Informist, Wednesday, Feb 22, 2023
By Aaryan Khanna and Shubham Rana
NEW DELHI - The Clearing Corp of India Ltd is looking to provide overnight indexed swap traders with a more convenient way to bet on a change in term spreads, or the difference in market rates, across any two maturities.
CCIL has started pilot testing a new feature for its OIS trading platform that will allow traders to execute term spread trades in a single click, officials from multiple financial institutions involved in the project said.
In a term spread trade, a trader pays fixed rates in a certain tenure and receives fixed rates in another, placing a bet on the movement of the overnight rates between the two. Market participants use spread trades to place bets on the trajectory of overnight rates between any two fixed points of time, allowing them to take advantage of any perceived distortions in interest rate swap curve.
In a move to develop this market, CCIL rolled out the new system called "Neutral Spread Trading" on Feb 13 on a mock basis in conjunction with its Anonymous System for Trading in Rupee OTC (over-the-counter) Interest Rate Derivatives or 'ASTROID' platform.
Although, currently there is no impediment to executing spread trades on ASTROID, such trades have to be executed as two separate opposite transactions in the maturity segments marking the term spread. Such trades also require monitoring the absolute level of swap rates in each of the maturities to achieve the desired spread to execute or unwind the trade.
With the new system introduced by the CCIL, traders may no longer need to monitor absolute levels for any contract and can simply quote a spread, in basis points, between two tenures. Trades are executed instantaneously when the difference between swap rates of the segments reaches the targeted level, dealers said.
Since the two trades will be instantaneous under the new system, the risk of market levels fluctuating between the two trades is minimised.
"There is enough of a market that trades in spreads, and the (new) spreads screen speaks to the main screen on ASTROID, making the trade pretty convenient," a dealer at a primary dealership said.
The underlying bid and ask levels are taken from quotes on the 'ASTROID' platform, and participants in the ongoing pilot can test the new system without the trades actually going through on their books.
While the Neutral Spread Trading feature makes execution of spread trades more convenient, it doesn't add any new functionality to the OIS market. Some dealers speculated that settlement costs may come down as the transactions would decrease from two to one, but were unsure whether that would take place until further development of the pilot.
"It's a good quality of life improvement, just because I won't have to run two separate trades on my book and can just call it a spread call," a dealer at another primary dealership said.
The clearing house is looking to push the pilot to a live environment soon, implying that the trades will go through on a real-time basis amongst a select market players, once the mock pilot has shown the intended results, market participants said.
PRACTICAL APPLICATION
Term spread trades are useful when market participants want to bet on a specific trajectory of interest rates, and not just their immediate or broad direction. For instance, as the Monetary Policy Committee is currently seen nearing the end of its rate hike cycle, most traders see domestic interest rates peaking out soon but have ruled out a rate cut in the next 12 months based on the Reserve Bank of India's repeated warnings about sticky inflation.
In such a scenario, dealers have placed spread trades in the one-year segment and receiving fixed rates in the two-year segment, expressing a view that although interest rates may stay high in the one-year horizon, the consequent fall in inflation and a likely slowdown in growth may prompt rate cuts thereafter.
Common parlance for spread trades includes two popular types – flatteners and steepeners. A flattener entails paying fixed rates on short-duration swaps and receiving fixed rates in longer tenures with an aim to profit when the spread between the two eventually decreases –effectively flattening the yield curve.
Flatteners are often in favour late in the rate hike cycles when interest rates are seen moving up in the short term, but concerns over economic growth play out for the longer term. With the Monetary Policy Committee's sharp 250-bps rate hike since May, the OIS yield curve is deeply inverted with swaps maturing in up to one year being quoted at much higher rates than those of longer maturities.
A "steepener" trade is the exact opposite, with the trader receiving short-term swap rates and paying fixed rates in long-term contracts, often in a falling interest rate scenario. Typically, the OIS yield curve is upward sloping. End
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