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Liffe Fights Back

The struggling exchange tries to recapture lost Bund business with an innovative new product.

By Robert Hunter

Exchanges have tried their hand at competing directly with the swaps market on a number of occasions over the years—all without much success. Now the London International Financial Futures and Options Exchange, no doubt reeling from the Deutsche Terminborse's lightening-quick usurpation of its franchise German Bund future, is trying a different approach. Instead of trying to beat the OTC market, Liffe has decided to help support it—and take a shot at getting back some of the Bund business it lost to the DTB.

On October 15, Liffe will unveil the Liffe Libor Financed Bond (LiffeLFB), a futures contract geared primarily toward big money-center banks and corporate bond traders. The LiffeLFB is designed to replicate the interest rate sensitivity of a plain vanilla interest rate swap, without reproducing the underlying fixed and floating cash flows inherent in swaps. It will be denominated in Deutsche marks for the December 1998 and March 1999 delivery months, and thereafter in euros. Its two initial maturities—five years and 10 years—target the most liquid area of the swap yield curve.

Liffe is hoping the LiffeLFB will carve out a sizable market niche by appealing to swaps traders and corporate bond issuers who, heretofore, have typically hedged their exposures with German Bunds or Bund futures, which often have similar interest rate sensitivities to interest rate swaps.

Structurally, the product is about as complex as an exchange-traded futures contract can be. The crux: it has all the qualities of a cash-settled bond future, with a single bond in the deliverable basket, as well as the interest rate sensitivity of a swap. The LiffeLFB generates a series of cash flows that replicate the cash flow structure of a notional bond, with annual coupon payments plus a principal payment at expiry. At expiry, the cash flows are discounted based on the International Swaps and Derivatives Association's benchmark swaps rate fixing, displayed on Reuters. Since any change in swap rates will affect the present value of the cash flows, the product effectively captures the interest rate sensitivity of equivalent five- or 10-year interest rate swaps—while eliminating the floating leg.

Why use an LiffeLFB instead of a Bund? The late-summer bond market provides one clear reason. When roiling international equity markets precipitate a flight to quality investments such as U.S. Treasury bonds and German Bunds, the attending market squeeze inevitably creates pricing discrepancies between asset classes—in this case, swaps and corporate bonds vs. government bonds. The LiffeLFB represents an interbank credit rather than AAA-rated sovereign debt, and thus serves as a more appropriate vehicle for many hedgers. “If your exposure is to a corporate bond, which is rated A or at best AA, or to the swaps market, it's better to hedge with a product that more accurately reflects your credit exposure—the LiffeLFB—than to use a product far away from your credit risk, such as a Bund future” says Peter Kästel, senior analyst, product development at Liffe. “The LiffeLFB is mainly an instrument for the interbank market to manage its over-the-counter swap risks and other interest rate risk in its books.”

The Liffe is taking aggressive steps to generate liquidity in the LiffeLFB early on. The most conspicuous: the contract will trade exclusively on its Automated Pit Trader (APT) system until its all-electronic Liffe Connect system goes on-line sometime next year—formally acknowledging the end of the open outcry era and signaling to the DTB that there is still some life left in the Liffe. LiffeLFB traders, moreover, will benefit from a “fee holiday”—the Liffe has waived its 25-pence trade execution fee, so the LiffeLFB will be subject only to a three-pence clearing fee.

“Because of the size of the swaps market in euros and the increasing use of the interest rate swap yield curve as a pricing benchmark for other interest rate products, this has true benchmark potential,” says Robert Alldis, a senior marketing executive at Liffe. The LiffeLFB is aimed at the long end of the euro yield curve as much as the DTB's Bund contract. Will it impinge on the swaps market? Not at all, says Alldis. “When the U.S. Treasury future was first introduced at the Chicago Board of Trade, people in the interbank market wondered what it would mean for the cash market, which was the natural hedging vehicle at the time. But rather than Treasury bond volume going down, there has been a virtuous circle, where increased volume and activity in one market has led to even greater activity in the other. We think that analogy applies to the LiffeLFB and the swaps market.”

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