nothing to do with the bank cutting or hiking. It adds an extra layer of uncertainty, which is somewhat of a negative for investors and might make people more reluctant to get involved, because it’s not as pure as it should be,” says Benjamin Reitzes, interest rates strategist at BMO.

Others worry recent developments have exposed more fundamental flaws in the benchmark. “Maybe Corra in the current form isn’t really doing as it should. Maybe it’s not the best metric,” says Desjardins Group’s Figueiredo.

The BoC and the Corra Advisory Group are expected to consider various changes to the benchmark methodology – including changes to the eligibility criteria and trimming mechanisms – as part of a regular five-year review of the rate scheduled for next year.

Other Libor replacement rates have seen post-transition methodology changes. In July, the Federal Reserve Bank of New York proposed revising the methodology for calculating the secured overnight financing rate to minimise the effect of so-called specials – collateral that trades significantly above or below prevailing market rates. The changes will be incorporated into the benchmark from November 25.

Risk free, with extra volatility

The overnight repo market in Canada saw a sudden influx of hedge funds following the May 27 shift to T+1 settlement.

These firms previously funded their long cash bond positions in the so-called tomorrow/next market, where the closing leg settles at T+2. The Canadian Alternative Reference Rate Working Group (Carr), which helped develop the methodology for Corra, explicitly excluded these trades from the calculation.

The overnight repo market underpinning Corra has historically been the preserve of dealers, who use it for general collateral funding. This kept a lid on volatility. Hedge funds typically used the tomorrow-next market to finance specific collateral – often, cheapest-to-deliver bonds or special securities with funding costs higher than the central bank’s target rate. The move to T+1 has flipped most of this activity to the overnight market, with tomorrow-next volumes plummeting by a similar magnitude.

For now, there’s a bit more volatility and you’re going to pay for that

Benjamin Reitzes, BMO

That, in turn, has made Corra more volatile. Hedge funds are currently net long Canadian government bonds, mostly through steepeners and basis trades. This has put upwards pressure on the repo rate. But hedge fund positioning can easily turn on a dime, pushing Corra in the opposite direction.

“These hedge fund trades are cyclical. There’s lots of demand for steepeners going into the rate-cutting cycle, but once that changes, it’s not crazy to think that if you put on flatteners, you could end up having excess cash, so these funds could – in theory – be putting downward pressure on Corra,” says Figueiredo.

Analysts at the BoC agree that hedge fund positioning could have a major impact on Corra, noting that if the move to T+1 had happened in the second half of 2023, it likely would have pushed the benchmark lower due to net short positioning at that time. The result, they conclude, is likely to be higher volatility. “Further shifts from tomorrow-next to overnight along with the skew will likely make Corra more volatile than it was in the past,” the BoC analysts wrote in an August report. 

While some volatility is conducive to trading – particularly in futures linked to the benchmark – market sources say it is already above a healthy level.

“You want a bit of volatility in these measures – within reason – because you want them to provide some information. You don’t want to get stuck at the overnight rate as then it’s a useless measure, but maybe this is a case where there’s just too much volatility,” says Figueiredo.

BMO’s Reitzes says higher volatility will translate to more costs for market participants. “For now, there’s a bit more volatility and you’re going to pay for that,” he says. “You need to pay for that risk and it depends on how much volatility there is. If you remain steady at some level above the policy rate, the cost doesn’t have to be that much but if we see lots of movement then you’re going to have to pay for that uncertainty.”

Others are more sanguine. “It’s a small change within the broader scheme and the bank seems able to keep thinks relatively close to target, if not exactly at target,” says Andrew Munn, head of CanDeal Benchmark Administration Services, which administrates term Corra benchmarks, while its data and analytics unit, DNA, publishes consensus Corra swaps pricing. 

“I think people understand these small variations are not due to changes in monetary policy – they’re changes of supply and demand of securities and cash,” he says.

Reitzes, though, argues the T+1 shift is just one factor in Corra’s persistent divergence from the target rate. While Bank of Canada analysis shows a distinct increase in the rate since the move to T+1, Corra has persistently traded above its target rate since late 2023, with the central bank having to intervene regularly to maintain the rate within 5bp of the bank target.

“Some of this is just an insufficient amount of liquidity in the market. Part of that is where the liquidity is – some banks have enough while others don’t and that imbalance is helping push Corra higher, plus the T+1 issue is in there as well,” says Reitzes.

Sailing into the sunset

After overnight repo volumes tripled in June, the BoC raised its limits on overnight repo operations from C$5 billion aggregate with a C$1 billion dealer cap to C$8 billion aggregate with a C$3 billion dealer cap. On October 24, the central bank further raised the ceiling by deeming C$8 billion a minimum offer amount.

Many in the market are hoping for a more permanent solution.

This could be hammered out as part of the upcoming sunset review of Corra, which will get underway next year. It is understood this will include discussion around eligible trades and trimming methodology as well as other structural issues, such as the development of Canada’s triparty system.

Excluding hedge fund trades from the calculation could be one way to address the problem, though there is some resistance to ignoring legitimate funding activity.

One of the solutions is publishing more information on the distribution

Tiago Figueiredo, Desjardins Group

“You could exclude those, but technically those funds are funding at the overnight rate. Even if the majority of activity is coming from these funds now, it’s something that’s happening,” says Figueiredo, adding any major revamp of the rate could be a messy affair. 

A third rates analyst says excluding hedge funds trades should be a last resort: “Some people say it’s a problem, but it is the true cost of funding right now. It’s important to understand the underlying mechanics and through the sunset review, perhaps there are changes at the margin that might improve the calculation.”

CanDeal’s Munn says any exclusions from the calculation would likely come in the form of revisions to trimming methodology to eliminate more outlier transactions.

“The objective would not be to eliminate any parties or their activity because a market is made up of many different players doing different things,” he says. “Rather, it’s about what is the appropriate trimming or fine-tuning of trade data.”

Figueiredo also wants the BoC to provide more transparency on the input data used to calculate Corra. Currently, the central bank publishes a median rate as well as the 5^th, 25^th, 75^th and 95^th percentiles of trimmed trading volume.

“One of the solutions is publishing more information on the distribution to help us decipher what’s driving the moves. Ironically, Corra is an average, but they publish a median. I think the average would help as you get a bit more information on the skew,” says Figueiredo. “If we know a bit more about the distribution and what’s driving it, maybe we can live with a bit more volatility in the Corra rate.”

Publishing a mean could open the door for the rate to be published beyond its current two decimal places, which could help increase liquidity in Corra futures, proponents argue.

Related

Why Canada may need to revisit term Corra methodology 

Canada looks beyond bankers’ acceptance market in rate reform 

“More transparency would be useful and help increase activity in futures by creating a more interesting arbitrage on overnight versus the one-month future,” says Munn. “If you are betting on how the future settles versus how Corra settles, if there’s an extra half or quarter of a basis point flipping around, you might be able to have a better arbitrage for holding it. You’d need to hold it for the whole month, but if you’re trading in large amounts, that half basis point makes a difference.”

While three-month Corra futures traded on TMX are liquid with open interest of 1.3 million contracts, one-month versions have struggled to gain traction with just over 500 contracts of open interest.

Increased transparency is understood to be under consideration in the Corra review, though some warn it is a double-edged sword.

“It would be nice to have the whole distribution, but too much transparency is negative for the benchmark as there’s more scope for manipulation,” says the third rates analyst.

“There are some metrics that could help people understand the gap risk present on the distribution – for example publication of the mean and mode with the median. Then you can see where things are moving and the direction of the skew,” this person adds. 

Most participants warn against a more aggressive overhaul of Corra, noting its predecessor CDOR regularly traded at a wide and unpredictable spread to the bank target rate.

“It was harder to predict what CDOR would do. Corra is a bit more predictable and still [has] much less volatility. You can better understand what’s happening, even when it moves away from target,” says Reitzes.

A spokesperson for the Bank of Canada and the Corra Advisory Group declined to comment.

Editing by Kris Devasabai