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Official Intervention In The ‘Specials’

Julian D. A. Wiseman

Abstract: Individual government debt securities are sometimes subject to a ‘squeeze’, in which the security becomes very expensive to borrow. This can be caused by one or some market participants gaining control of most of one security, allowing these participants to extract a ‘monopoly rent’ from others. This is a description of a repo-switch mechanism which would enhance the efficiency of government debt markets by deterring would-be squeezers.

Publication history: This document closely follows the text of a letter sent to the Bank of England on 15th August 1996. This letter was sent in the professional capacity of the author, as an employee of a Gilt-Edged Market Maker. Variants of this letter were subsequently discussed with other government issuers. Usual disclaimer and copyright terms apply.

Official Intervention In The ‘Specials’

[The letter opened by saying that “Recent market behaviour has re-raised the question of the possibility of official intervention to alleviate tightness in the repo market in some specific stocks” — no less true in early 1999 than in Autumn 1996. It continued by discussing my then employer’s position in one of Europe’s less liquid strip markets. My then employer was long a particular long-dated principal strip. The most obvious hedge would have been to sell this holding — but that strip market was so illiquid that this was near-impossible for a price-maker. An alternative would have been to borrow the coupon strips, reconstitute and sell the whole bond; separately hedging the short position in the circa 10-year duration coupon stream. But the repo market in the coupon strips was so thin as to make this impossible. So instead the long position was hedged with a short position in the bond. The long of the principal was funded at GC, and the short of the bond between 60bp and 1% special, costing a fortune in carry every month, and deterring my then employer from offering to an investor any coupon strip which required stripping more of that bond. Indeed, my then employer suspected that the one other price-maker in that strip market was in a similar position. The introduction concluded by saying that the absence of reliable repo in strips explained — at least in part — why the strip market in that country had failed.]

… Hence we urge the Bank of England to consider a mechanism to prevent excessive squeezes, corners or stock-specific tightness in the gilt repo market. To which issues should this apply? It must apply to coupon strips because of their small size. Currently plans [subsequently realised] envisage coupon strips being identical to principal strips in tax treatment and creditworthiness, and there seems to be no advantage in breaking symmetry here. So such an intervention mechanism would also apply to principals, and therefore, to reduce the administrative burden, to strippable gilts. Given a suitable mechanism — which is given below — we see only advantages in extending the facility to non-strippables and non-conventionals. The Bank might wish to exclude those stocks which are so small that the Gilt-Edged Market Makers are not obliged to make markets in them. We reserve judgment on whether this facility should be extended to T-bills, at least until after the Bank has published its forthcoming consultative document on money-market reform. [Having seen both the Bank’s plans, and the modifications thereto to be implemented by the UK Debt Management Office, the facility should be so extended.]

Currently [in August 1996], with many domestic investors not geared up for repo, such a facility might be used extensively. But over time use of this facility will become less frequent. One should note that even if it is only rarely used, the very presence of the facility will help ensure an orderly repo market.

What properties should an intervention mechanism have?

So how can this be done? We favour the following:

This does assume, hopefully not too optimistically, that the Treasury would be willing to give the Bank carte blanche to create temporarily unlimited amounts of stocks and strips for market management purposes. We defer to the Bank’s expertise as to whether or not this would cause accounting or legal complications.

This facility provides a transparent combination of uncertainty and reassurance. During the morning market-makers know that they can access stock between 100bp and 200bp special, but do not know the exact price at which the assistance will be provided. Thus repo-trading in near-squeeze issues will continue. But because the price is decided by the street rather than the Bank, it is signal-free. Further, the Bank will run this facility at a profit!

This facility would significantly increase the probability that the gilt strip market achieves sustainable liquidity.

[Excepting the substitution of “the Debt Management Office” for “the Bank”, the author still believes this to be an excellent recommendation.]

Julian D. A. Wiseman, August 1996 and April 1999

[Postscript: On Friday 17th September 1999 the UK’s Debt Management Office published a paper (local copy) seeking comment from market participants on a possible non-discretionary special repo facility, to which a reply was sent on 20th September 1999. On 22nd February 2000 the DMO published a “Response to DMO Consultation Document on ‘Special’ Gilt Repo Operations” (local copy), announcing the introduction of such a non-discretionary repo switch facility; see also this author's commentary on the DMO's February 2000 decision.]

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