U.S. Treasury Floating Rate Note Based On A Repo Index

Background

The Treasury Department is considering the issuance of a Floating Rate Note (FRN). This topic was brought up before and I now expect a FRN U.S. Treasury will become a reality. The Treasury is soliciting comments about the new issue to be submitted by January 22, 2013.

I believe such an FRN will be extremely good for the overall Treasury market, allowing another tool for the trading of floating rates, especially since the recent LIBOR scandal has partially undermined that integrity of that market. If the FRN Treasury is based on Repo rates, it will further the development of the Repo market, creating an official Repo floating rate index.

The Treasury is considering two floating rate indexes:  1. the 3 month T-Bill auction stop out rate; 2. an overnight general collateral (GC) Repo rate. Earlier this year when they discussed the subject, LIBOR was also mentioned, but that rate is out of the running now, for obvious reasons.

Problems With The T-Bill Index Rate

There is no doubt that the Repo rate is, by far, the best and most representative rate for the Treasury market. First, there are a number of issues which prevent the T-Bill rate from being a serious alternative. The T-Bill auction stop-out rate is currently a weekly index, which, from the start means there are problems changing, modifying, and maintaining it as an overnight index rate. Second, hence its name, it’s a “bill” rate which represents the bill market, not the overall Treasury market which includes Notes and Bonds. T-Bill rates are the specific to the prices of bills, and that market has its own supply and demand dynamics, which is somewhat different from that of Notes and Bonds. Third, T-Bills are highly susceptible to a flight-to-quality premium during a time of crisis, and that would cause a severe distortion in the index for certain periods of time. Fourth, T-Bill rates experience the largest quarter-end and year-end price distortions due to “window dressing.” Oops, I forgot that this is not supposed to exist, so ignore the last reason against T-Bills.

Repo Rates

General collateral Repo rates are the most representative of the overall treasury market. The Repo market is the largest financial market in the world – according the Fed economists there is between $4 and $5 trillion outstanding Repo in the U.S. The GC rate specifically represents the overnight supply and demand for U.S. Treasurys, including Bills, Notes, and Bonds. If the FRN U.S. Treasury is based on U.S. Treasury credit, no other overnight rate will do a better job.

With the T-Bill rate a non-contender, it doesn’t mean the choice of a Repo rate becomes easy. There is currently no overnight Repo index rate which truly reflects the daily performance of the entire Repo market. There is an existing index, the DTCC GCF Index, but that has drawbacks. So, the next question is whether to use the existing DTCC GCF index which is already published or create a new official index out of the Repo rates unofficially published by the individual Repo brokers.

One good thing about the DTCC GCF index is that it already exists and even has a futures contract, traded on NYSE Liffe, based on it’s rates. However, there still are problems with it’s calculation. Since it’s based on “GCF” rates, it reflects equivalent of “tri-party” for U.S. Treasurys which settle and clear in Fixed Income Clearing Corp (FICC). Much of the volume credited to this index is generated from mortgage-backed securities GCF trades. Given that, GCF therefore only represents a segment of the Repo market. On top of that, GCF rates tend to trade about 1 to 2 basis points higher than the equivalent GC rate. As I said, the DTCC GCF rate is a contender and it’s certainly better than the T-Bill rate stop-out rate, but it’s not the best rate to represent the overall Repo market.

The Solution

The solution is to create an overnight Repo index which represents the entire GC Repo market. This would require compiling all the GC rates which are unofficially published by the Repo brokers. The broker averages are not centralized, they are delivered individually by email or Bloomberg message at the end of each morning. The BrokerTec averages are, by far, the most important rates with the largest volume traded each day. However, for GC, BrokerTec is still not a representation of the whole market.

The next question is which specific GC rates to include. A variety to GC rates trade each day, based on the underlying collateral. These include: TIPS, Notes/Bills, Bond collateral, Bill collateral, under 2 year maturities, etc. A true Broker Average Market (BAM) should take all the GC averages into account from all the brokers and it should be weighted by dollar volume. That way, there is a true overnight index rate which represents all U.S. Treasurys. This methodology would be the best representation of the entire Repo market and the best overnight rate to use for the U.S. Treasury.